Which one of the following is a true statement regarding prepayment penalties in the context of revenue and expense recognition?

• A. Prepayment penalties are never recognized in the financial statements.
• B. Prepayment penalties paid by a lender are recognized as an asset.
• C. Prepayment penalties are always recognized as revenue over the life of the loan.
• D. Prepayment penalties paid by a borrower are recognized as an expense in the period the loan is prepaid.

Answer: (D)

Verified step by step guidance

1. Understand the concept of prepayment penalties: Prepayment penalties are fees charged by lenders when a borrower pays off a loan early. These penalties are designed to compensate the lender for the loss of interest income that would have been earned over the life of the loan.
2. Analyze the context of revenue and expense recognition: Revenue and expense recognition principles dictate that transactions should be recorded in the period they occur and are relevant to the financial statements.
3. Evaluate the options provided: Each statement must be assessed for its accuracy based on accounting principles. For example, the statement 'Prepayment penalties are never recognized in the financial statements' is incorrect because penalties are recognized either as an expense or revenue depending on the party involved.
4. Focus on the correct statement: 'Prepayment penalties paid by a borrower are recognized as an expense in the period the loan is prepaid.' This aligns with the matching principle in accounting, which states that expenses should be recognized in the period they are incurred.
5. Conclude the reasoning: Prepayment penalties paid by a borrower are recorded as an expense because they represent a cost incurred by the borrower at the time of prepayment. This ensures accurate representation of financial performance in the period the transaction occurs.