Which of the following correctly describes the effects of initially recording prepaid insurance expense when cash is paid to purchase an insurance policy?

Question

BlackTom AI · Accepted Answer

Recording prepaid insurance requires debiting Prepaid Insurance (an asset) and crediting Cash.

1. Relevant knowledge points and concepts
- Accrual accounting recognizes assets and expenses when earned or incurred, not necessarily when cash changes hands.
- Prepaid expenses (like prepaid insurance) are current assets representing future economic benefits.
- Journal entry on purchase: Debit Prepaid Insurance (asset), Credit Cash (asset).
- Expenses are recognized later as the insurance coverage is used (adjusting entry), which then reduces net income and equity.

2. Step-by-step reasoning
- Before purchase: assume Cash = $1,000, Prepaid Insurance = $0, Total Assets = $1,000.
- Transaction: pay $1,000 cash for a policy.
- Journal entry: Dr Prepaid Insurance $1,000; Cr Cash $1,000.
- After purchase: Cash = $0, Prepaid Insurance = $1,000, Total Assets = $1,000.

3. Intermediate calculation/example
- Assets before = Cash ($1,000) + Prepaid ($0) = $1,000.
- Assets after = Cash ($0) + Prepaid ($1,000) = $1,000.
- Change in Total Assets = $1,000 − $1,000 = $0.

4. Why the correct answer is correct
- Because one asset (cash) decreases by the same amount another asset (prepaid insurance) increases, total assets remain unchanged at the moment of the purchase. No expense has been recorded yet, so net income and equity are unaffected until insurance is expensed over time.

5. Why the other options are incorrect
- "Liabilities are decreased.": No liability account is involved; liabilities do not change.
- "Net income decreases.": No expense is recorded when prepaid is initially recorded; net income is unaffected until the insurance is expensed.
- "Stockholders' equity increases.": Equity is unaffected by an asset exchange; only future expense recognition will reduce retained earnings (equity), not increase it now.

6. Conclusion
Total assets do not change. This matches the provided correct answer: "Total assets do not change."

Which of the following correctly describes the effects of initially recording prepaid insurance expense when cash is paid to purchase an insurance policy?Single choice

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