Yummy foods purchased a two-year fire and extended coverage insurance policy on august 1, 2006, and charged the $4,200 premium to insurance expense. at its december 31, 2006, year-end, yummy foods would record which of the following adjusting entries?

a) insurance expense875 prepaid insurance875
b) prepaid insurance875 insurance expense875
c) insurance expense875 prepaid insurance3,325insurance payable4,200
d) prepaid insurance3,325 insurance expense3,325

A) insurance expense $875 Dr - Prepaid insurance $875 Cr

Explanation:

Lets first understand what an adjusting entry is. Adjusting entry is a double entry passed at the end of the reporting period, the purpose of which is to comply to the accruals concept of accounting. The accruals concept requires entities to record revenue and expenses in the period in which they get earned and incurred respectively and don't wait until they are received and paid off.  

Therefore, following the accruals concept we have to charge only this years insurance expense. Another important thing to note here is that Yummy Foods has paid for the two-year insurance in advance (which means that the insurance policy will be recorded as an asset/prepaid insurance). Yummy Foods purchased a two-year fire & extended coverage insurance policy on Aug 1 2006 and it's year end is Dec 31 2006. Insurance expense of five months will only be charged this year, see as follows:

Two-year prepaid insurance paid on Aug 1 2006 = $4200

Lets first split the premium on two year and calculate monthly insurance expense, see as follows:

Yearly insurance exp= $4200÷ 2

Yearly insurance exp= $2100

Monthly insurance exp= $175

Insurance expense to be recorded for 5 month period till Dec 31 2006 is as follows:

Insurance expense = $175× 5

Insurance expense = $875

The adjusting entry would be recorded to charge 5 months insurance expense and reduce the prepaid insurance (a current asset) with the same amount.