Question

Which of the following adjustments will increase liabilities?

1) Interest incurred on money borrowed during the period but not yet paid to the bank is accrued
2) Depreciation for the period is recorded
3) The use of supplies is recorded
4) The gradual expiration of an insurance policy is recorded

Answer 1

Interest incurred but not yet paid will increase liabilities. Money under bank assets may not be present as banks lend out most of the funds, causing an asset-liability time mismatch. When buying loans, the price paid depends on the borrower's payment history and current economic interest rates.

Step-by-step explanation:

To answer which adjustment will increase liabilities, we look at the four options given:

1. Interest incurred on money borrowed during the period but not yet paid to the bank is accrued. This means an expense has been recognized, but the cash has not yet been paid, so this will indeed increase liabilities because it results in an accrued interest liability.
2. Recording depreciation for the period does not affect liabilities, as it is an allocation of the cost of an asset over its useful life.
3. The use of supplies being recorded affects expenses and assets, not liabilities unless the supplies were purchased on credit, in which case the supplies account would decrease, and accounts payable would increase.
4. Recording the gradual expiration of an insurance policy typically affects prepaid expenses (an asset) and insurance expense, not liabilities.

Regarding the money listed under assets on a bank balance sheet not actually being in the bank, this occurs because banks operate on the principle of fractional reserve banking. They lend out a portion of the deposits they receive, meaning that at any given time, a bank's cash on hand is less than the total of its customers' deposits. The asset-liability time mismatch refers to the difference in the time it takes for a bank's assets (like loans) to be repaid compared to the speed with which its liabilities (like customer deposits) can be withdrawn.

When buying loans in the secondary market:

• If a borrower has been late on loan payments, you would likely pay less for the loan due to increased risk.
• If interest rates in the economy have risen since the bank made the loan, the loan is less attractive, and you would probably pay less.
• If the borrower is a firm that has just declared a high level of profits, you might pay more for the loan because the borrower's ability to repay has likely improved.
• If interest rates in the economy have fallen since the loan was made, the loan is more valuable, and you would likely pay more for such a loan.