As you move through the year and consume the insurance, your prepayment gets used up. The term “prepaid” means the portion of the insurance premium that has not been used up as at the date of the balance sheet. Likewise, the company can make insurance expense journal entry by debiting insurance expense account and crediting prepaid insurance account. Additional expenses that a company might prepay for include interest and taxes. 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.

• Prepaid Expenses are expenses that are paid more than the amount that the company owed.
• In the subsequent year, when insurance is lapsed, then the amount will be deducted as an expense from the Income Statement.
• The payment of the insurance expense is similar to money in the bank—as that money is used up, it is withdrawn from the account in each month or accounting period.

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. In this case, the company’s balance sheet may show corresponding annual budgeting process planning and best practices charges recorded as expenses. Prepaid expense is personal account in nature and default normal
balance is debit balance and shown under current asset in asset
side of balance sheet.

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 Insurance Journal Entry

Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own.

• Prepaid expenses are initially recorded as assets, because they have future economic benefits, and are expensed at the time when the benefits are realized (the matching principle).
• You don’t need a bank account to use prepaid cards, which is why they appeal to people who are unable to access traditional banking.
• But, at the end of the financial year, this would then be carried down to the next year, as a prepaid expense.
• This means that the debit balance in prepaid insurance on December 31 will be $2,000.
• 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.

If you pay a six-month premium for a car insurance policy, the coverage will protect your automobile from the effective date until it’s time to renew the policy. Prepaid insurance is coverage you pay for in full before you receive its benefits. For example, if you take out a mortgage to buy a new home, the lender may require you to pay a one-year homeowners premium at closing.

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. 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. Expenses that are used to make payments for goods or services that will be received in the future are known as prepaid expenses. But, as the benefit of the prepaid expense is realized, or as the expense is incurred, it is recognized on the income statement.

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The normal balance of any account is the balance (debit or credit) which you would expect the account have, and is governed by the accounting equation. Prepaid Expenses are found on almost every financial statement across different companies. In this regard, it is essential to ensure that the treatment of prepaid expenses is adequately adhered to so that there are no inconsistencies in preparing financial statements. You must pay prepaid expenses upfront before you receive any type of benefit.

Understanding Prepaid Expenses in the Balance Sheet

The initial journal entry for a prepaid expense does not affect a company’s financial statements. The initial journal entry for prepaid rent is a debit to prepaid rent and a credit to cash. The payment is entered on November 20 with a debit of $2,400 to prepaid insurance and a credit of $2,400 to cash. Assume that a company’s annual premium on its liability insurance policy is $2,400 and is due on the first day of each year. When the $2,400 payment is made on January 1, the company debits Prepaid Insurance and credits Cash.

Hence, it is important to record actual expenses for the year, so that the correct amount of profit is calculated. Prepaid Insurance vs. Insurance Expense The prepaid amount will be reported on the balance sheet after inventory and could part of an item described as prepaid expenses. As the prepaid amount expires, the balance in Prepaid Insurance is reduced by a credit to Prepaid Insurance and a debit to Insurance Expense.

Common prepaid expenses may include monthly rent or insurance payments that have been paid in advance. 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 adjusting journal entry is done each month, and at the end of the year, when the insurance policy has no future economic benefits, the prepaid insurance balance would be 0. When there is a payment that represents a prepayment of an expense, a prepaid account, such as Prepaid Insurance, is debited and the cash account is credited. This records the prepayment as an asset on the company’s balance sheet. 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.

Based on this, the first component is the current year’s expense, since it is relevant to the timeline for which the financial statements are being prepared. Therefore, it is supposed to be treated as an expense for the current year. In the example above, it can be seen that Abdul Co. has made an annual payment for insurance, amounting to $2,400. This amount corresponds to 12 months, beginning on 1st July 2019, and ending on 30th June 2020.

Contra Accounts

The company records the refund with a debit to Cash and a credit to Prepaid Insurance. At December 31, the balance in Prepaid Insurance will be a credit balance of $120, consisting of the debit of $2,400 on January 1, the 12 monthly credits of $200 each, and the $120 credit on July 1. 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. 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.

In the subsequent year, when insurance is lapsed, then the amount will be deducted as an expense from the Income Statement. Insurance is not the only expense that must be accounted for over multiple reporting periods. Any salaries earned in one month but paid in the next month must be accounted for in a similar manner so that the expense is accounted for in the month that the pay was earned. Property taxes are often paid every six months, and require the same treatment. A business may collect a prepayment for sales on product that has not been delivered, and these sales must be entered as deferred revenue. As prepaid insurance is an asset that will expire through the passage of time, the cost of expiration will need to be recognized as an expense during the period.

Like all financial products, prepaid insurance has both advantages and disadvantages to consider. Insurance companies often offer incentives to customers who prepay their premiums, but this type of plan requires making a large lump-sum payment. Some insurers prefer that insured parties pay on a prepaid schedule such as auto or medical insurance. 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. For example, on September 01, 2020, the company ABC Ltd. pays $1,200 for one year of fire insurance which covers from September 01, 2020.

For example, if you pay your $1,500 annual home insurance premium in one payment, then sell your house six months into the policy’s term, the insurer will have to refund the unused premium. Although providers do issue prorated refunds, you may have to wait days or weeks to receive the money. Prepaid insurance requires you to pay your premium before receiving the financial benefits of the policy. Insurers commonly offer prepayment for many types of insurance, including auto and homeowners insurance.

As mentioned above, the premiums or payment is recorded in oneaccounting period, but the contract isn’t in effect until a future period. A prepaid expense is carried on an insurance company’s balance sheetas acurrent assetuntil it is consumed. That’s becausemost prepaid assets are consumed within a few months of being recorded.