You are an accountant working for an advertising agency and you are working on the adjusting entries for the year ending December 31st. You notice that the prepaid insurance account is too high, because the policy has now been used up based on time. You paid for another year on January 1st, so the December 31 balance did not require any adjusting. Discuss whether this is accurate and what the effect will be of this behavior on the financial statements.
1. How are you going to correct last year's balance? Debit? Credit?
2. When you prepaid an expense and the prepaid expires on a certain month the accountant
must credit the account when the prepaid expires. In this case the prepaid expired December 31
the accountant must credit the expense at the end of the fiscal period.
This is not accurate. Accounts must be adjusted at year-end. It does not matter that the amounts were the same. At year-end, prepaid accounts need to be adjusted for the expense that has been used, throughout the year. The financial statements will be misstated, even though the amounts are the same. Insurance expense will be too low - which will make expenses too low, which will in turn make net income too high.
1. You are going to correct last year's balance by the following:
The solution provides a detailed breakdown of how to handle the exercise, including giving all necessary adjustments and entries.