Which of the following is a reason companies use adjusting journal entries for prepaid expenses?

• A. To correct errors made in previous accounting periods
• B. To allocate the cost of prepaid expenses to the periods in which they are used
• C. To recognize revenue when cash is received
• D. To record cash received from customers in advance

Answer: (B)

Verified step by step guidance

1. Understand the concept of prepaid expenses: Prepaid expenses are payments made in advance for goods or services that will be consumed or used in future accounting periods. Examples include prepaid rent, insurance, or subscriptions.
2. Recognize the purpose of adjusting journal entries: Adjusting entries are made at the end of an accounting period to ensure that revenues and expenses are recognized in the correct period, following the accrual basis of accounting.
3. Identify why prepaid expenses require adjustment: Prepaid expenses initially appear as assets on the balance sheet because they represent future economic benefits. As the benefits are consumed or used, the cost must be allocated to the appropriate period as an expense.
4. Determine the adjustment process: To allocate the cost of prepaid expenses, an adjusting journal entry is made to decrease the prepaid expense account (asset) and increase the corresponding expense account. This ensures accurate representation of expenses in the income statement.
5. Relate the adjustment to the options provided: The correct reason for adjusting prepaid expenses is 'To allocate the cost of prepaid expenses to the periods in which they are used,' as this aligns with the accrual accounting principle of matching expenses to the period they benefit.