Problem 6 - Accounting

Question

The balance in the prepaid insurance account, before adjustment at the end of the year, is \(\$ 2,475\). Journalize the adjusting entry required under each of the following alternatives for determining the amount of the adjustment: (a) the amount of insurance expired during the year is \(\$ 1,215\); (b) the amount of unexpired insurance applicable to future periods is \(\$ 1,260\).

Step-by-Step Solution

Answer

Adjust by expensing \(1,215\) for both scenarios.

Step 1: Understanding the Problem

We are given the prepaid insurance balance before adjustments and need to make the appropriate journal entry adjustments based on two scenarios: (a) the amount that expired, and (b) the amount that remains unexpired.

Step 1: Calculate Adjustment for Expired Insurance

For part (a), if the amount of insurance expired during the year is \(1,215\), we need to adjust the Prepaid Insurance by this amount. The journal entry will involve debiting the Insurance Expense account and crediting the Prepaid Insurance account.

Step 2: Journal Entry for Expired Insurance

The journal entry for the expired insurance is:Debit Insurance Expense: \(1,215\)Credit Prepaid Insurance: \(1,215\).

Step 3: Calculate Adjustment for Unexpired Insurance

For part (b), if the amount of insurance unexpired and applicable to future periods is \(1,260\), we find out the expired amount by subtracting this from the initial balance.\(2,475 - 1,260 = 1,215\). The journal entry will also involve debiting Insurance Expense and crediting Prepaid Insurance.

Step 4: Journal Entry for Unexpired Insurance

The journal entry for the unexpired insurance is the same as in step 2:Debit Insurance Expense: \(1,215\)Credit Prepaid Insurance: \(1,215\).

Key Concepts

Prepaid Insurance

Prepaid Insurance is a current asset that indicates the insurance premiums a company has paid in advance for coverage extending beyond the current accounting period. This means the company expects to receive future benefits from these insurance policies, as they provide coverage for potential losses or damages.

When a company purchases insurance, it often pays the premium upfront for a period longer than just one month or even an entire year. This advance payment is initially recorded as a prepaid asset. Over time, as the insurance coverage actually applies to the periods it is intended for, part of this prepaid amount is gradually expensed.

For example, if a business pays $2,475 for an annual insurance policy, this amount is recorded in the Prepaid Insurance account. Each month, as the insurance coverage is provided, a portion of this prepaid amount becomes an expense (Insurance Expense) to align the expense with the period that benefits from it, following the matching principle in accounting.

Insurance Expense

Insurance Expense represents the cost of an insurance policy that a business recognizes during a specific accounting period. It is the part of the prepaid insurance that has been "used up," meaning the coverage has been provided for that time.

The transition from prepaid insurance to insurance expense happens through accounting adjustments. At the end of an accounting period, companies must determine how much of the prepaid insurance has expired and should now be recognized as an expense. For instance, if $1,215 of insurance coverage was used during the year, it transitions from an asset (Prepaid Insurance) to an expense (Insurance Expense).

In accounting terms, the correct recording involves:

• Debiting the Insurance Expense account by the amount of expired coverage, which increases the expenses on the income statement.
• Crediting the Prepaid Insurance account by the same amount, reducing the asset on the balance sheet.

This process ensures that the financial statements accurately reflect the expense incurred for the period, maintaining compliance with accounting principles.

Accounting Adjustments

Accounting Adjustments are essential procedures that ensure financial statements reflect the true financial position and performance of a business. They are needed to adhere to the matching principle, which states that expenses should be recognized in the same period as the revenues they help to generate.

For prepaid insurance, adjustments are made at the end of an accounting period to shift costs from the balance sheet to the income statement as they become relevant expenses. This keeps financial records synchronized with actual operations. Without such adjustments, financial statements could misrepresent income, expenses, and asset values.

In the exercise, the adjustment process involves assessing the amount of prepaid insurance that has expired and recording it as an expense. For instance:

• If the expired portion is $1,215, this amount is adjusted from Prepaid Insurance and recorded as Insurance Expense.
• The adjustments ensure that only expenses related to the present period are reported on the income statement, providing an accurate reflection of the business's performance.

In summary, accounting adjustments maintain the integrity of financial statements by ensuring that expenses and revenues are matched in the period they occur.