[Rhunter]

Hi,

This is from the Ninja FAR MCQ.

On November 1, 20X1, Key Co. paid $3,600 to renew its only insurance policy for three years. On December 31, 20X1, Key’s unadjusted trial balance showed a balance of $90 for prepaid insurance and $4,410 for insurance expense. What amounts should be reported for prepaid insurance and insurance expense in Key’s December 31, 20X1, financial statements?

A. Prepaid insurance: $3,300; Insurance expense: $1,200

B. Prepaid insurance: $3,400; Insurance expense: $1,200

C. Prepaid insurance: $3,400; Insurance expense: $1,100

D. Prepaid insurance: $3,490; Insurance expense: $1,010

Here is the explanation:

At the end of the period, the expired insurance should be moved into expense, leaving only the unexpired portions in prepaid insurance.

Prepaid insurance on November 1, 20X1 $3,600
Less November and December expense
2($3,600/36 months) 200
——
Prepaid insurance on December 31, 20X1 $3,400
======

Insurance expense Total payments Prepaid insurance
on December 31, 20X1 = for insurance – balance
= ($90 + $4,410) – $3,400
= $4,500 – $3,400
= $1,100

I can’t understand why the ending interest expense is netted with the amount of the prepaid. Makes no sense. If these was already interest expense recognized up through December of $4,410, wouldn’t the additional $200 from the renewed amount of prepaid insurance just be added along with the other $90 of remaining prepaid yet to be expensed?

4,410 – Already recognized
200 – November & December, from renewal
90 – Recognized from remaining prepaid
= 4,700 in expense for the year

[Adam]

It's tricky in the fact pattern. It is not saying that there is $4,410 of expense plus the $3,600; the $4,410 total includes the $3,600. So for prepaid at 12/31/XX, you would have $3,400 (3,600 less 2 months @ $100/each).

For expense, you know you need the old $90 moved from prepaid (since that policy is now gone according to the wording in the problem) and you now know you need $200 expense from the new policy for November and December. The rest will be the original difference from the $4,410 less the $3,600 ($810). So $90 + $200 + 810 = $1,100

Final answer: C

Does this make sense?

[Rhunter]

Hi Adam,

Thanks for your response.

I understand, but think this problem would be better if more detail were provided. I really wish it would have let us know how the $4,410 ended up in the expense account in the first place. Instead we are left to assume that this was a classification error. I don't think anyone would even consider a classification error without first seeing the answer choices and making the math work. This would make for a terrible SIM. Just my .02.

[kayfcpa16]

This is EXACTLY how they ask questions on the FAR exam and other sections.. Without looking at the answers I immediately calculated what the balance should be at year end … The question is asking what the balance should be, that’s all.. I would suggest you practice more questions to become familiar with the format..
Just a note. unless the question specifically states otherwise, they expect candidates to assume certain things based on accounting principles … like accruals, prepayments & if the information is not in accordance with that … it may be an error, miscalculation or misclassification (like what happens a lot in the real accounting departments)..
That’s why the exams can be so frustrating to many people!

FAR - 2/16 - 78
BEC - 2/16 - 78
AUD - 8/16
REG - 8/16

[Adam]

@RHunter – I understand where your reasoning comes from, but as @kayfcpa16 said, this is exactly the type of question the exam seems to shoot for – it requires a little more logic and “higher order skills” as they say to be able to determine the proper classifications and amounts for various P&L/BS accounts.

Speaking from my experience, this situation is not at all uncommon in the “real world” – it's up to accountants to determine whether an expense stays on the P&L, gets moved to a prepaid, gets capitalized according to policies, etc.

[Anonymous]

The way I thought of these is to calculate the correct ending balance first. Then add up all the expenses and prepays. Subtract correct ending balance of prepays to get your expense. There was a similar problem in the Becker software that confused me at first because they didn't tell you what the previous policy amount was, but I worked around my assumption for a need for more info and realized what I thought I needed didn't matter. In form the calculations are below.

$3,600 policy for 3 year period beginning 11/1/x1
Monthly expense for policy is $100 so at year end this policy is expensed $200, leaving behind a prepay of $3,400.
$3,600 / 36 = $100 $3,600 – ($100 x2) = $3,400
**What they fail to tell you is that they had already screwed up the accrual of the previous policy**
$4,410 + $90 = $4,500. This $4,500 is the total amount of insurance related items for the year (new policy purchased and old policy expenses (or not))
$4,500 – $3,400 =$1,100. So we know the ending prepaid is $3,400 and the proper amount to be expensed is $1,100 of which $900 is from the old policy and $200 from the new policy.

Like I said my confusion was their assumption of what they believed I should have deduced from the fact pattern.

[Rhunter]

Thanks, damaniam. I appreciate the help.

[Author]

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