Prepaid insurance plays a significant role in financial accounting, influencing how companies report their financial health. Understanding its classification on financial statements is essential for accurate reporting and compliance with accounting standards. This topic affects the balance sheet presentation and the timing of expense recognition. Prepaid insurance is commonly recorded, because insurance providers prefer to bill insurance in advance. If a business were to pay late, it would be at risk of having its insurance coverage terminated.
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A business buys one year of general liability insurance in advance, for $12,000. The initial entry is a debit of $12,000 to the prepaid insurance (asset) account, and a credit of $12,000 to the cash (asset) account. In each successive month for the next twelve months, there should be a journal entry that debits the insurance expense account and credits the prepaid expenses (asset) account. Prepaid insurance is usually charged to expense on a straight-line basis over the term of the related insurance contract. When the asset is charged to expense, the journal entry is to debit the insurance expense account and credit the prepaid insurance account.
The matching principle is the basis for allocating expenses to the periods in which they are used or consumed. Someone on our team will connect you with a financial professional in our network holding the correct designation and expertise. This team of experts helps Finance Strategists maintain the highest level of accuracy and professionalism possible. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.
- For example, if a company pays $12,000 for a one-year policy, the monthly insurance expense would be $1,000.
- Prepaid or unexpired expenses can be recorded under two methods – asset method and expense method.
- The insurance used for December will be reported as an Insurance Expense on December’s income statement.
Prepaid Insurance Journal Entry
Thus, the amount charged to expense in an accounting period is only the amount of the prepaid insurance asset ratably assigned to that period. For example, the following journal entry shows an initial payment of $12,000 for one year of insurance, which is recorded as an asset. At the payment date of prepaid insurance, the net effect is zero on the balance sheet; and there is nothing to record in the income statement. However, after adjusting entry at the end of the period for the insurance expense, the asset account will decrease while the expense account will increase. Likewise, the adjusting entry at the end of the period is necessary for the company to recognize the cost that expires through the passage of time.
The premium covers twelve months from 1 September 2019 to 31 August 2020, i.e., four months of 2019 and eight months of 2020. It would be incorrect to charge the whole $4,800 to 2019’s profit and loss account. At the end of the year, there may be expenses whose benefits have been received but not paid for and expenses that may have been paid, but their benefit will appear in the next financial year. Some insurers prefer that insured parties pay on a prepaid schedule such as auto or medical insurance.
If the prepayment covers a longer period, then classify the portion of the prepaid insurance that will not be charged to expense within one year as a long-term asset. To illustrate prepaid insurance, let’s assume that on November 20 a company pays an insurance premium of $2,400 for insurance protection during the six-month period of December 1 through May 31. On November 20, the payment is entered with a debit of $2,400 to Prepaid Insurance and a credit of $2,400 to Cash. A prepaid expense is an expenditure that a business or individual pays for before using it. When someone purchases prepaid insurance, the contract generally covers a period of time in the future.
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For example, on September 01, 2020, the company ABC Ltd. pays $1,200 for one year of fire insurance which covers from September 01, 2020. For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. The matching convention requires allocation of the expenditure between the asset that represents the remaining economic benefits and the expense that represents the benefits used or consumed by the firm. A financial professional will offer guidance based on the information provided and offer a no-obligation call to better understand your situation. Our team of reviewers are established professionals with decades of experience in areas of personal finance and hold many advanced degrees and certifications.
When insurance is due for each quarter, i.e., $2,000 will be subtracted from the prepaid account and is shown as an expense in the income statement for that reporting quarter. In this case, Prepaid Insurance is classified as current assets on the Balance Sheet, as shown below. The original journal entry, as well as the adjusting entry and the relevant T-accounts, are illustrated below. Although Mr. John’s trial balance does not disclose it, there is a current asset of $3,200 on 31 December 2019.
What is the best way to estimate the amount of a prepaid asset’s monthly benefit?
If a company is in an industry where the operating cycle is longer than one year, the company’s current assets are cash and assets that will be converted to cash or be used up/consumed during the operating cycle. At the end of each month, the company usually make the adjusting entry for insurance expense to recognize the cost of that has expired during the period. is prepaid insurance an asset Unless an insurance claim is filed, prepaid insurance is usually renewable by the policyholder shortly before the expiry date on the same terms and conditions as the original insurance contract.
In this case, the company’s balance sheet may show corresponding charges recorded as expenses. The payment of expense in advance increases one asset (prepaid or unexpired expense) and decreases another asset (cash). For most industries, a company’s current assets are defined as cash and other assets that will turn to cash or will be used up or consumed within one year of the balance sheet date.
Prepaid insurance is the portion of an insurance premium that has been paid in advance and has not expired as of the date of a company’s balance sheet. This unexpired cost is reported in the current asset account Prepaid Insurance. To illustrate how prepaid insurance works, let’s assume that a company pays an insurance premium of $2,400 on November 20 for the six-month period of December 1 through May 31. The payment is entered on November 20 with a debit of $2,400 to prepaid insurance and a credit of $2,400 to cash.
