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 both cases by debiting Insurance Expense \(\$1,215\) and crediting Prepaid Insurance \(\$1,215\).

Step 1: Understanding Adjustments for Expired Insurance

Determine the amount of insurance expired during the year. In this case, the expired insurance is given as \( \$1,215 \). This amount needs to be recognized as an expense for the period.

Step 2: Journalizing Adjusting Entry for Expired Insurance (Case A)

According to generally accepted accounting principles, when insurance expires, we record it as an expense. The journal entry to adjust for expired insurance is:- **Debit:** Insurance Expense \( \\(1,215 \)- **Credit:** Prepaid Insurance \( \\)1,215 \)This entry reduces the prepaid insurance account and records the cost of insurance that has been utilized during the year.

Step 3: Understanding Adjustments for Unexpired Insurance

Determine the amount of insurance that is still unexpired and applies to future periods. The unexpired insurance given is \( \$1,260 \). This amount will remain in the prepaid insurance account.

Step 4: Calculate Expired Insurance Amount for Case B

Subtract the unexpired amount from the initial balance to find the expired insurance:\[\text{Expired Insurance} = \\(2,475 - \\)1,260 = \\(1,215\]The expired insurance amount is \( \\)1,215 \), which is the same as in Case A.

Step 5: Journalizing Adjusting Entry for Unexpired Insurance (Case B)

Even though we've focused on unexpired amounts, the expired insurance for Case B remains the same as in Case A. Therefore, the adjusting journal entry is:- **Debit:** Insurance Expense \( \\(1,215 \)- **Credit:** Prepaid Insurance \( \\)1,215 \)This entry aligns with the recording of the expired insurance cost during the year.

Key Concepts

Prepaid Insurance

Prepaid insurance is an accounting term used to describe insurance premiums that have been paid in advance and are yet to be used. When a business pays for insurance coverage upfront, it is essentially paying for protection that extends into the future. Therefore, this payment is recorded as an asset on the balance sheet under the "prepaid insurance" account.

To visualize, think of it as buying movie tickets for a film that's playing in a few weeks. Until you actually watch the movie, those tickets are like prepaid assets to you. In accounting, the value of prepaid insurance decreases over time as the insurance coverage is used up. This decrease is gradually recognized as an expense through adjusting entries.

Expired Insurance

Expired insurance refers to the portion of prepaid insurance that has been used up over time. As time passes, the insurance coverage is consumed, and this is recognized as an expense in the accounting records.

For example, if a company purchased a $2,475 insurance policy for a year, initially, the entire amount is recorded as a prepaid asset. At the end of the year, if $1,215 worth of insurance coverage has expired (meaning it has been used), this amount needs to be reported as an insurance expense for the year.

Adjusting for expired insurance ensures that the financial statements reflect the actual cost of insurance protection used during a given period, aligning with the matching principle of accounting.

Journal Entries

Journal entries are the backbone of accounting. They are the way accountants record all the financial transactions of a business in a systematic way. Each journal entry must have at least one debit and one credit entry, and the total debits must equal the total credits. This is to ensure that the accounting equation stays balanced: \[ \text{Assets} = \text{Liabilities} + \text{Equity} \] For adjusting entries related to expired insurance, the journal entry would typically be:

• Debit: Insurance Expense
• Credit: Prepaid Insurance

This entry decreases the prepaid insurance asset and records it as an expense, thus matching the cost with the revenue of the period. Each journal entry provides a clear record of all changes in accounts and is essential for preparing accurate financial statements.

Accounting Principles

Accounting principles are the comprehensive, standardized guidelines that govern the financial reporting and accounting practices of businesses. These principles ensure consistency, reliability, and comparability of financial reports.

When it comes to adjusting entries like those for prepaid and expired insurance, the matching principle is particularly relevant. This principle mandates that expenses be matched with revenues in the period in which they are incurred, ensuring that each period reflects an accurate portrayal of economic activity.

Additionally, the accrual principle requires recognizing expenses when they are incurred rather than when paid, as seen in the treatment of expired insurance. These principles ensure that financial statements provide a true and fair view of a company's financial performance and position.