Final answer:
The correct adjusting entry for the Gibson Company's insurance policy on December 31, 2020, is to debit Prepaid Insurance and credit Insurance Expense for $7,000, representing seven months' worth of the insurance cost.
Step-by-step explanation:
The Gibson Company situation represents an example of accounting for prepaid expenses. When the company paid $24,000 on June 1, 2020, for a two-year insurance policy, it should have initially recorded the payment as Prepaid Insurance, an asset on the balance sheet, rather than expensing the entire amount immediately. By the end of the year, on December 31, 2020, seven months of the insurance policy have been used up, meaning seven months' worth of insurance cost should be reported as Insurance Expense for the year 2020.
To calculate the expense for seven months, we take the total cost of $24,000 and divide it by 24 months to get a monthly cost, which is then multiplied by 7 months:
Monthly Cost = $24,000 / 24 months = $1,000 per month
Insurance Expense for 7 months = $1,000 per month * 7 months = $7,000
The adjusting entry on December 31, 2020, should therefore be:
- Debit Prepaid Insurance and credit Insurance Expense for the amount that represents the insurance cost for the seven months of the year, which is $7,000.
This entry will properly allocate the cost of insurance to the periods in which the insurance coverage is actually used. Therefore, the correct answer is c. debit Prepaid Insurance and credit Insurance Expense, $7,000.