Question

"During year 8, Creek Co. determined that an insurance premium paid and entirely expensed in year 7 was for the period January 1, year 7 through January 1, year 9. How should Creek classify and treat the above transaction on its financial statements?"

Answer 1

Creek Co. should reclassify the portion of the insurance premium covering year 8 and year 9 as a prepaid expense, with the respective amount expensed in each subsequent year according to the accrual basis of accounting.

Step-by-step explanation:

Creek Co. needs to reclassify the insurance premium payment that was expensed entirely in year 7. The premium covers a period extending from January 1, year 7, through January 1, year 9. Therefore, the portion of the premium that applies to year 7 should remain as an expense for that year. However, the portion of the premium that applies to year 8 and year 9 should be treated as a prepaid expense, which is an asset on the balance sheet. At the end of each subsequent year, the company should recognize the portion of the prepaid expense that has been 'used up' as an expense of that year. This matches the expense recognition with the period in which the insurance coverage is provided, adhering to the accrual basis accounting principle.

Answer 2

Creek Co. should adjust its financial statements by classifying the insurance premium payment as a prepaid expense for the years not yet covered and expense it throughout coverage. This aligns with the matching principle, ensuring expenses are recognized in the periods they benefit.

Step-by-step explanation:

When Creek Co. discovered that an insurance premium that was entirely expensed in year 7 covered the period from January 1 of year 7 through January 1 of year 9, accounting principles required them to adjust their financial statements. The insurance premium should not have been fully expensed in year 7 as it relates to multiple accounting periods. Instead, it should be classified on the balance sheet as a prepaid expense for the portion of the premium that applies to the future periods (years 8 and 9). Each year, the relevant portion of the premium would be recognized as an expense, aligning the expense recognition with the period in which the insurance coverage is applicable.

This process is consistent with the matching principle in accounting, ensuring that expenses are matched with the revenues of the corresponding period. Hence, for years 8 and 9, the financial statements would reflect the insurance premium expense on a prorated basis as the services are consumed rather than as a lump sum in the year the payment was made.

Creek Co.'s financial statements need to be amended to correct the premature expensing of the insurance premium, and the accounts need to reflect the appropriate allocation of insurance costs over the periods benefiting from the insurance coverage.