[PrinceofDubtown]

Studying for FAR, came across this first question on F2:

“Roro, Inc. paid $7,200 to renew its only insurance policy for three years on March 1, 1995, the effective date of the policy. At March 31, 1995, Roro’s unadjusted trial balance showed a balance of $300 for prepaid insurance and $7,200 for insurance expense. What amounts should be reported for prepaid insurance and insurance expense in Roro’s financial statements for the three months ended March 31, 1995? “

Becker says the answer is $7,000 for prepaid ins. and $500 for insurance expense. My question is…wouldn’t insurance expense be $7,200 PLUS the $500 (for a total of $7,700)?

I understand why the $500 would be included in insurance expense (the $300 from the old policy expired during the period plus the additional $200 from the new policy). However, if this is an unadjusted balance, the insurance expense recorded would be at zero for the beginning of the period, which leaves me questioning where the $7,200 is coming from? Do they not close out expense? Is the question implying that the $7,200 was recorded in insurance expense in error? Or am I missing something and being a complete idiot?

Any help would be appreciated.

FAR - 92 (7/13)
AUD - 98 (10/13)
REG - 92 (7/14)
BEC - 95 (8/14)

[zcyankeefan]

You're supposed to know that the company made an incorrect entry at the end of the month. Instead of putting all of the $7,200 into insurance expense (shown in the facts), you're only allowed to put a small “chunk” into insurance expense on a per month basis (as you “use” up your insurance policy). Therefore, you have to reverse the journal entries and start from scratch.

Reversing entry:

DR: Cash……………………7200 (assuming the company paid cash)

CR: Insurance expense…..7200

As for the prior balance in the prepaid account you have to switch the $300 into insurance expense. This is assuming that as of March 1st there weren't any other insurance policies in effect other than the one you just purchased. This $300 amount could be from a prior month (the old insurance policy before the one being purchased).

DR: Insurance expense…300

CR: Prepaid insurance…..300

Now that everything is reversed and “normal,” you start with the purchase of the NEW insurance policy:

When purchased:

DR: Prepaid insurance….7200

CR: Cash…………………..7200

At the end of the month you have to “eat up” the insurance already used (you bought 3 year's worth of insurance and one month has passed, you have to account for the one month). Each month you “use” $200 (which is 7200/36 months) of insurance.

On March 31st:

DR: Insurance expense…..200

CR: Prepaid insurance…….200

The credit reduces the prepaid account (since it's an asset) and increase the expense account (since you used it)

Therefore:

Prepaid insurance=7,200 (what you started with) – 200 (what you used up) = 7,000

Expense= 300 (what you started with) + 200 (what you used up) = 500

It seems a bit complicated but you have to notice that they never properly accrued for the expense in the first place. Hope this helps.

FAR -> 76
AUD -> 74...Revenge 2/16/13
REG -> 83
BEC -> 75

[Author]

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