How are prepaid expenses and accruals treated in adjusting entries?

• A. Prepaid expenses are recorded as assets and expensed when used; accruals recognize expenses or revenues before cash is exchanged, increasing liabilities or receivables accordingly.
• B. Prepaid expenses are recognized as expenses immediately; accruals are not used.
• C. Prepaid expenses reduce cash; accruals reduce equity; not applicable.
• D. Prepaid expenses and accruals have no impact on balance sheet.

Answer: (A)

Adjusting entries are used to align what has actually happened with what is reported for the period. Prepaid expenses start as assets because you’ve paid cash in advance for benefits you’ll receive later. As those benefits are used, you reduce the asset and recognize an expense, so the entry moves from asset to expense (debit the expense, credit the prepaid asset). This reflects the consumption of the prepaid benefit over time.

Accruals cover items that have occurred but where cash hasn’t yet moved. They ensure you record either revenue earned but not yet received or expenses incurred but not yet paid. The result is a liability or a receivable being created. For accrued revenue, you debit accounts receivable and credit revenue; for accrued expenses, you debit the expense and credit accrued liabilities (or accounts payable). This keeps the financial statements accurate for the period and prepares them for the cash flows that will occur later.