Question

On August 1, Year 1, Lace Company paid $2,400 cash for an insurance policy that would provide protection for a one-year term. Which of the following shows how the required adjustment on December 31, Year 1, will affect Lace Company's ledger accounts?

1) (2,400) 2,400
2) (800) (800)
3) 2,400 2,400
4) (1,000) (1,000)

Answer 1

On December 31, Year 1, Lace Company must adjust its ledger to reflect the portion of the insurance policy that has been used. Five months of coverage equals 5/12 of the annual policy amounting to $1,000. Thus, a debit of $1,000 to Insurance Expense and a credit of $1,000 to Prepaid Insurance is made, corresponding to option 4).

Step-by-step explanation:

When Lace Company paid $2,400 cash for an insurance policy on August 1, Year 1, it represented a prepayment for services to be received over the course of the next year. On December 31, Year 1, the company needs to record how much of this policy has been used. Since five months have passed (August 1 to December 31), the company has used 5/12 of the annual policy.

By calculating 5/12 of $2,400, we find that Lace Company has used $1,000 of the insurance policy. Therefore, the required adjustment is an expense of $1,000 and a reduction in prepaid insurance (an asset) by $1,000. This adjustment is shown as a debit to Insurance Expense and a credit to Prepaid Insurance, affecting the ledger accounts accordingly.

The correct ledger adjustment on December 31, Year 1, is therefore: Insurance Expense (Debit) $1,000 and Prepaid Insurance (Credit) $1,000, which corresponds to option 4) in the question. This reflects the expense recognized for the period and reduces the prepaid asset on the balance sheet.