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?

Bailey must adjust three accounts:

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

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