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Chapter 3: Problem 9

At the end of February, the first month of the business year, the usual adjusting entry transferring rent earned to a revenue account from the unearned rent account was omitted. Indicate which items will be incorrectly stated, because of the error, on (a) the income statement for February and (b) the balance sheet as of February 28. Also indicate whether the items in error will be overstated or understated.

Short Answer

Expert verified
On the income statement, revenue and net income are understated. On the balance sheet, unearned revenue is overstated and equity is understated.

Step by step solution

01

Understand the Adjusting Entry

In normal circumstances, an adjusting entry should have been made to transfer the correct amount of rent from the "unearned rent" account to the "rent revenue" account. This transfer recognizes the earned revenue in the income statement.
02

Determine Income Statement Impacts

Without the adjusting entry, the rent earned is not recorded as revenue. This results in an understatement of revenue and, consequently, an understatement of net income for the month of February.
03

Assess Balance Sheet Consequences

The balance sheet will be affected in the Liability section. Without the transfer, the unearned rent remains on the balance sheet, meaning the liabilities are overstated. Simultaneously, equity is understated due to the understatement of net income on the income statement.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Income Statement Impacts
When rent earned is not transferred to the revenue account due to a missed adjusting entry, the income statement for February will reflect two key inaccuracies: understated revenue and understated net income.

Revenue is one of the main factors on the income statement, directly affecting the company's profitability. If earned rent is not recorded as revenue, the reported revenue will appear less than what was actually earned. Revenue understatements lead to a direct reduction in net income, as net income is calculated by subtracting expenses from total revenue.
  • Revenue is recorded less than the actual amount.
  • This causes a decrease in reported profitability for the period.


Understanding how these entries affect profitability highlights the importance of accurate adjustments. It's vital to recognize all earned revenue to truly reflect the business鈥檚 financial performance.
Balance Sheet Analysis
The omission of the adjusting entry also impacts the balance sheet as of February 28th, especially in the liabilities and equity sections.

Normally, the amount of unearned rent should decrease as it gets transferred to the rent revenue account, thus reducing the liabilities on the balance sheet. However, without this adjustment:
  • Unearned rent remains in the liability section.
  • This results in an overstatement of liabilities.


Consequently, since net income was understated on the income statement, the equity section that includes retained earnings is also understated. In summary, the balance sheet falsely suggests a stronger liability position and a weaker equity position than is accurate.
Overstatement and Understatement
In accounting, precision is crucial, and the concepts of overstatement and understatement play significant roles in capturing accurate financial information.

Overstatement occurs when financial figures are reported higher than their actual amounts. In this scenario, liabilities are overstated because the unearned rent hasn鈥檛 been adjusted and reported correctly. This can lead to a misconception about the company鈥檚 financial conditions, portraying more obligations than it truly has.
  • Overstated liabilities suggest more resources owed than in reality.


On the other hand, understatement reflects figures shown lower than their true values. Both revenue and net income are understated here due to the missed entry.
  • Understated revenues depict less income.
  • Understated net income issues a false picture of less profitability.


An understanding of these concepts underscores the importance of timely and accurate financial entries to avoid misleading financial statements.

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Most popular questions from this chapter

In a recent balance sheet, Microsoft Corporation reported Property, Plant, and Equipment of \(\$ 7,223\) million and Accumulated Depreciation of \(\$ 4,179\) million. a. What was the book value of the fixed assets? b. Would the book value of Microsoft Corporation's fixed assets normally approximate their fair market values?

At the end of the current year, \(\$ 8,140\) of fees have been earned but have not been billed to clients. a. Journalize the adjusting entry to record the accrued fees. b. If the cash basis rather than the accrual basis had been used, would an adjusting entry have been necessary? Explain.

The balance in the supplies account, before adjustment at the end of the year, is \(\$ 1,736\). Journalize the adjusting entry required if the amount of supplies on hand at the end of the year is \(\$ 813\).

Northwest Financial Services was organized on April 1 of the current year. On April 2, Northwest prepaid \(\$ 4,500\) to the city for taxes (license fees) for the next 12 months and debited the prepaid taxes account. Northwest is also required to pay in January an annual tax (on property) for the previous calendar year. The estimated amount of the property tax for the current year (April 1 to December 31) is \(\$ 21,375\). a. Journalize the two adjusting entries required to bring the accounts affected by the two taxes up to date as of December 31, the end of the current year. b. What is the amount of tax expense for the current year?

The estimated amount of depreciation on equipment for the current year is \(\$ 1,840\). Journalize the adjusting entry to record the depreciation.
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