Question

On April 1, 2020, Rare Finds Bookstore paid for an insurance policy costing $24,000 in cash that would insure the retail building for two years against fire loss. The company accounted for this transaction on April 1, 2020 by recording a prepaid asset. If no additional accounting entries related to the transaction are made before the financial statements are prepared as of December, 31, 2020, Rare Finds Bookstore will report:

Multiple Choice

assets that are overstated by $9,000.

assets that are understated by $9,000.

net income that is overstated by $15,000.

net income that is understated by $15,000.

contributed capital that is overstated by $9,000.

Answer 1

• The amount paid in advance was recorded as ‘prepaid asset’ on April 1 2020
• On 31 Dec 2020, the adjusting entry is required to record the ‘insurance expense’ for period of insurance expired.
  This will lead to increase in Expense (Insurance expense) and decrease in Asset (Prepaid asset)
• Amount of adjustment for 9 months = $ 24000 x 9 / 24 = $ 9000
• Hence, if adjusting entry is omitted:
  >The expenses would be understated by $9000 and
  >Asset would be overstated by $ 9000
• Correct Answer = Option #1: Assets that are overstated by $ 9000