Question

On June 30, a company paid $3,600 for insurance premiums for the current year and debited the amount to Prepaid Insurance. At December 31, the bookkeeper forgot to record the amount expired (forget to do the adjusting entry). The omission has the following effect on the financial statements prepared December 31:

Select one:

a. understates net income.

b. overstates assets.

c. overstates both owners’ equity and assets.

d. overstates owners' equity

Answer 1

Answer: "c. overstates both owners' equity and assets"

This is because on assets side the current assets are overstated as Prepaid insurance are not reduced by the expired amount and on Owners' Equity side, the Retained Earnings has overstated Net Income for the year as Expired insurance expense was not charged to Net Income. The adjusting entry should be:

Debit Insurance Expense (reducing/charging the Net Income)

Credit Prepaid Insurance (reducing the Current assets - Prepaid Insurance)