This payment represents a prepaid expense, but its classification as an asset might surprise you. The most important calculation regarding prepaid insurance reflects the unexpired portion of the policy. We’ve outlined the procedure for reporting prepaid expenses below in a little more detail, along with a few examples. Prepaid expenses are classified as assets as they represent goods and services that will be consumed, typically within a year.
Prepaid expenses aren’t included in the income statement per generally accepted accounting principles (GAAP). Thus, prepaid expenses aren’t recognized on the income statement when paid because they have yet to be 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.
Thus, the amount charged to expense in an accounting period is only the amount of the prepaid insurance asset ratably assigned to that period. Things change if a business is using the “accrual basis” accounting method. These companies, usually larger corporations, will need to count prepaid expenses (like insurance) as an asset until it’s used up. When the numbers get high enough, you can understand why this matters. A company spending six or seven figures a year on insurance costs will want to count that cash as an asset until it’s actually used.
Prepaid insurance can be classified as a current asset because it is used up or expires in a short period of time, usually one year, of the balance sheet date. Let’s say a delivery company takes out some commercial auto insurance for its fleet of cars. However, it not until month six that the company has used all of the $24,000 worth of insurance. In this way, the asset value of the prepaid insurance will be reduced to zero at the end of the time period which was paid for in advance. Similarly, the expense will reach the total of the prepaid amount at the end of that same period. At the end of each month, an adjusting entry of $400 will be recorded to debit Insurance Expense and credit Prepaid Insurance.
As of November 30, none of the $2,400 has expired and the entire $2,400 will be reported as prepaid insurance. 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 what is accounting and why it matters for your business and a credit of $2,400 to Cash. 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. Prepaid insurance is commonly recorded, because insurance providers prefer to bill insurance in advance.
The transaction does not affect the company’s liabilities or shareholder’s equity. Prepaid insurance is usually considered a current asset, as it becomes converted to cash or used within a fairly short time. But if a prepaid expense is not consumed within the year after payment, it becomes a long-term asset, which is not a very common occurrence. The payment of the insurance expense is similar to money in the bank—as that money is used up, it is withdrawn from the account in each month or accounting period. Regardless of whether it’s insurance, rent, utilities, or any other expense that’s paid in advance, it should be recorded in the appropriate prepaid asset account.
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. As the amount of prepaid insurance expires, the expired portion is moved from the current asset account Prepaid Insurance to the income statement account Insurance Expense. This is usually done at the end of each accounting period through an adjusting entry.
Prepaid Insurance: Is It an Asset or Owner’s Liability?
It represents the right to insurance protection over a specific period, providing peace of mind and potentially reducing future expenses. This article dives into the world of prepaid insurance, answering your frequently asked questions and clearing up any doubts. As the policy is consumed from month to month, the policy’s value for those months will be recorded as a credit, and the entries in the two columns will eventually cancel out or total zero. This reflects its short-term nature and its expected use within the current accounting cycle. Prepaid insurance can be a confusing term, especially when it comes to accounting.
Simply put, prepaid insurance is a payment you make for insurance coverage in advance, typically covering a period longer than one accounting period. It would be entered into the general ledger as a debit of $12,000 to the asset account and a credit for the same amount to the cash account. Then, when the expense is incurred, the prepaid expense account is reduced by the amount of the expense, and the expense is recognized on the company’s income statement in the period when it was incurred. All assets, liabilities, and equity of a company are represented on the balance sheet.
- 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.
- Other less common prepaid expenses might include equipment rental or utilities.
- Technically, we can argue that prepaid insurance counts as an asset for individuals too.
- If a business were to pay late, it would be at risk of having its insurance coverage terminated.
- This payment represents a prepaid expense, but its classification as an asset might surprise you.
Prepaid insurance is important because a business should correctly record all of its transactions and resources to have accurate financial statements. Some insurers prefer that insured parties pay on a prepaid schedule such as auto or medical insurance. This is because it has value and future economic benefit for the company.
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When paying for prepaid insurance, the initial record is a debit to the “Prepaid Insurance” account, a current asset. The business’s records would show four months of insurance policy as https://www.bookkeeping-reviews.com/the-ultimate-guide-to-construction-accounting/ a current, prepaid asset. Prepaid insurance also creates other benefits for the business. It is considered a prepaid asset, which is a way to express these benefits in accounting terms.
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Technically, we can argue that prepaid insurance counts as an asset for individuals too. I get a slight discount from my insurance company doing it this way, as opposed to paying monthly. Technically, I could claim the unused portion when I calculate my net worth. At the end of twelve months, the asset account would show a balance of zero for the insurance premium and a total of $12,000 in the insurance expense account.
Other Prepaid Expenses
Any remaining prepaid portion of the premium could be redeemed or refunded to the business if the business cancels the policy before the period covered by those premiums has expired. Insurance providers may allow a business to pay multiple monthly premiums in advance, in the form of one lump sum. For the insurance company, it generates more working capital and greater customer retention.
While the prepaid amount has not expired, it is treated as an asset, which is supposed to be used or converted to cash over the period of the contract. In case the insurance covers a longer period of time, the portion of the payment is classified as a long-term asset. If the prepaid insurance is not fully used when financial statements are prepared, it is going to be an asset at the payment date.