Aurora Corporation operated without insurance coverage for the first month of operations. Then, on February 1, the company paid the $4,800 premium on a two-year insurance policy with benefits beginning on that date. The company uses the accrual basis. How much insurance expense will be reported on the company's income statement for their first year ended December 31?
$4,400 insurance expense will be reported on the company's income statement for their first year ended December 31.
When the company pays for the premium on a two-year insurance policy on February 1, the following must happen.
1. Recognize the Asset : Prepaid Insurance
2. De-recognize a decrease in Assets of Cash
At the end of the First year, the company will have utilized 11 months of the insurance policy, the following must happen
1. Recognize an Expense : Insurance Expense to the extent the insurance was utilized.
2. De-recognize the Asset : Prepaid Insurance to show utilization of the Asset benefit.
Entry is as follows :
Insurance Expense $4,400 (debit)
Prepaid Insurance $4,400 (credit)
Insurance Expense Calculation = $4,800 × 11/ 12 = $4,400.
Correct answer is letter B, $2,200
Using accrual basis method, revenue and expenses will be recognized when incurred whether paid (expenses) nor collected (revenues).
The $4,800 is a 24 months policy, therefore we must compute the insurance expense applicable for the year covering from February 1 to December 31 (11 months)
$4,800 divided by 24 months = $200 insurance per month multiply by 11 months expired portion (February 1 to December 31) = $2,200.
An adjusting entry to recognize the expire portion of the insurance must be done at the year end in the amount of $2,200.
($4,800 / 24 months = $200 x 11 months = $2,200)