Prepaid insurance definition

As per the golden rules of accounting (for personal accounts), prepaid insurance is debited. Prepaid insurance works similarly to many products or services you pay for fully in advance. 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. You must pay prepaid expenses upfront before you receive any type of benefit. For example, you might buy a one-year magazine subscription and receive one magazine per month for 12 months.

Prepaid insurance is usually charged to expense on a straight-line basis over the term of the related insurance contract. When the asset is charged to expense, the journal entry is to debit the insurance expense account and credit the prepaid insurance 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. This adjustment reduces the value of the prepaid insurance asset account to reflect the value of the insurance coverage that has been used up. As mentioned above, the premiums or payment is recorded in one accounting period, but the contract isn’t in effect until a future period.

Overview: What is a prepaid expense?

Most prepaid expenses appear on the balance sheet as a current asset unless the expense is not to be incurred until after 12 months, which is rare. Therefore, it can be said that prepaid insurance is both a debit and credit, depending on whether it is recognized as an asset or an expense. Prepaid insurance’s purpose is to ensure that business operations remain protected, and keeping track of prepaid insurance payments and expenses is essential to the business’s smooth running.

• The payment is entered on November 20 with a debit of $2,400 to prepaid insurance and a credit of $2,400 to cash.
• Your next step would be to record the insurance expense for the next 12 months.
• When the asset is charged to expense, the journal entry is to debit the insurance expense account and credit the prepaid insurance account.
• 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.
• For example, at the end of the first month when the expense is recognized, the accountant will debit the insurance expense account by $1,000 and credit the prepaid insurance account by $1,000.
• That’s because most prepaid assets are consumed within a few months of being recorded.

This refers to the overall difference between debits and credits in an account or a set of accounts. If the debits exceed the credits, the account is said to have a debit balance, while if the credits exceed the debits, the account has a credit balance. There are several different accounts used in accounting, and each one has its debit and credit rules.

Since your mileage varies from month to month, pay-per-mile programs do not offer a prepay option, only monthly billing. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia.

Rent As a Prepaid Expense

It is essentially an asset recorded by a company when it pays for insurance coverage in advance before the coverage period begins. The amount paid in advance is recognized as an asset until the coverage period begins after which it is then recognized as an expense. Prepaid insurance is commonly recorded, because insurance providers prefer to bill insurance in advance.

In essence, the balance sheet offers a snapshot of a company’s assets, liabilities, and equity at a specific point in time. For example, if you pay your rent on January 31 for February, that is not a prepaid expense. But if you pay your rent for the entire upcoming year, that is a prepaid expense and needs to be recorded as one. Prepaying your insurance premium might complicate the cancellation process. 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.

Prepaid Expense Accounting

If the prepayment covers a longer period, then classify the portion of the prepaid insurance that will not be charged to expense within one year as a long-term asset. On July 1, the company receives a premium refund of $120 from the insurance company. The company records the refund with a debit to Cash and a credit to Prepaid Insurance.

Is prepaid insurance a debit or credit?

The first step in recording a prepaid expense is the actual purchase of the expense. For example, if you pay your insurance for the upcoming year, you would first pay the expense, making sure to record it properly. While prepayment and monthly billing are standard ways to pay an insurance contribution margin income statement premium, some auto insurance companies offer pay-per-mile policies. 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.

Being aware of the adjustments that occur in prepaid insurance account ensures that a business records accurate financial statements and adheres to accounting rules. 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.

Pay the expense

The prepaid insurance account is crucial since it helps to ensure that the financial statements of a company reflect its true financial position, taking into account all assets and liabilities. To recognize the expense, the accountant will debit the insurance expense account and credit the prepaid insurance account. This means that the asset account is reduced and the expense account is increased.

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. When January comes around, you would then debit $2,000 as rent expense for January and credit your prepaid rent expense account for $2,000, leaving you with a balance of $22,000. The $2,000 you expensed for January’s rent appears on your income statement as rent expense, while your prepaid rent asset account is reduced by $2,000 on your balance sheet. At the end of the year, you will have expensed the entire $24,000, and your prepaid rent account will have a $0 balance. 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.

As each month passes, the prepaid insurance is recognized as an expense, and the prepaid insurance account is adjusted accordingly. The treatment of prepaid insurance is an important aspect of accounting for any business that has insurance coverage. The prepaid insurance account is created when the business pays for the insurance coverage.

Mary Girsch-Bock is the expert on accounting software and payroll software for The Ascent. Pay-per-mile car insurance policies are designed to benefit customers who maintain low annual mileage, such as people who work from home, are stay-at-home parents, or are retirees. Some insurers prefer that insured parties pay on a prepaid schedule such as auto or medical insurance.

– The prepaid insurance account would be credited for $1,200, reflecting the fact that the business owner prepaid for an insurance policy. 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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This journal entry is completed to establish your Prepaid Insurance asset account that represents the prepaid amount. Remember, to track prepaid expenses properly, they need to be recorded in your general ledger as a prepaid expense asset, with a portion of the prepaid asset accounted for each month as an 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.