If the adjusting entry to record expired insurance was omitted, which statement is true?

• A. Net income will be understated for the year
• B. Net income will be overstated for the year
• C. Cash balance will be affected
• D. Liabilities will increase

Answer: (B)

Prepaid insurance is an asset that becomes an expense as time passes. At period end, you recognize the portion that has expired by debiting Insurance Expense and crediting Prepaid Insurance. If that adjusting entry is not made, expenses are understated, so net income for the period is overstated. The cash balance isn’t affected by the adjusting entry because cash was paid when the policy was bought, not when the adjustment is recorded. Liabilities aren’t affected because nothing new is owed; you’re simply reallocating part of an asset to an expense. For example, if you paid $12,000 for a year's insurance, month by month $1,000 should be expensed; omitting the adjustment leaves insurance expense too small and net income too high by $1,000.