Prepaid Insurance: Definition, Example & Why It Matters
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 The payment of the insurance expense is similar to money in the bank—as that money is used up, it is withdrawn from the account in each month or accounting period. 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 adebitof $2,400 to prepaid insurance and a credit of $2,400 to cash. As of November 30, none of the $2,400 has expired and the entire $2,400 will be reported as prepaid insurance. 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.
Recognition of expenses
The business would record the prepaid insurance as an asset on the balance sheet and amortize the expense over the one-year coverage period. The accounting process for booking prepaid expenses is to initially record the payment as an asset and then gradually reduce that balance over time as the goods or services are used. Prepaid Insurance is the insurance premium paid by a company in an accounting period that didn’t expire in the same accounting period. Therefore, the unexpired prepaid insurance portion of this insurance will be shown as an asset on the company’s balance sheet. Most calculations dealing with prepaid insurance involve determining how much of that prepaid insurance expense is recognized in each accounting period. This is usually done by dividing the total premium paid by the coverage period, which may be expressed in months or years.
What is prepaid insurance?
To pass an adjustment entry, one must debit the actual expense and credit the prepaid expense account throughout the amortization. This prepaid account will come to the NIL balance at the end of the accounting period and all the expenses accrued in the income statement. Unexpired or prepaid expenses are the expenses for which payments have been made, but full benefits or services have yet to be received during that period. Prepaid assets are nonmonetary assets whose benefits affect more than one accounting period.
Entry at the Time of Cash Payment
As the coverage term progresses and sections of the prepaid insurance are expensed, the prepaid insurance account is credited to reflect the decrease in the prepaid amount. 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. 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 contribution margin the prepaid insurance that will not be charged to expense within one year as a long-term asset. Prepaid insurance is initially recorded as a current asset in the general ledger.
You decide to purchase prepaid insurance for this machinery for a period of one year. You pay the premium upfront, ensuring coverage against any potential losses or damages to the machinery during that year. Prepaid insurance policies are commonly used in the business world, particularly by companies that want to manage their risks and Food Truck Accounting protect their assets.
- It represents the amount that has been paid but has not yet expired as of the balance sheet date.
- A related account is Insurance Expense, which appears on the income statement.
- Prepaid expenses are amounts paid in advance by a business in exchange for goods or services to be delivered in the future.
- All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.
- As of November 30, none of the $2,400 has expired and the entire $2,400 will be reported as prepaid insurance.
- When the policy goes into effect, you’ll then get the benefits of the coverage over a 12-month period.
- Prepaid insurance is reported on the balance sheet under current assets.
- Cash and other assets that may reasonably be expected to be realized in cash, sold, or consumed through the normal operations of a business, usually longer than one year, are called current assets.
- Since your mileage varies from month to month, pay-per-mile programs do not offer a prepay option, only monthly billing.
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- For example, the following journal entry shows an initial payment of $12,000 for one year of insurance, which is recorded as an asset.
- XYZ company needs to pay its employee liability insurance for the fiscal year ending December 31, 2018, which amounted to $10,000.
- 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.
This means that the debit balance in prepaid insurance on December 31 will be $2,000. This translates to fivemonths of insurance that has not yet expired times $400 per month or five-sixthsof the $2,400 insurance premium cost. Because they represent a future benefit owed to the company, companies list prepaid expenses first on the balance sheet in the prepaid asset account. Because companies anticipate them to be consumed, employed, or spent through regular business activities within a year. Prepaid insurance for businesses is very valuable in terms of providing financial stability, budgeting accuracy, and risk mitigation.
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- This translates to fivemonths of insurance that has not yet expired times $400 per month or five-sixthsof the $2,400 insurance premium cost.
- Prepaid expenses are recorded as an asset on a company’s balance sheet because they represent future economic benefits.
- It is usually listed together with other prepaid expenses and short-term assets.
- Suppose that Smith Company, which has a yearly accounting period ending on 31 December, purchases a two-year comprehensive insurance policy for $2,400 on 1 April 2019.
Prepaid expenses are recorded as an asset on a company’s balance sheet because they represent future economic benefits. The payment of expense in advance increases one asset (prepaid or unexpired expense) and decreases another asset (cash). Prepaid expenses are expenses that are bought or paid for in advance, and may include things like insurance, rent, utilities, and subscriptions. Individuals benefit from prepaid expenses to make sure they will not miss payments for things like health insurance.