The Baltimore Company's payment for insurance is accounted for as a prepaid expense, which is an asset. The transaction affects the Cash and Prepaid Insurance accounts on the balance sheet, and will be expensed over the insurance coverage period in accordance with the matching principle of accounting.
Step-by-step explanation:
When the Baltimore Company paid cash to purchase insurance for future protection, this transaction is an economic event that would be recognized in the company's financial records. This purchase of insurance is known as a prepaid expense, which is an asset for the company because it represents future economic benefits. The payment reduces cash, which is also reflected in the company's financial statements.
The recognition of this transaction affects two accounts on the balance sheet: Cash and Prepaid Insurance. Cash is an asset that would decrease because funds have been disbursed. At the same time, Prepaid Insurance, another asset, would increase, representing the service that will be received over the term of the insurance policy.
In accordance with the matching principle of accounting, the cost of the insurance will be expensed over the period it covers. As the insurance coverage period elapses, the Prepaid Insurance account will be decreased by the amount that applies to that period, and an Insurance Expense account will be increased, reflecting the cost on the income statement for that period.
The journal entry to record the initial payment would be a debit to Prepaid Insurance and a credit to Cash. Subsequent entries will involve debiting Insurance Expense and crediting Prepaid Insurance as the insurance is recognized as an expense over time. This process is part of accrual accounting, which matches revenues with expenses in the periods in which they are incurred, regardless of when cash transactions occur.