Question

On May 1, Richardson Company paid $18, 600 for two years of insurance in advance. Richardson debited Insurance Expense, which is an alternate way of recording the initial expenditure. If the appropriate adjusting entry is not made at the end of the year, what will be the effect on: Income statement accounts (overstated, understated, or no effect)?

Answer 1

If Richardson Company doesn't make the appropriate adjusting entry for the prepaid insurance at the end of the year, it will have the following effects on the income statement accounts:

The Effects

1. Overstated Income:

Insurance Expense: Since the entire $18,600 was debited to Insurance Expense in May, it will appear as if the entire cost was incurred in the current year. This overstates the actual expense for the year, leading to an inflated net income.

2. Understated Assets:

Prepaid Expenses: By not recognizing the portion of the insurance premium that applies to the next year, the prepaid expense account will be understated. This means the balance sheet will not accurately reflect the remaining value of the unused insurance coverage.

Therefore, not making the adjusting entry at the end of the year will overstate income and understate assets. This can lead to misleading financial statements and potentially inaccurate decisions based on them.

Here's why the adjusting entry is important:

It allocates the cost of the prepaid insurance to the periods in which it will be used. This ensures accurate matching of expenses to the revenue they generate.

It provides a more accurate picture of the company's financial health by showing the correct expenses and assets on the income statement and balance sheet.