On March 31, 20X8, your calendar year company takes out a 3-year insurance polic

Question

On March 31, 20X8, your calendar year company takes out a 3-year insurance policy with a premium of $4,000 per year. The entire $12,000 is paid in advance and is recorded as prepaid insurance. At year-end 20X8, you discover that the adjusting entry debits Insurance Expense for $4,000 and credits Prepaid Insurance for $4,000. If you do not correct this, assets will be understated and net income will be understated assets will be overstated and net income will be overstated everything will be fine. Since the original adjusting entry was correct, no correction needs to be made. assets will be overstated and net income will be understated assets will be understated and net income will be overstated

Explanation / Answer

Amount of $12,000 has been paid for 3 years that is 36 months

So, Expired period in current year

= April 20X8 to December 20X8

= 9 months

So, Insurance expenses for 9 months

= Total amount paid / Total number of months x Expired period

= $12,000 / 36 x 9

= $3,000

The Journal Entry at the end of the year should be

Insurance Expense    $3,000

    Prepaid Insurance    $3,000

(Being expenses transferred from prepaid expenses)

But the actual entry was done with amount $4,000 in place of $3,000. Sue to this, expenses have been overstated by $1,000 ($4,000 - $3,000) resulting in Net Income being understated by $1,000 and assets will be understated by $1,000

So, as per above discussion, option A is the correct option

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