Prepaid Insurance: Definition, How It Works, Benefits, and Example
Interest paid in advance may arise as a company makes a payment ahead of the due date. Meanwhile, some companies pay taxes before they are due, such as an estimated tax payment based on what might come due in the future. Other less common prepaid expenses might include equipment rental or utilities. One of the more common forms of prepaid expenses is insurance, which is usually paid in advance. This means that the premium you pay is allotted to the upcoming time period.
If a business were to pay late, it would be at risk of having its insurance coverage terminated. You may be wondering why we singled out insurance companies as not having the option to treat the prepaid insurance as revenue right away and move on. That’s because the IRS requires larger corporations to use the accrual basis accounting method. While the qualifications are out of the scope of this article, it’s safe to say that no insurer will ever qualify to use the cash basis accounting method.
These expenses are not initially recorded on an income statement. Instead, prepaid expenses are first recorded on the balance sheet. But, as the benefit of the prepaid expense is realized, or as the expense is incurred, it is recognized on the income statement. 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.
Rent As a Prepaid Expense
A prepaid asset is a type of asset that has economic value to the business because of its future benefit. In exchange, the insurance company usually offers the customer a discount on the premium price, so the business saves money on the policy. Once realized, the expense is recorded on the income statement.
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.
The full value of the prepaid insurance is recorded as a debit to the asset account and as a credit to the cash account. Each month, as a portion of the prepaid premiums are applied, an adjusting journal entry is made as a credit to the asset account and as a debit to the insurance expense account. 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. For instance, many auto insurance companies operate under prepaid schedules, so insured parties pay their full premiums for a 12-month period before the coverage actually starts.
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How is Prepaid Insurance Recorded in Accounting?
Prepaid insurance is exactly what it sounds like – insurance that’s been prepaid. Just pay the bill when it arrives, then rest easy knowing that you’re protected. The question of how long prepaid insurance remains a current asset can feel like a grey area, but accounting principles offer some clear guidelines.
- 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.
- The payment is entered on November 20 with a debit of $2,400 to prepaid insurance and a credit of $2,400 to cash.
- For instance, many auto insurance companies operate under prepaid schedules, so insured parties pay their full premiums for a 12-month period before the coverage actually starts.
- It represents the right to insurance protection over a specific period, providing peace of mind and potentially reducing future expenses.
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.
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 https://www.kelleysbookkeeping.com/about-form-4868-application-for-automatic/ Insurance 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.
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.
Why Is Prepaid Insurance Considered a Debit in the Asset Account?
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 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.
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, insurance journal entry 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.
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