Question

1. Y Company's auditor discovered an error when conducting the 2018 audit. (This is prior to the company permanently closing the accounting system to 2018 entries and issuing the 2018 financial statements, and the error was not caught during the preparation of the 2017 tax return. In both years, the company had positive net income greater than $1 million.) A two-year insurance policy purchased on April 30, 2017, in the amount of $24,000 was debited to Prepaid Insurance. No adjustment was made on December 31, 2017, or on December 31, 2018.

Required:

Prepare appropriate journal entries. Apply U.S. GAAP. The tax rates for all tax years involved is 40%. Think carefully about how this transaction affects taxes.

Answer 1

As per the US GAAP, prepaid expenses are not recorded as an expense in the Profit and loss of a company. Rather expenses are recorded on accrual basis, therefore Prepaid expenses are recorded as they become accrued during the span of time.

In the question, the company has taken a Two year insurance policy of $24000 on 30-04-2017 i.e. from 30-04-2017 upto 29-04-2019. The company should put the whole amount of $24000 in the prepaid Insurance ledger and at the end of every year, it should transfer the accrued insurance amount to the insurance expense ledger from such prepaid insurance ledger. But the company has not done any transfer entry to insurance expense ledger in both the two years.

Following are the appropriate journal entries to be passed by the company:

YEAR 2017

On 30-April-2017

Prepaid Insurance A/c Dr. $24000

To Cash/Bank A/c $24000

At the closing of Year 2017, 8 months has passed, so the expense related to these 8 months on accrual basis is to be transferred to Insurance expense ledger from Prepaid Insurance ledger (i.e $24000/24*8)

On 31-Dec-2017

Insurance Expenses A/c Dr. $8000

To Prepaid Insurance A/c $8000

The tax rate applicable to the relevant year is 40% as given in the question. The company will have a tax benefit to the tune of 40% on such insurance expense for the year 2017. The company tax liability will get decreased by $3200 (i.e $8000*40%) for the year 2017.

YEAR 2018

Now at the opening of year 2018, the prepaid Insurance ledger will have a balance of $16000 ($24000-$8000). At the end of year 2018 i.e. on 31-Dec-2018, the company will transfer the insurance expense related to the year 2018 to the insurance expense ledger from the prepaid insurance ledger (i.e 24000/24*12)

On 31-Dec-2018

Insurance Expenses A/c Dr. $12000

To Prepaid Insurance A/c $12000

As the tax rate for the year 2018 is same as of Year 2017 i.e 40%. The company's tax liability for year 2018 will also get decreased by $4800 (i.e $12000*40%).