On December 1, Ford Company received three months’ rental income in advance and increased a liability account. On December 31, the end of the accounting period, Ford failed to make an adjusting entry reflecting that a portion of this rent had been earned. This error results in:

Question

On December 1, Ford Company received three months’ rental income in advance and increased a liability account.  On December 31, the end of the accounting period, Ford failed to make an adjusting entry reflecting that a portion of this rent had been earned.  This error results in:

BlackTom AI · Accepted Answer

First, let's restate what's going on: Ford received three months' rent in advance, creating a liability (deferred revenue) because the company has not yet earned all of that rent. At period end, December 31, an adjusting entry to recognize the portion actually earned was not made.

Option 1: Overstated assets. This is not correct because the transaction initially increases cash (an asset) and a liability; failing to adjust for earned revenue does not inflate assets. The error affects liabilities and revenue, not asset balances.

Option 2: Understated assets. This is also not correct for the same reason—there is no reason for asset balances to be understated due to this specific error, since the rent in advance pertains to a liability and revenue recognition, not asset valuation.

Option 3: Overstated revenue. This would imply more revenue is recognized than earned. In reality, revenue would be understated if the earned portion isn’t recorded, because we are recognizing too little revenue by December 31, not too much.

Option 4: Overstated liabilities. This aligns with the situation: because the earned portion was not deducted from the liability (deferred revenue) account, the liability remains higher than it should be at year-end. In other words, the liability is overstated since part of the rent has been earned but not recognized as revenue and not removed from the liability.

Therefore, the described error leads to an incorrect balance where the liability account is higher than it should be, while revenue is lower than it should be, with assets unaffected by this specific adjustment issue.

On December 1, Ford Company received three months’ rental income in advance and increased a liability account. On December 31, the end of the accounting period, Ford failed to make an adjusting entry reflecting that a portion of this rent had been earned. This error results in:

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