Question

Consider a scenario where $18,500 in cash is expended for insurance coverage for the upcoming year. Propose the appropriate debit and credit entries for this transaction in the accounting records. Analyze the impact of the transaction on the fundamental accounting equation, discussing the specific accounts affected and their corresponding changes. Additionally, explore the broader implications of this entry on the financial statements and the overall financial position of the entity. Provide a step-by-step explanation of the reasoning behind selecting the particular debit and credit accounts for this insurance payment transaction.

Answer 1

An $18,500 insurance expenditure is recorded as a debit to Prepaid Insurance and a credit to Cash, affecting the balance sheet without altering the overall equation of Assets = Liabilities + Owners' Equity. Over time, this prepaid expense will impact the income statement and the entity's profitability.

Step-by-step explanation:

When an entity spends $18,500 in cash for insurance coverage for the upcoming year, the correct accounting entries would be a debit to an asset account called Prepaid Insurance and a credit to the Cash account. The entry would look like this:

• Debit Prepaid Insurance $18,500
• Credit Cash $18,500

This transaction affects the fundamental accounting equation (Assets = Liabilities + Owners' Equity) by reducing one asset (Cash) and increasing another asset (Prepaid Insurance), with net effect on assets being zero. No liabilities or owners' equity are affected by this transaction.

The broader implications on the financial statements are seen in the balance sheet where cash is reduced, and prepaid expense is increased. Over the coverage period, this prepaid insurance will become an expense, affecting the income statement by increasing expenses and thereby potentially decreasing net income. The payment itself is regarded as a money out payment, which impacts the company's liquidity in the short term. It's important to note these payments are essential for insurance companies as they have to make payments to customers, cover operating expenses, and ensure they can endure profits or losses from claims.