If you memorize our table mentioned above, you’ll already make a huge progress. However, the best way to keep the information in your mind is to work with it. While prepayment and monthly billing are standard ways to pay an insurance premium, some auto insurance companies offer pay-per-mile policies. If ABC produced quarterly management reports, this type of balance day adjustment process would be required for each quarter. Let’s look quickly at the end of the first quarter of their current year – the three months ending June 30. In accounting, control of something is more important in defining an asset than ownership – the reason being those economic benefits again.

• Prior to issuing the December 31 financial statements, the company must remove the $120 credit balance in Prepaid Insurance by debiting Prepaid Insurance and crediting Insurance Expense.
• This account is no longer required as we are expensing the economic benefits for the rest of the year.
• This reflects the depletion of the asset by the amount of one month’s insurance, and it correctly enters the expense on the income statement.
• Prepaid insurance is an asset account on the balance sheet, in which its normal balance is on the debit side.
• This means the company should record the insurance expense at the period end adjusting entry when a portion of prepaid insurance has expired.

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.

Accounting for Use of Prepaid Expenses

The term “prepaid” means the portion of the insurance premium that has not been used up as at the date of the balance sheet. 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.

• The term “prepaid” means the portion of the insurance premium that has not been used up as at the date of the balance sheet.
• When canceling an insurance policy, you may incur a cancellation fee.
• 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.
• This means that the premium you pay is allotted to the upcoming time period.
• Insurance becomes an asset when you experience a risk covered in your insurance plan, which activates your coverage, allowing you to make a claim and receive a successful payout.

When the $2,400 payment is made on January 1, the company debits Prepaid Insurance and credits Cash. It also sets up automatic monthly adjusting entries to debit Insurance Expense for $200 and to credit Prepaid Insurance for $200 on the last day of each month. 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. These types of payments are handled using a prepaid expense account. Prepaid expenses aren’t included in the income statement per generally accepted accounting principles (GAAP).

How to Account for Dividends Paid? (Definition, Example, Journal Entry, And More)

The journal entries above shows how insurance expense is treated, in case of prepayments. Insurance expense, as an expense is treated in the same way as other expenses that are incurred. Similarly, the treatment of prepaid (as well as accrued) insurance is also how to change your tax filing status similar to that of prepaid (and accrued) expenses. However, during normal course of the business, insurance is generally a prepaid expense, because it is paid in advance, in most cases. Prepaying your insurance premium might complicate the cancellation process.

Importance of Recording Prepaid Insurance

Therefore, it is supposed to be treated as an expense for the current year. 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. 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.

Example of a Credit Balance in Prepaid Insurance

As of November 30, none of the $2,400 has expired and the entire $2,400 will be reported as prepaid insurance. 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. The same applies to many medical insurance companies—they prefer being paid upfront before they begin coverage. 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.

Prepaid Expenses Defined

Whenever your business buys insurance, you will pay the premium in advance for a specific coverage period. For example, you might pay an entire year’s worth of premium on Jan. 1, for the whole of 2019, or you might pay an insurance premium for the six-month period of Jan. 1 through June 30. As you move through the year and consume the insurance, your prepayment gets used up.

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. Prepaid insurance is usually considered a current asset, as it will be converted to cash or used within a fairly short time.

The company should credit Insurance Expense for $1,470 and debit

This reflects the depletion of the asset by the amount of one month’s insurance, and it correctly enters the expense on the income statement. This second journal entry creates the prepaid insurance asset with a debit of $7,500. ABC will disclose this amount under current assets in the balance sheet (statement of financial position).