Problem 7 - Accounting

Question

The prepaid insurance account had a balance of \(\$ 5,600\) at the beginning of the year. The account was debited for \(\$ 1,800\) for premiums on policies purchased during the year. Journalize the adjusting entry required at the end of the year for each of the following situations: (a) the amount of unexpired insurance applicable to future periods is \(\$ 3,680\); (b) the amount of insurance expired during the year is \(\$ 3,720\).

Step-by-Step Solution

Answer

In both situations, the adjusting entry is to debit Insurance Expense $3,720 and credit Prepaid Insurance $3,720.

Step 1: Identify the Initial Balance and Adjustments

The prepaid insurance account begins with a balance of $5,600. Throughout the year, an additional $1,800 is debited to the account for new policies, bringing the total to $7,400. We must adjust this balance at year-end based on additional information.

Step 2a: Situation A - Calculate Expired Insurance

In this situation, the unexpired insurance amount at the end of the year is $3,680. Subtract this from the total balance to find the expired insurance:\(7,400 - 3,680 = 3,720\).This represents the expired insurance for the year.

Step 3a: Journalize the Adjusting Entry (Situation A)

For the adjusting journal entry, debit Insurance Expense for $3,720 (the expired portion) and credit Prepaid Insurance for the same amount to adjust the balances correctly: - Debit Insurance Expense: $3,720 - Credit Prepaid Insurance: $3,720.

Step 2b: Situation B - Given Expired Insurance

In this situation, we are directly given the expired insurance as $3,720. Therefore, the unexpired amount can be found by subtracting expired insurance from the total, but there's no need to do so since we're focused only on the expired amount.

Step 3b: Journalize the Adjusting Entry (Situation B)

Similarly, record the expired insurance in the adjusting entry: - Debit Insurance Expense: $3,720 - Credit Prepaid Insurance: $3,720.

Key Concepts

Prepaid Insurance

Prepaid insurance is an asset on a company's balance sheet. It represents the insurance premiums paid for future coverage periods. When a company buys an insurance policy, it's often required to pay the premium before any coverage starts. This upfront payment is initially recorded as a prepaid insurance asset, reflecting that the company has paid for a service it hasn't yet received.
Despite being recorded as an asset when paid, its balance decreases over time as the insurance coverage is received. The account is adjusted at regular intervals, usually at the end of a fiscal period, to account for the portion of the prepaid amount that has been "used up" as the insurance coverage period progresses.

• For example, if a company pays $5,600 for a one-year insurance policy at the beginning of the year, this entire amount is initially recorded as prepaid insurance.
• As each month passes and the insurance is "used," the prepaid insurance asset decreases, reflecting reduced value remaining as future coverage becomes present coverage.

Understanding this concept is essential for making necessary adjustments in a company's financial records to reflect the cost of insurance coverage as it's actually incurred.

Insurance Expense

Insurance expense is the portion of the insurance premium that corresponds to the coverage period that has already passed. This cost is reflected on the income statement and impacts the company's net income directly. As time passes, part of the prepaid insurance becomes an expense.
For example, when the prepaid insurance of $7,400 is analyzed at the end of the year, it needs an adjustment to transfer the expired coverage costs from an asset on the balance sheet to an expense on the income statement. In this case, we must determine the insurance expense:

• Calculate the expired portion, say $3,720, which represents the coverage already received.
• This amount is transferred from the prepaid insurance account to the insurance expense account.

This adjustment ensures accurate reflection of the used value of the insurance in financial reports, aligning the cost with the period in which coverage was provided.

Balance Adjustments

Balance adjustments are necessary to ensure financial statements accurately reflect the company's financial status at any given time. Adjusting journal entries are made to update the balances of certain accounts at the end of an accounting period.
In our example, we have an original prepaid insurance balance and new premium payments that bring the total to $7,400. By year-end, adjustments are needed to reflect actual conditions.

Why Make Balance Adjustments?

These adjustments recognize that the financial position of a company changes over time as transactions occur. Adjusting entries help ensure that revenues and expenses are matched to the correct periods, in accordance with the accrual basis of accounting.
Here's how it works:

• The expired portion of insurance of $3,720, based on the situation, is transferred by debiting insurance expense and crediting prepaid insurance by the same amount, adjusting the asset balance while recognizing the expense.
• This keeps books, like the income statement and balance sheet, accurate and up-to-date.

Understanding balance adjustments is vital for keeping the company's financial information correct and for complying with accounting principles.