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
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A. B. C. D.Explanation
Income is understated. Hence, retained earnings and equity are understated. Hence, assets are understated.
If a firm recognizes expenses before that dictated by accrual accounting, it means that the firm is recognizing expenses earlier than they should be recognized based on the matching principle of accrual accounting. The matching principle requires that expenses be recognized in the same period as the revenue they help generate.
Now let's analyze the effects on income, total assets, and retained earnings based on the given options:
I. Understated Income, Understated Total Assets, Understated Retained Earnings: If expenses are recognized earlier than they should be, it means that more expenses will be recognized in the current period, leading to a decrease in reported income. Since expenses are recognized earlier, they will be deducted from revenue, resulting in a lower net income.
Recognizing expenses earlier does not have a direct impact on total assets, as it mainly affects the income statement. Therefore, total assets would not be understated in this scenario.
Retained earnings are derived from net income, which is reduced due to the early recognition of expenses. Hence, retained earnings would be understated.
II. Understated Income, Overstated Total Assets, Understated Retained Earnings: If total assets are overstated, it suggests that some assets have been incorrectly reported at a higher value than their actual worth. This situation is unrelated to the early recognition of expenses, so this option can be ruled out.
III. Overstated Income, Understated Total Assets, Overstated Retained Earnings: If expenses are recognized earlier, it would result in lower reported income, as discussed in option I. Therefore, this option can be ruled out.
IV. Understated Income, Overstated Total Assets, Overstated Retained Earnings: If expenses are recognized earlier, it reduces reported income, as discussed in option I. Additionally, if total assets are overstated, it suggests that some assets have been incorrectly reported at a higher value than their actual worth. This overstatement of assets would not affect expenses or the income statement directly. However, it does impact the balance sheet and, consequently, retained earnings. If assets are overstated, the equity section of the balance sheet, which includes retained earnings, would also be overstated.
Therefore, the correct answer is option B. IV. Understated Income, Overstated Total Assets, Overstated Retained Earnings.