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Introduction to Financial Statement Analysis: practice question
Halstock Media pays its staff on the fifth business day of each month for the month just ended. Salaries earned in December 20X6, amounting to $42,000, were paid on 7 January 20X7. Ignoring taxes, the effect on Halstock's 20X6 financial statements of accounting correctly for the December salaries is that:
- salary expense of $42,000 is recognized in 20X6 and an accrued liability of $42,000 is reported at 31 December
- no salary expense is recognized in 20X6, because the cash payment to employees occurs in 20X7
- a prepaid salary asset of $42,000 is reported at 31 December and the expense follows the cash payment
Show answer and explanation
Correct answer: A
Explanation: The staff earned the salaries through their December work, so accrual accounting requires the $42,000 expense in 20X6 together with an accrued liability (salaries payable) of the same amount at the balance sheet date, which keeps 20X6 net income correct. The second option applies cash-basis reasoning: the January payment date affects only the timing of the cash outflow, not the period in which the expense was incurred. The third option reverses the logic of deferrals: a prepaid asset arises when cash precedes the work, whereas here the work precedes the cash, so there is no asset to report at 31 December.
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