11) Generally, the entire original amount of the insurance policy is placed in the Prepaid Insurance account. Later, when time passes and part of insurance is used, an adjustment is made. An appropriate amount of insurance is transferred from the Prepaid Insurance account to the Insurance Expense account, i.e., expense recognition takes place. Prepaid insurance is an example of a prepaid expense.

Prepaid expenses are expenses paid in cash and recorded as assets before they are used or consumed. Prepaid expenses are usually shown in the assets section on the balance sheet.

The company paid for one-year insurance coverage (transaction No. 2). The cost of insurance coverage per month is $100 ($1,200 / 12 months). By the end of the accounting period, 9 months of coverage have been used, and 3 months will be available for the next period. So, $900 (9 months x $100) is to be charged to the insurance expense at the end of 20X8 accounting period:

Illustration 21: Effect of recognizing insurance expense

Now, when we have seen the effects of all transactions on the accounting equation, let us look at the ending balances of all accounts:

Illustration 22: 20X8 ending account balances

As you can see, the total assets and claims (liabilities and equity) are equal, or balance. The reason is that even though we did not show the full accounting equation in analyzing 20X8 transactions, we still involved at least two accounts in a transaction (except Event No. 7, when we involved three accounts) and applied double-entry accounting.

Also pay attention to the way we showed retained earnings and revenues and expenses. We carried forward the beginning balance of retained earnings and then listed all revenues and expenses for the period 20X8. The reason is that all revenues and expenses are closed to retained earnings at period end. The ending balance of retained earnings would be $3,400 if you added the beginning retained earnings and all revenues and expenses for the period.