The same applies to many medical insurance companies—they prefer being paid upfront before they begin coverage. Prepaid insurance (and how it’s accounted for in the balance sheet) isn’t something the majority of us need to worry about. However if you are using the accrual basis accounting method at your company, then prepaid insurance might come into play.
Here’s how an insurance company accounts for prepaid insurance. 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. A business buys one year of general liability insurance in advance, for $12,000.
The term prepaid insurance refers to payments that are made by individuals and businesses to their insurers in advance for insurance services or coverage. Premiums are normally paid a full year in advance, but in some cases, they may cover more than 12 months. When they aren’t used up or expired, these payments show up on an insurance company’s balance sheet. Each month, the business’s accounting department would make an adjusting journal entry of $1,000, representing the amount of one month’s premium payment in the general ledger. It would be entered as a credit in the asset account and as a debit to the insurance expense account. 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.
Why Can’t Insurers Use the Cash Basis Accounting Method?
Such assets as prepaid insurance are subject to an adjusting journal entry. The prepaid insurance account balance should be monitored throughout the year in order to report assets and expenses timely. For example, if a business had purchased six months of insurance and decided to cancel the policy after two months, it could redeem the value of the four remaining unused months of coverage. In other words, it could get a refund of the premiums for those four months. In this way, prepaid insurance has economic value, not unlike an investment in stocks or bonds, that can be redeemed at a later time.
When the full amount is received by the insurer, accounting will treat the payment as an asset. An entry will then be created on the books to move this amount from current assets to the expense side. The leftover ($16,000 in this case) will be counted as prepaid insurance for the insurer. Naturally, the leftover will still be counted as an asset on the balance sheet, with the understanding that the full amount will be used up by the end of the six-month term. Expenses that are used to make payments for goods or services that will be received in the future are known as prepaid expenses.
Prepaid insurance is recorded in the general ledger as a prepaid asset under current assets. A current asset is a financial resource that can be easily liquidated, or converted to cash, in a year or https://www.online-accounting.net/examples-of-straight-line-amortization/ less. In contrast, a non-current or fixed asset, like real estate, cannot be easily liquidated in a year or less. Additional expenses that a company might prepay for include interest and taxes.
Prepaid insurance is considered a prepaid asset because it benefits future accounting periods. It relieves them of the monthly premium expense, and in doing so, reduces their costs, while at the same time still conferring the benefit of having coverage for the business. Prepaid insurance is nearly always classified as a current asset on the balance sheet, since the term of the related insurance contract that has been prepaid is usually for a period of one year or less. 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.
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Prepaying your insurance can seem like a tempting way to save money and simplify your finances. The company expects to use the coverage within the next year, even if the formal period extends beyond. 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.
- In theory, they could cancel the insurance early and receive a huge cash refund.
- That’s because the vast majority of businesses in the United States use the “cash basis” accounting method.
- This unexpired cost is reported in the current asset account Prepaid Insurance.
- The transaction does not affect the company’s liabilities or shareholder’s equity.
For these businesses, any unused insurance that’s been received but haven’t expired count as an asset. Yes, prepaid insurance is considered a current asset on the balance sheet. Prepaid insurance refers to premiums for insurance that are paid in advance. A premium is a regular, recurring payment made to a provider for the benefit of having insurance coverage. A common financial question we see asked is related to prepaid insurance.
Simply add it as a current asset as long as it’ll be used up within the year. Then subtract the appropriate portion off every accounting period — likely monthly, but possibly what is cost accounting quarterly or annual. Most prepaid expenses appear on the balance sheet as a current asset unless the expense is not to be incurred until after 12 months, which is rare.
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In theory, they could cancel the insurance early and receive a huge cash refund. Most businesses won’t have to worry about the accounting side of prepaid insurance. That’s because the vast majority of businesses in the United States use the “cash basis” accounting method. This simply means that the company records revenue as the money is received and expenses as it pays them. If I pay for insurance, for example, I simply log the expense as any other bill when I pay it. There’s no need for me to keep it on the balance sheet and then “use it up” over the period of the insurance contract.
How is Prepaid Insurance Recorded in Accounting?
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.
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. However, the premiums may be marginally higher to account for inflation and other operating factors. When the insurance coverage comes into effect, it is moved from an asset and charged to the expense side of the company’s balance sheet. Insurance coverage, though, is often consumed over several periods. In this case, the company’s balance sheet may show corresponding charges recorded as expenses. Prepaid insurance is also considered an asset because of its redeemable value.
An asset is an economic resource that provides future benefits for the business. Prepaid expenses are assets that are paid in cash in advance and have benefits that apply over future periods. It’s only insurance companies, with the need to have pristine financial statements, that need to make sure every dollar is accounted for.
For example, you might pay a year’s worth of car insurance upfront at the beginning of the year. Eric White earned his educational credentials from the University of Texas, where he honed his skills and gained in-depth knowledge of insurance writing, risk management, and claims assessment. His commitment to staying at the forefront of industry trends ensures that he continues to be a valuable asset to the insurance field. Eric White, a proficient Content Writer at Insurance Insights, brings a unique perspective to the insurance industry. With a solid foundation in insurance writing, risk management, claims assessment, and customer education, Eric plays a pivotal role in creating insightful and accessible content.