Question

Swan Finance Company, an accrual method taxpayer, requires all of its customers to carry credit life insurance. If a customer dies, the company receives from the insurance company the balance due on the customer's loan. Ali, a customer, died owing Swan $1,500. The balance due included $200 accrued interest that Swan has included in income. When Swan collects $1,500 from the insurance company, Swan:

A). Must recognize $1,500 income from the life insurance proceeds.
B). Must recognize $1,300 income from the life insurance proceeds.
C). Does not recognize income because life insurance proceeds are tax-exempt.
D). Does not recognize income from the life insurance because the entire amount is a recovery of capital.
E). None of these

Answer 1

Swan Finance Company would recognize the $1,300 principal part of the insurance proceeds as income upon collection since it has not previously been accounted for. The $200 interest had been previously recorded as income and thus would not be recognized again. This treatment aligns with proper accounting principles and the fundamental law of insurance.

Step-by-step explanation:

When Swan Finance Company collects the $1,500 from the insurance company due to customer Ali's death, it would include the collected amount as part of its normal business operations. Although life insurance proceeds are typically tax-exempt for the beneficiary, in this case, the insurance proceeds are being used to pay off a debt. Therefore, this transaction is different from receiving a life insurance benefit due to the death of an insured party under personal circumstances. Swan has previously recognized $200 of this amount as income due to their accrual accounting method. Thus, when they receive the insurance proceeds, they would not recognize that $200 as income again since it has previously been accounted for. However, the remaining $1,300, which is the principal of the loan that had not yet been recognized as income, will be recognized at this point as it has now been recovered.

In the context of business operations, an insurance payoff to a company for a debt owed to them following the death of a borrower essentially serves to make the company whole. This payoff is analogous to receiving the loaned funds back, rather than a tax-exempt benefit. If the interest had not been previously recorded as income, it would have been at this juncture, to reflect the accurate reporting of income for the financial period.

The fundamental law of insurance, which states that an average person's insurance payments must cover claims, company costs, and profits, ties into this scenario through the underlying principle of accounting for income accurately, which includes recognizing when a receivable is finally paid off through insurance proceeds.