A company prepaid $6,000 for six months of insurance on October 1. On December 31, the adjusting entry should:

Question

Accepted Answer

Debit Insurance Expense $3,000 and credit Prepaid Insurance $3,000. Three months have passed between October 1 and December 31 (October, November, December). Since $6,000 covers six months of insurance, each month costs $1,000. After three months, $3,000 of the prepaid insurance has been "used up" (expired). The adjusting entry debits Insurance Expense for $3,000 (recognizing the cost of three months of coverage) and credits Prepaid Insurance for $3,000 (reducing the asset by the expired portion). The remaining $3,000 stays on the balance sheet as a prepaid asset.

Expensing the full $6,000 would be incorrect because only three of the six months have elapsed  -  the company still has three months of coverage remaining as an asset. The third option reverses the debits and credits. The fourth option only recognizes one month of expense instead of three.

Prepaid expense adjustments are among the most commonly tested adjusting entries on the CLEP exam. The initial entry when payment is made records an asset (Prepaid Insurance). As time passes and the benefit is consumed, the asset is gradually transferred to expense through adjusting entries. The key skill is determining how much of the prepaid amount has expired by the end of the accounting period. This same logic applies to prepaid rent, prepaid advertising, and office supplies  -  all situations where cash is paid before the expense is incurred.

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