Accounting 101 Practice Exam — Free

Start with what the adjusting entry should have been. The policy costs $6,000 for six months, so it expires at $1,000 per month. From November 1 to December 31 two months have been used up, so $2,000 of coverage has been consumed and only $4,000 is still an asset.

The required entry on December 31 is: debit Insurance Expense $2,000; credit Prepaid Insurance $2,000. This follows the expense-recognition (matching) principle: the cost of coverage belongs in the period that received the coverage.

Now reason through the omission one account at a time. Insurance Expense was never debited, so expenses are understated by $2,000. Lower expenses mean net income is overstated by $2,000, and because net income closes into retained earnings, equity is overstated by the same amount. Prepaid Insurance was never credited, so it still shows $6,000 instead of $4,000: assets are overstated by $2,000. The accounting equation stays balanced because assets and equity are both too high by $2,000.

Option C is the most common slip: counting only one month (December) instead of November and December. Option B has every direction reversed. Option D is wrong because the adjustment moves an amount out of an asset and into an expense; it is not a reclassification within the balance sheet.

Answer: A — expenses understated by $2,000, net income overstated by $2,000, assets overstated by $2,000.

Everything here rests on the accounting equation, $\text{Assets} = \text{Liabilities} + \text{Equity}$, which must hold at every date.

(a) Opening equity. Rearrange the equation: Equity = Assets − Liabilities = $240,000 − $90,000 = $150,000.

(b) Closing equity. Only four kinds of events change equity: owner contributions and net income increase it; dividends (distributions) and net losses decrease it. Borrowing is not one of them, because a loan raises assets (cash) and liabilities (the loan) by the same amount and leaves the owners' claim unchanged.

So closing equity is $195,000.

(c) Closing assets. Liabilities rose only through the bank loan: $90,000 + $30,000 = $120,000. Then Assets = Liabilities + Equity = $120,000 + $195,000 = $315,000.

As a cross-check, trace the asset side directly: assets rose by the $20,000 share issue, the $30,000 loan and the $35,000 of net income (which, whatever form it takes, increases net assets), and fell by the $10,000 dividend, for a net increase of $75,000; $240,000 + $75,000 = $315,000, the same figure.

Answer: (a) $150,000; (b) $195,000; (c) $315,000.

Apply the rules: debits increase assets and expenses; credits increase liabilities, equity and revenues. Every entry must have equal debits and credits.

Why each entry looks this way: the March 3 purchase is a compound entry, with the $18,000 asset financed partly by cash and partly by a liability. On March 10 revenue is recognized when the work is performed ($9,500), regardless of how much cash arrives; the unpaid $5,500 is a receivable. The March 22 collection converts a receivable into cash and is not revenue, which would double-count it. Supplies bought on account are an asset until used, offset by a payable.

Cash ledger (T-account): debits 50,000 + 4,000 + 3,000 = 57,000; credits 6,000 + 1,500 = 7,500; balance 57,000 − 7,500 = $49,500 debit.

Accounts Receivable: debit 5,500, credit 3,000; balance $2,500 debit.

Debits equal credits: total debits = 50,000 + 18,000 + 4,000 + 5,500 + 1,500 + 3,000 + 800 = 82,800; total credits = 50,000 + 6,000 + 12,000 + 9,500 + 1,500 + 3,000 + 800 = 82,800. The two agree, so the entries balance.

Answer: Cash $49,500; Accounts Receivable $2,500; total debits = total credits = $82,800.