The company debited Insurance Expense on 04/01/03 for $36,000.00 and probably credited cash for $36,000.00 as company policy required.
In accrual world (sorry :P), we would have initially recorded the transaction as:
DR. Insurance Expense $1,500.00 ($36,000.00/2 Years gives us $18,000.00 Annual Insurance Expense. Assuming Insurance is due at the beginning of the month, we would have to recognize 1/12 of the $18,000.00 which equals $1,500.00).
DR. Prepaid Insurance Expense (An Asset Account) for $34,500.00 (This is $36,000.00 for the two years of the policy – $1,500 for April Expense).
CR. Cash for $36,000.00
The company didn't record the transaction that way, so we adjust it at year end.
At 12/31/03 we have used 9 months of the policy costing $13,500.00 (April-December at a rate of $1,500.00 per month, which is $18,000.00/12)
Remember, we also had 3 months of the year still covered under the policy purchased way back on 04/01/01. That policy was $24,000.00 for two years. That works out to $12,000.00 per year or $1,000.00 per month. At 3 months, the expense should have been $3,000.00.
At 12/31/03 our insurance expense should have been $$16,500 ($3,000.00 from old policy + $13,500.00 from new policy).
Since we expensed the entire $36,000.00 on 04/01/03, we have to back out the prepaid amount. In this case $36,000.00 for two years less the actual expense of $16,500.00 equals $19,500.00.
We over expensed $19,500.00 which should have been recorded as a Prepaid Expense (Asset Account) because it benefits future periods.
Our adjustment then, at 12/31/03 is:
DR. Prepaid Insurance Expense $19,500.00
CR. Insurance Expense $19,500.00
This takes the left over, erroneously expensed amounts and puts them in the prepaid account. Then on 01/01/04, we could recognize a month of insurance expense by a debit to Insurance Expense for $1,500.00 and crediting Prepaid Insurance Expense for $1,500.00.
I hope that helped.
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