Yummy Foods purchased a two-year fire and extended coverage insurance policy on August 1, 2027, and charged the $3,840 premium to Insurance expense. At its December 31, 2027, year-end, Yummy Foods would record which of the following adjusting entries?

Question

BlackTom AI · Accepted Answer

The question asks how Yummy Foods should adjust its insurance accounting at year-end after paying a 2-year premium of 3,840 on August 1, 2027.
First, determine the period covered and which portion is expensed versus prepaid. The policy spans 24 months from August 1, 2027, through July 31, 2029. By December 31, 2027, five months have elapsed (August through December), leaving 19 months unexpired on the prepaid asset. The monthly cost of the policy is 3,840 / 24 = 160. Therefore, the expired portion (insurance expense) for five months is 5 × 160 = 800, and the remaining unexpired portion (prepaid insurance asset) is 19 × 160 = 3,040.

Option 1: Debit Insurance expense 800; Credit Prepaid insurance 3,040. This entry would recognize 800 as an expense and reduce prepaid insurance by 3,040, which is not consistent with restoring the full 3,040 as a prepaid asset while expensing only 800. The amounts do not balance: total debits would be 800, while total credits would be 3,040, creating an inconsistency.

Option 2: Debit Prepaid insurance 800; Credit Insurance expense 800. Here, the entry would increase the prepaid asset by 800 and decrease the expense by 800. This reverses the correct direction for expensing the used portion and also omits the reduction of the prepaid asset by the unexpired portion that should remain on the books. The net effect fails to reflect both the expense incurred and the asset remaining.

Option 3: Debit Insurance expense 800; Credit Prepaid insurance 800. This shows recognizing the five months of expense (800) but reduces prepaid insurance by only 800, ignoring that the remaining 3,040 should stay as a prepaid asset. The total effect misstates the asset balance while correctly stating the expense, but the mismatch in the prepaid amount makes the entry incorrect.

Option 4: Debit Prepaid insurance 3,040; Credit Insurance expense 3,040. This entry would increase the prepaid asset by 3,040 and simultaneously increase the insurance expense by 3,040, which would not reflect the actual 800 expense for the period and would overly inflate both accounts in opposite directions. The net result is inconsistent with the service consumed and the asset still on hand.

In summary, each option has issues either with correctly recording the portion expensed (800) and the portion prepaid (3,040) or with the direction of the entries and the relation between the two accounts. The goal of a proper adjusting entry is to recognize the 800 as expense for the period and to reduce prepaid insurance by 3,040 to reflect the unexpired portion remaining as an asset. The combination that achieves this balance is a debit to Insurance expense for 800 and a credit to Prepaid insurance for 3,040, leaving a 3,040 balance in Prepaid insurance and 800 recognized as expense for the year.

Yummy Foods purchased a two-year fire and extended coverage insurance policy on August 1, 2027, and charged the $3,840 premium to Insurance expense. At its December 31, 2027, year-end, Yummy Foods would record which of the following adjusting entries?

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