Can someone please tell me what is wrong with this journal entry? Please tell me
ID: 2378692 • Letter: C
Question
Can someone please tell me what is wrong with this journal entry? Please tell me the general purpose of adjusting journal entries, the financial statement effects of her error, and the proper entry that should have been made.
Assume that you are the chief accountant at a small service company that prepares financial statements on December 31 of each year. You have a new staff member, Bethany Johnson, who is tasked with preparing journal entries for the company. While reviewing Bethany's work, you come across the following scenario.
On June 1, 2009, the company paid for property insurance on a newly purchased building. The insurance expires on May 31, 2010. Bethany recorded the following two journal entries regarding the insurance. Please explain the error that Bethony made. In your explanation, please discuss the general purpose of adjusting journal entries, the financial statement effects of her error, and the proper entry that should have been made.
Explanation / Answer
The first journal entry is correct; it is simply recording the purchase of insurance. The problem is that there is a journal entry missing on December 31! Notice that the financial statements are prepared on December 31. On that date, an entry should be recorded to show that 7 months (June - December) of the prepaid insurance has been "used up." Because this entry was not made, the income statement at the end of the year will not show enough insurance expense (and thus net income will be overstated). Similarly, on the year-end balance sheet, the prepaid insurance account will be overstated. The correct entires are as follows:
6/1/09 - Same as above
12/31/09
DR: Insurance Expense 2100 ((7/12)*3600)
CR: Prepaid Insurance 2100
5/31/10
DR:Insurance Expense 1400 (3600 total - 2100 used)
CR: Prepaid insurance 1400
The general purpose of this adjusting journal entry is to account for the "using up" of the prepaid asset. In accounting, assets are not expensed when they are paid for but instead are expense as they are used.