On November 1, Year 1, Key Co paid $3600 to renew its now-expired insurance policy for 3 years. It recorded this payment as an expense. At December 31, Year 1, Key's unadjusted trial balance showed a balance of $90 for prepaid insurance and $4410 for insurance expense. What amounts should be shown for prepaid insurance and insurance expense in Key's December 31, Year 1 financial statements?

Prepaid Expense Insurance Expense

A. $3400 $1100

B. $3490 $1010

C. $3300 $1200

D. $3400 $1200

Question

On November 1, Year 1, Key Co paid $3600 to renew its now-expired insurance policy for 3 years.  It recorded this payment as an expense.  At December 31, Year 1, Key's unadjusted trial balance showed a balance of $90 for prepaid insurance and $4410 for insurance expense.  What amounts should be shown for prepaid insurance and insurance expense in Key's December 31, Year 1 financial statements?

Prepaid Expense                                      Insurance Expense

A.                     $3400                                                        $1100

B.                     $3490                                                        $1010

C.                     $3300                                                        $1200

D.                     $3400                                                        $1200

BlackTom AI · Accepted Answer

Question restatement: On November 1, Year 1, Key Co paid 3600 to renew an insurance policy for 3 years, recording it as an expense. By December 31, Year 1, the unadjusted trial balance shows prepaid insurance 90 and insurance expense 4410. We must determine the correct December 31 balances for prepaid insurance and insurance expense.

Option A: Prepaid 3400, Insurance expense 1100.
- Why this is unlikely: The prepaid amount after adjustment should reflect the portion of the 3600 that has not yet expired. Since the policy covers 36 months, 2 months (Nov and Dec) have passed by December 31, meaning 34 months remain. The prepayment should be 3600 * (34/36) = 3400, which matches the idea of a remaining asset; however, the expense portion in this option (1100) does not align with the 2-month usage worth of 200 (3600/18). Using 1100 would imply either more months expensed or an erroneous allocation, contradicting the 2-month consumption.

Option B: Prepaid 3490, Insurance expense 1010.
- Why this could be correct: Start from the given unadjusted figures. The 3600 paid was recorded as an expense, so we must reverse that incorrect 3600 and place it into the prepaid asset. That would increase prepaid by 3600 and decrease expense by 3600. The unadjusted expense would then reflect 4410 − 3600 = 810 of genuine expense. But we actually only consumed 2 months worth of the policy (Nov and Dec) as of Dec 31, which equals 200 (3600/36 = 100 per month; 2 months = 200). So we add 200 to the reversed amount to match the actual expense for the period, yielding a total year-end expense of 810 + 200 = 1010. The prepaid balance becomes the original 90 plus the 3600 reversed from expense, minus the 200 used, giving 90 + 3600 − 200 = 3490. This aligns with Option B’s numbers.

Option C: Prepaid 3300, Insurance expense 1200.
- Why this is unlikely: 3300 as prepaid would imply 300 less than the 3600 total minus 2 months used, but the standard calculation yields 3400 remaining (34/36 of 3600). Additionally, 1200 as expense would correspond to 12 months of usage at 100 per month, which is inconsistent with the 2-month usage (which should be 200) and the reversal-plus-adjustment logic. This option misallocates both the asset and the periodic expense.

Option D: Prepaid 3400, Insurance expense 1200.
- Why this is unlikely: While the prepaid 3400 matches the straightforward remaining balance after 34 months, the expense component would be 1200, which implies 12 months of usage or an annual amount of 1200. But the period in question only covers 2 months (Nov and Dec), which should total 200, not 1200. Therefore this option overstates the current period expense and underadjusts the reversal of the original 3600.

Additional notes on the underlying concept: The 3600 paid for a 3-year policy should be amortized over 36 months. When an upfront payment is mistakenly expensed, you must reclassify the amount to an asset (prepaid insurance) and then recognize the expense for the portion of the policy that actually expired in the period. In Year 1, only two months have expired (Nov and Dec), so the correct current-year expense is 200, and the remaining prepaid balance should be 3400 after adjusting for the 2 months of usage. The selected option that most closely reflects this corrected allocation—and which matches the given unadjusted balances after applying the reversal and proper recognition—is Option B, with prepaid 3490 and insurance expense 1010 after the required adjustment steps.

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