Question

On December 31, 2017, insurance costs that were related to a policy that started January 1, 2018 and ended December 31, 2019 was paid and debited to insurance expense. Indicate the effect of this transaction on net income and retained earnings at December 31, 2019 by entering "no effect", "overstated" or "understated" in the text boxes provided.

Net Income :

Retained Earnings:

Answer 1

In the present situation, the entire expense has been debited on December 31, 2017 to expenses. As per accrual system of accounting, expenses for a period are recognized in the period in which they are incurred and all expenses which are not related to a period but are paid in advance are recorded as prepaid expense

So, on December 31, 2017, originally, the amount should have been debited to prepaid expenses for prepaid insurance for year 2018 and 2019 ( 2 years) and later in year 2018 and 2019, the prepaid amount should have been transferred to insurance expenses account

But the amount was recognized as expense in year 2017 itself. Due to this, the net income of year 2017 reduced and retained earnings also got reduced

In 2018

As the amount was not shown as expense in 2018 and 2019 relating to one year insurance expense for 2018 as it was already booked in 2017 as expense, the net income of years 2018 and 2019 were overstated but since the retained earnings had already reduced in 2017, there was no effect on retained earnings as retained earnings is a cumulative value of all past net incomes and since the net income was already reduced in 2017 resulting in retained earnings being lower than it actually should be in 2017 but with no effect on retained earnings in future, the retained earnings of 2019 will have no effect of this mistake

So, as per above discussion, the following conclusion arises

For the year 2019

Net Income – Overstated

Retained Earnings – No Effect