On July 1, 2011 you purchase and pay $36,000 for a three year insurance policy. How much will your insurance expense be this year and during the following three years under the cash and accrual basis methods? At December 31 of each year, how much will Pre-Paid Insurance be on your Balance Sheet under each method?
Under the cash basis method, the insurance expense is recognized when the cash payment is made. Therefore, the insurance expense for this year would be $36,000.
Under the accrual basis method, the expense is recognized over the period the insurance policy covers. In this case, the policy covers three years. Therefore, the insurance expense for each year would be $36,000/3 = $12,000.
At December 31 of each year, the Pre-Paid Insurance account on the Balance Sheet would be the portion of the insurance payment that has not yet been recognized as an expense.
Under the cash basis method, the Pre-Paid Insurance account on the Balance Sheet would remain unchanged, as the entire payment has been recognized as an expense in the year of payment.
Under the accrual basis method, the Pre-Paid Insurance account on the Balance Sheet would decrease by the amount of insurance expense recognized for that year. Therefore, at December 31 of the first year, the Pre-Paid Insurance account would be $36,000 - $12,000 = $24,000. At December 31 of the second year, it would be $12,000, and at December 31 of the third year, it would be zero.
To calculate the insurance expense and Pre-Paid Insurance amount, we need to understand the concepts of cash basis and accrual basis accounting.
Under the cash basis method, expenses and revenues are recorded when cash is paid or received. On the other hand, the accrual basis method records expenses and revenues when they are incurred or earned, regardless of when the corresponding cash transaction occurs.
First, let's calculate the insurance expense for each year:
Cash Basis Method:
Since you paid $36,000 upfront for a three-year insurance policy, the insurance expense for each year would be $36,000 divided by three, which equals $12,000 per year.
Accrual Basis Method:
Under the accrual basis method, we evenly distribute the prepaid expense over the policy's duration.
For the first year, the insurance expense would be $36,000 divided by three, which equals $12,000, just like in the cash basis method.
For the second and third years, since the policy covers three years in total, the insurance expense would be $12,000 each year.
Now let's determine the Pre-Paid Insurance amount on the Balance Sheet at the end of each year:
Cash Basis Method:
Under the cash basis method, the Pre-Paid Insurance amount on the Balance Sheet will remain constant throughout each year. It will be $36,000 until the end of the third year.
Accrual Basis Method:
At December 31 of each year, the Pre-Paid Insurance amount on the Balance Sheet will decrease gradually.
At the end of the first year, the remaining prepaid insurance would be $36,000 minus the insurance expense of $12,000, resulting in $24,000.
At the end of the second year, the remaining prepaid insurance would be $24,000 minus the insurance expense of $12,000, resulting in $12,000.
Finally, at the end of the third year, the remaining prepaid insurance would be $12,000 minus the insurance expense of $12,000, resulting in $0.
So, to summarize:
Cash basis insurance expense for each year: $12,000
Cash basis Pre-Paid Insurance on the Balance Sheet at each year-end: $36,000
Accrual basis insurance expense for each year: $12,000, $12,000, $12,000
Accrual basis Pre-Paid Insurance on the Balance Sheet at each year-end: $24,000, $12,000, $0