Part 1On October 1 of the current year, a company received $ 10,800$10,800 for services to be performed evenly over the next six months. If no adjusting entry was made on December 31 of the current year: Part 1
A. net income would be overstated by $ 5,400$5,400. B. net income would be overstated by $ 2,700$2,700. C. net income would be understated by $ 5,400$5,400. D. net income would be understated by $ 10,800$10,800.

Question

Part 1On October 1 of the current​ year, a company received $ 10,800$10,800 for services to be performed evenly over the next six months. If no adjusting entry was made on December 31 of the current​ year: Part 1
A. net income would be overstated by $ 5,400$5,400. B. net income would be overstated by $ 2,700$2,700. C. net income would be understated by $ 5,400$5,400. D. net income would be understated by $ 10,800$10,800.

BlackTom AI · Accepted Answer

Treat the cash receipt as initially recorded as Service Revenue; the required adjusting entry on December 31 would reduce revenue by the unearned portion.

1. Relevant concepts
- Unearned revenue (deferred revenue) is a liability when cash is received before services are performed.
- Revenue must be recognized as earned over the service period (revenue recognition principle).
- If revenue already has been credited to Service Revenue at receipt, an adjusting entry is needed to move the unearned portion to Unearned Revenue. Failure to adjust will overstate revenue and thus net income.

2. Step-by-step reasoning
- Total cash received = $10,800 on October 1, covering six months of services (Oct 1 through Mar 31).
- Revenue is earned evenly over six months, so monthly revenue = $10,800 ÷ 6.

3. Calculations (all intermediate steps)
- Monthly revenue = 10,800 ÷ 6 = $1,800 per month.
- Number of months earned by Dec 31: October, November, December = 3 months.
- Revenue that should be recognized by Dec 31 = 1,800 × 3 = $5,400.
- If the company initially credited the entire 10,800 to Service Revenue when cash was received, it must reduce revenue by the unearned portion (10,800 − 5,400 = 5,400) by debiting Service Revenue and crediting Unearned Revenue.
- If no adjusting entry is made, Service Revenue remains too high by $5,400, and thus net income is overstated by $5,400.

4. Why the correct answer is correct
- The $5,400 represents the portion of revenue that should not yet be recognized as of Dec 31. Leaving it in revenue inflates revenues and net income by that amount.

5. Why the other options are incorrect
- B ($2,700) is half of the correct misstatement and does not match three months of unearned revenue; it would correspond to 1.5 months, which is not the period here.
- C and D (understatements) are wrong because failing to reclassify revenue (when it was initially credited to revenue) causes revenue to be overstated, not understated. (If the company had instead initially recorded a liability, failing to adjust would understate revenue, but that is not the scenario consistent with the provided answer.)

Conclusion: Net income would be overstated by $5,400, matching answer A.

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