Financial Accounting: An Integrated Statements Approach, 2nd Edition

Chapter 3 Accrual Accounting Concepts 101

balances are carried forward from the preceding month. In this sense, the accounting

equation represents a cumulative history of the financial results of the business. In

addition, the receipt of cash has the effect of increasing cash flows from operating

activities on the statement of cash flows.

Transaction b. On November 1, paid $2,400 for an insurance premium on a two-year,

general business policy.This insurance policy covers a variety of possible risks to the

business, such as fire and theft. By paying the premium, Family Health Care has pur-

chased an asset, insurance coverage, in exchange for cash. Thus, the mix of assets has

changed and cash flows from operating activities decreases by $2,400. However, the

prepaid insurance coverage is unique in that it expires with the passage of time. At the

end of the two-year period, the asset will have been used up, and the insurance pol-

icy will be completely expired. Such assets are called prepaid expensesordeferred

expenses. Thus, the purchase of the insurance coverage is recorded as prepaid insur-

ance, as shown below.

Balance Sheet

Assets  Liabilities Stockholders’ Equity

Prepaid Notes Unearned Capital Retained

Cash Insurance Land Payable Revenue  Stock Earnings

9,120 12,000 10,000 1, 800 6,000 3,320

2,400 2,400

6,720 2,400 12,000 10,000 1, 800 6,000 3,320

Statement of Cash Flows

b. Operating 2,400

Statement of

Cash Flows

Income

Statement

Income Statement

Balances

b. Paid insurance for 2 yrs.

Balances

Later in this illustration, we will discuss how such accounts are updated at the end

of an accounting period to reflect the portion of the asset that has expired.

Transaction c. On November 1, paid $6,000 for an insurance premium on a six-month

medical malpractice policy.This transaction is similar to transaction (b), except that

Family Health Care has purchased medical malpractice insurance that is renewable

every six months. The transaction is recorded as follows:

Balance Sheet

Assets  Liabilities Stockholders’ Equity

Prepaid Notes Unearned Capital Retained

Cash Insurance Land Payable Revenue  Stock Earnings

6,720 2,400 12,000 10,000 1, 800 6,000 3,320

6,000 6,000

720 8 ,400 12,000 10,000 1, 800 6,000 3,320

Statement of Cash Flows

c. Operating 6,000

Statement of

Cash Flows

Income

Statement

Income Statement

Balances

c. Paid insurance for 6 mos.

Balances