In preparing its adjusting entries at the end of this year, Johns Company neglected to adjust the Prepaid Insurance account for the amount of insurance expired during the year.
This error:
A) Understates this year's net income and overstates both retained earnings and assets at year-end
B) Overstates this year's net income and understates both retained earnings and assets at year-end
C) Understates this year's net income and understates both retained earnings and assets at year-end
D) Overstates this year's net income and overstates both retained earnings and assets at year-end
E) None of the above

Question

Quizplus · Accepted Answer

Failing to adjust the Prepaid Insurance account for expired insurance results in not recognizing an expense that should have been recognized. This omission overstates net income because expenses are understated. Consequently, retained earnings are also overstated because net income, which flows into retained earnings, is too high. Assets are overstated as well because the Prepaid Insurance account is not reduced by the expired portion.

In Preparing Its Adjusting Entries at the End of This