Gibson Company paid $12,000 on June 1, 2014 for a two-year insurance policy and recorded the entire amount as Insurance Expense. The December 31, 2014 adjusting entry is A. Debit Prepaid Insurance and credit Insurance Expense, $3,500 B. Debit Prepaid Insurance and credit Insurance Expense, $8,500 C. Debit Insurance Expense and credit Prepaid Insurance, $3,500 D. Debit Insurance Expense and credit Prepaid Insurance, $8,500

None of the options is correct, given the facts in the question.

The appropriate answer is:

Debit Prepaid insurance                             $12,000

Credit Insurance expenses                        $12,000

(Reversal of erroneous posting to insurance expenses)

Debit Insurance expenses                          $3,000

Credit Prepaid insurance                            $3,000

(To record 6 months prepaid insurance amortization)

Explanation:

Prepaid insurance is a payment for insurance policy premium in advance, whose service has not been fully enjoyed.

Gibson Company paid $12,000 for a two-year insurance policy. This was erroneously recorded as an expense. This wrong posting has to be reversed for the purpose of audit trail, as provided by the first journal.

To determine the monthly amortization, simply divide $12,000 by 24 months to arrive $500 amortization monthly. Since we are adjusting for December 31, 2014 (6 months from June 1, 2014), the 2014 amortization will be $500 x 6 months = $3,000. This has to be adjusted for by applying the second journals above.