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

For both scenarios, debit Insurance Expense and credit Prepaid Insurance by \(\$ 3,720\).

Step 1: Calculate Total Insurance Available

Begin the year with the balance in the prepaid insurance account and add any additional premiums paid during the year. The opening balance is \(\\( 5,600\) and \(\\) 1,800\) is added for new policies. So, the total insurance available for the year is \(\\( 5,600 + \\) 1,800 = \$ 7,400\).

Step 2: Adjust for Unexpired Insurance (Scenario a)

In scenario (a), the unexpired insurance amount is \(\\( 3,680\). Subtract this from the total insurance available to determine the expired insurance. Thus, \(\\) 7,400 - \\( 3,680 = \\) 3,720\) expired during the year. Journalize the entry as a debit to the Insurance Expense account for \(\\( 3,720\) and credit the Prepaid Insurance account for \(\\) 3,720\).

Step 3: Adjust for Expired Insurance (Scenario b)

In scenario (b), it's given that the amount of insurance expired is \(\\( 3,720\). Subtract this expired amount from the total available insurance to find the unexpired insurance, \(\\) 7,400 - \\( 3,720 = \\) 3,680\). Journalize the entry by debiting the Insurance Expense by \(\\( 3,720\) and crediting the Prepaid Insurance by \(\\) 3,720\).

Step 4: Record the Journal Entry

For both scenarios, the journal entry to adjust for expired insurance is the same due to the equals amounts: Debit Insurance Expense for \(\\( 3,720\) and Credit Prepaid Insurance for \(\\) 3,720\). This reflects the adjustment needed to account for insurance costs applicable to the current fiscal year.

Key Concepts

Prepaid Insurance

Prepaid Insurance is an asset account that represents the amount of insurance premiums a company has paid in advance for coverage that extends beyond the current accounting period. This means that the business has spent money for insurance that will provide benefits in future periods, making it an asset until it is used up.

- **Accounting for Prepaid Insurance:** Every time a business pays for an insurance policy that covers multiple periods, the payment is recorded in the prepaid insurance account. This initial payment is considered an asset, as the business hasn’t yet received the benefits of these premiums. - **Example Calculation:** Suppose a business starts the year with a prepaid insurance balance of $5,600, and during the year, it purchases additional insurance policies for $1,800. This increases the total prepaid insurance available to $7,400 ($5,600 + $1,800).

Insurance Expense

The Insurance Expense account comes into play when the prepaid insurance benefits have been consumed within the period. Essentially, as time passes and the insurance coverage period rolls over, the prepaid insurance amount transitions from an asset to an expense. This is crucial for accurately reflecting the business's financial standing.

- **Adjusting for Insurance Expense:** Periodically, usually at the end of the month or year, businesses adjust their prepaid insurance account to reflect the expired portion that should now be considered an expense. This ensures that only the insurance actually used during the period is expensed. - **Journalizing the Entry:** For example, if at year-end it is determined that $3,720 of insurance coverage expired during the year, this amount will be debited to the Insurance Expense account and credited from Prepaid Insurance. This adjustment captures the true expense for insurance consumed in the fiscal period.

Expired Insurance

Expired Insurance refers to the portion of prepaid insurance that has been "used up" or "spent" during an accounting period. This is the amount that should be recorded as an expense in the books. When insurance is expired, it signifies that the business has received the full benefit of the prepaid premium for the specific period.

- **Calculating Expired Insurance:** To determine the expired portion, subtract the unexpired balance from the total available prepaid insurance. If the total insurance for the year is $7,400 and $3,680 remains unexpired, then $3,720 is expired ($7,400 - $3,680). - **Reflecting in Financial Statements:** Properly accounting for expired insurance ensures that a business isn’t overstating its assets, thus giving a fair view of its actual financial position. In our scenario, recognizing the $3,720 as expired turns it into a current period expense, accurately reflecting the insurance cost for the year.