What Is Prepaid Insurance?

If you keep a ledger, enter the prepaid insurance payment as both a debit and credit. Prepaid insurance is a future expense, which you must pay upfront and receive its benefits over time. However, once you make the premium payment, the policy’s coverage becomes an asset, which diminishes over time during the coverage period. Additional expenses that a company might prepay for include interest and taxes. Interest paid in advance may arise as a company makes a payment ahead of the due date.

As a rule, one of the major indicators that something goes wrong is the fact that an account has an abnormal balance, which is the opposite of the normal one. In this case, there might be an error or other issue that requires an urgent investigation.Keep in mind that if an account is usually a debit one, any debit entry increases the balance. If an account is usually credit, any credit entry increases the balance.

However, during normal course of the business, insurance is generally a prepaid expense, because it is paid in advance, in most cases. For reference, the chart below sets out the type, side of the accounting equation (AE), and the normal balance of some typical accounts best accounting software of 2021 found within a small business bookkeeping system. Prepaid insurance is coverage you pay for in full before you receive its benefits. For example, if you take out a mortgage to buy a new home, the lender may require you to pay a one-year homeowners premium at closing.

Upon signing the one-year lease agreement for the warehouse, the company also purchases insurance for the warehouse. The company pays $24,000 in cash upfront for a 12-month insurance policy for the warehouse. Knowing what a normal balance gives you the basics of double-entry bookkeeping. It’s not that difficult to figure out to what account type each transaction belongs to.

The term prepaid insurance refers to payments that are made by individuals and businesses to their insurers in advance for insurance services or coverage.
However, the second part of the payment corresponds to the next year, and therefore, it is supposed to be treated as a Current Asset in the financial statements that are prepared for this year.
We trust this article has helped in your understanding of prepayments.
But, as the benefit of the prepaid expense is realized, or as the expense is incurred, it is recognized on the income statement.
Throughout the home insurance policy’s term, you will reduce the value of the asset.

As mentioned above, the premiums or payment is recorded in one accounting period, but the contract isn’t in effect until a future period. A prepaid expense is carried on an insurance company’s balance sheet as a current asset until it is consumed. That’s because most prepaid assets are consumed within a few months of being recorded. Prepaid insurance is considered a business asset, and is listed as an asset account on the left side of the balance sheet. The payment of the insurance expense is similar to money in the bank, and the money will be withdrawn from the account as the insurance is „used up“ each month or each accounting period.

Accounting for Use of Prepaid Expenses

Abdul Co. has a new insurance policy that requires them to pay $2,400 per year, in a lump sum manner. Abdul Co. prepares their financial statements at the end of every year, i.e. 31st December. Therefore, the financial statements for Abdul Co. would be prepared as at 31st December 2019. Throughout the home insurance policy’s term, you will reduce the value of the asset. For example, the $1,200 prepaid policy will reduce in value by $100 each month, which you adjust in your ledger. Otherwise, one ends up with a contingent asset, which, although it may need to be disclosed by a reporting entity it will not be recognised in the financial statements.

The adjusting entry on January 31 would result in an expense of $10,000 (rent expense) and a decrease in assets of $10,000 (prepaid rent). Certain expenses, such as taxes and insurance, are paid in lump sums during one particular accounting period. The benefits from these payments extend past the single accounting period, so it is not accurate to charge the full payment to an expense account at that time. The adjusting journal entry is done each month, and at the end of the year, when the insurance policy has no future economic benefits, the prepaid insurance balance would be 0. On July 1, the company receives a premium refund of $120 from the insurance company. The company records the refund with a debit to Cash and a credit to Prepaid Insurance.

Normal Balance and the Accounting Equation

Therefore, it’s so important to make only the right entries, as they influence the balance directly. If they’re filled out incorrectly, the company will eventually suffer inevitable losses. Make sure to check what the normal balance should be for each particular account type as often as possible. 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.

Importance of Recording Prepaid Insurance

Since adjusting entries involve a balance sheet account and an income statement account, it is wise to monitor the balances in both Prepaid Insurance and Insurance Expense throughout the year. The amount that has not yet expired should be the balance in Prepaid Insurance. The balance itself can be debit or credit, whereas an account can be active or passive.

Prepaid insurance is usually considered a current asset, as it will be converted to cash or used within a fairly short time. As before, the debit to prepaid insurance creates a current asset – in this case, now one only worth $5,000. This is because, as of June 30, ABC Ltd has consumed six months worth of the insurance it prepaid on January 1. And the credit of $5,000 to the insurance expense account reduces the insurance expense line in the profit and loss statement down to $2,500 ($7,500 – $5,000). Remember, these accrual financial statements reflect the flow of economic resources (benefits and obligations), not the movement of money.

If the premium were $1,200 per year, for instance, you would record the check for $1,200 as a credit to the cash account in your journal, decreasing the value of that account. Then you would enter a debit of $1,200 to the prepaid insurance asset account, increasing its value. On December 31, an adjusting entry will show a debit insurance expense for $400—the amount that expired or one-sixth of $2,400—and will credit prepaid insurance for $400. This means that the debit balance in prepaid insurance on December 31 will be $2,000. This translates to five months of insurance that has not yet expired times $400 per month or five-sixths of the $2,400 insurance premium cost. Each month, you will need to move the used portion of the insurance payment to an expense account.

Pros and Cons of Prepaid Insurance

Prepaid insurance is not considered an expense and it is treated in the accounting records as a current asset. However, it must be noted that this charge is then gradually charged to the expense account across the period when the charge is actually incurred. As noted above, prepaid expenses are payments made for goods and services that a company intends to pay for in advance but will incur sometime in the future. Examples of prepaid expenses include insurance, rent, leases, interest, and taxes. Each of the accounts in a trial balance extracted from the bookkeeping ledgers will either show a debit or a credit balance. The normal balance of any account is the balance (debit or credit) which you would expect the account have, and is governed by the accounting equation.