Page 122 - Accounting Principles (A Business Perspective)

3. Adjustments for financial reporting

By 2010 December 31, one month of the year covered by the policy has expired. Therefore, part of the service
potential (or benefit obtained from the asset) has expired. The asset now provides less future services or benefits
than when the company acquired it. We recognize this reduction by treating the cost of the services received from

the asset as an expense. For the MicroTrain Company example, the service received was one month of insurance
coverage. Since the policy provides the same services for every month of its one-year life, we assign an equal
amount (USD 200) of cost to each month. Thus, MicroTrain charges / of the annual premium to Insurance
1
12
Expense on 2010 December 31. The adjusting journal entry is:
2010
Dec. 31 Insurance Expense 200 Adjustment
Prepaid Insurance 200 1—Insurance
To record insurance expense for December.

After posting these two journal entries, the accounts in T-account format appear as follows:
(Dr.) Prepaid Insurance (Cr)
2010 2010
Dec. 1 Purchased Dec. 31 Adjustment 1 200
on account 2,400
Decreased by $200
Bal. After adjustment 2,200
(Dr.) Insurance Expense (Cr.)
Increased by 2010
$200 31 Adjustment 1 200
In practice, accountants do not use T-accounts. Instead, they use three-column ledger accounts that have the

advantage of showing a balance after each transaction. After posting the preceding two entries, the three-column
ledger accounts appear as follows:
Prepaid Insurance
Date Explanation Post Ref. Debit Credit Balance
Dec. 2010 1 Purchased on Account G1 2400 2400 Dr.

31 Adjustment G3* 200 2200 Dr.

Insurance Expense
Date Explanation Post Ref. Debit Credit Balance
Dec. 2010 31 Adjustment G3* 200 200 Dr.

*Assumed page number
Before this adjusting entry was made, the entire USD 2,400 insurance payment made on 2010 December 1, was
a prepaid expense for 12 months of protection. So on 2010 December 31, one month of protection had passed, and

an adjusting entry transferred USD 200 of the USD 2,400 (USD 2,400/12 = USD 200) to Insurance Expense. On
the income statement for the year ended 2010 December 31, MicroTrain reports one month of insurance expense,
USD 200, as one of the expenses it incurred in generating that year’s revenues. It reports the remaining amount of
the prepaid expense, USD 2,200, as an asset on the balance sheet. The USD 2,200 prepaid expense represents 11
months of insurance protection that remains as a future benefit.
Prepaid rent Prepaid rent is another example of the gradual consumption of a previously recorded asset.
Assume a company pays rent in advance to cover more than one accounting period. On the date it pays the rent, the

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