Question

Bailey Co. changed their accounting for insurance expense from the cash-basis to the accrual-basis in the current year. In January of the prior year, Bailey recorded insurance expense of $240,000 for the cash purchase of a four-year insurance policy. How should Bailey report the insurance transaction in the current year's financial statements?

Answer 1

$60,000

Step-by-step explanation:

Since Bailey Co. changed their accounting for insurance expense from the cash-basis to the accrual-basis in the current year, and in January of the prior year, Bailey recorded insurance expense of $240,000 for the cash purchase of a four-year insurance policy.

Bailey should report the insurance transaction in the current year's financial statements of an amortization of the insurance expense over the four year period, and take account the portion that pertains to the current year.

Therefore = $240,000 / 4 years = $60,000 per year

Answer 2

Bailey must adjust three accounts:

1. insurance expense
2. prepaid insurance
3. retained earnings

First we will start to adjust retained earnings: since retained earnings were underestimated in the past year because $180,000 more of insurance expense was recorded, then we must increase it by $180,000.

Since the insurance will cover this year plus two more years, we must record two years worth of prepaid insurance = $60,000 x 2 = $120,000

Finally we must record the insurance expense for this year = $60,000

The adjusting entry will be:

Dr Insurance expense 60,000

Dr Prepaid insurance 120,000

Cr Retained earnings 180,000