What is the effect of adjusting entries for prepaid expenses on net income?

Adjusting entries for prepaid expenses are necessary to align the expense recognition with the period in which the benefit of the prepaid expense is actually received. When a business pays for an expense in advance, such as rent or insurance, it initially records this payment as an asset. As time passes, a portion of that prepaid expense is recognized as an expense.

When these adjustments are made, the overall effect is that expenses increase in the income statement. This increase in expenses leads to a decrease in net income, as all expenses reduce the income earned during the period. For example, if a company prepaid for one year of insurance and records one month of that as an expense, the company's monthly net income will decrease due to that monthly expense being recognized. Thus, the correct understanding is that net income decreases due to the increased expenses from the adjusting entries for prepaid expenses.