Question

On May 1, 2017, a company purchased a one-year insurance policy for $1,560. The policy was renewed for another year on May 1, 2018, for $1,680. The company recorded both payments as expenses when paid. What is the effect of this on the company’s 2018 calendar year net income and year-end assets?

• A : Net income is overstated by $40 and assets are overstated by $560.

• B : Net income is understated by $40 and assets are understated by $560.

• C : Net income is overstated by $560 and assets are understated by $560.

• D : Net income is understated by $40 and assets are overstated by $40.

Answer 1

Solution:

Expense recorded in 2018 for insurance = $1680

Expense that should have been recorded (Expired insurance) = ($1560 *4/12) + ($1680*8/12) = $520 + $1120 = $1,640

Expenses Overstated = $1680 - $1640 = $40

Therefore, Net income understated = $40

Now, since $1680 is recorded as expenses in total but prepaid insurance for 4 months of 2019 year is understated. Therefore:

Understated asset (Prepaid insurance at the end of 2018) = $1680 *4/12 = $560.

Hence,  Net income is understated by $40 and assets are understated by $560.

Hence option "B" is correct.