Omission of prepayment adjustment understates assets and equity

Steps:

• Prepayment is an expense paid in advance for future periods, creating a current asset.
• Adjusting entry: debit prepayments (asset) and credit expenses to reduce current-year expense.
• Without adjustment, full prepayment is expensed, overstating expenses and understating profit.
• This leaves no asset recorded, understating current assets and owner's capital via lower retained profit.

Why B is correct:

• Per accrual accounting principle, unadjusted prepayments overstate expenses (understating profit/capital) and omit the asset (understating current assets).

Why the others are wrong:

• A: Adjustment increases assets and capital, so omission does the opposite.
• C: Profit is understated (not overstated); prepayments do not affect trade payables.
• D: Trade payables unaffected by prepayments; profit is understated, not overstated.

Final answer: B