Effects of Recognizing Expenses Before Accrual Accounting on Income, Total Assets, and Retained Earnings

Effects on Income, Total Assets, and Retained Earnings

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Question

If a firm recognizes expenses before that dictated by accrual accounting, which of the following best describes the effects on income, total assets and retained earnings?

Income Total assets Retained earnings

I. Understated Understated Understated

II. Understated Overstated Understated

III. Overstated Understated Overstated

IV. Understated Overstated Overstated

Answers

Explanations

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A. B. C. D.

A

Total assets Retained earnings Understated Understated Overstated Understated Understated Overstated Overstated Overstated

If expenses are recognized before they should be, then income gets understated since you subtract more from the revenues than you should. Hence, retained earnings get understated, leading to an understatement of total equity. Since assets equal liabilities plus equity and liabilities have not been affected, the understatement of equity leads to an understatement of assets.

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