Prepaid Insurance (Definition, Journal Entries)

What is Prepaid Insurance?

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 portion of this insurance will be shown as an asset in the company’s balance sheet.

In simple terms, it refers to the portion of the outstanding insurance premium paid by the company in advance and is currently not due.

An insurance premium is an amount that an organization pays on behalf of its employees and the policies that a business has rendered. Generally, the insurance premium is paid monthly or quarterly. The expense, unexpired and prepaid, is reported in the books of accounts under under current assetsUnder Current Assets Current assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more. And the expense for that period is shown under the profit and loss statement.

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Source: Prepaid Insurance (wallstreetmojo.com)

Is Prepaid Insurance an Asset?

To understand this, let’s take an example.

FastTrack company buys one-year insurance for its delivery truck and pays $1200 for the same on December 1, 2017. Now that the company has prepaid for services to be used, it is classified as an asset.

In this case, Prepaid Insurance is classified as current assets on the Balance SheetBalance Sheet A balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more, as shown below.

This means that each month’s insurance expenseInsurance Expense Insurance Expense, also called Insurance Premium, is the amount a Company pays to obtain an insurance contract for covering their risk from any unexpected catastrophe. You can calculate it as a fixed percentage of the sum insured & it is paid at a daily pre-specified period. read more is $1200/12 = $100. So for one month between December 1, 2017, and December 31, 2017, $100 worth of insurance is used up.

Let us look at the balance sheet at the end of one month on December 31, 2017.

Please note that the reporting amount of prepaid insurance on the balance sheet asset is $1200 – $100 = $1100.

The insurance used for December will be reported as an Insurance Expense on December’s income statement. Therefore, it is shown below in the sample income statement.

Prepaid Insurance Journal Entries

XYZ company needs to pay its employee liability insurance for the fiscal year ending December 31, 2018, which amounted to $10,000. The company has paid $10,000 of the insurance premium for the entire year at the beginning of the first quarter.

The following journal entry will be passed and reflected in the books of accounts of XYZ company.

Journal Entry when Prepaid Insurance is paid

Particulars	Debit	Credit
Prepaid Insurance A/c	$10,000
To Bank/Cash A/c		$10,000

Prepaid Insurance is debited, which indicates the creation of an asset in the balance sheet.
The bank is credited with an equal amount which balances the rule of accountingRule Of Accounting Accounting rules are guidelines to follow for registering daily transactions in the entity book through the double-entry system. Here, every transaction must have at least 2 accounts (same amount), with one being debited & the other being credited. read more (for each credit, there is an equal debit)

Journal Entries when Prepaid Insurance is Due

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.

Particulars	Debit	Credit
Insurance Expense A/c	$2,000
To Prepaid Insurance A/c		$2,000

The income statement for the quarter ending will show an expense of $2,000 under the line item of Insurance Expense.
In the balance sheet of XYZ company, the closing balance of the current prepaid account will show a balance of $8,000 ($10,000- $2,000) for the quarter ending as the amount due for the quarter has been expensed for that period.
Amount due and expensed in this quarter is also known as the period costPeriod Cost Period cost refers to all those costs which are not related or tied with the production process of the company i.e., they are not assigned with any of the particular product of the company and are thus shown in the financial statement of the company for the accounting period in which they are incurred.read more as it is the cost to be incurred in this period.
The process of deduction from the account periodically is often known as Amortization.

Adjustment entry for Prepaid Expenses

Passing adjustment entries to balance the books of accounts is often helpful, which prevents one from making an entry for new business transactionsBusiness Transactions A business transaction is the exchange of goods or services for cash with third parties (such as customers, vendors, etc.). The goods involved have monetary and tangible economic value, which may be recorded and presented in the company's financial statements.read more. To pass an adjustment entry, one must debit the actual expense and credit the prepaid expense accountPrepaid Expense Account Prepaid expenses are expenses for which the company paid in advance in an accounting period but which were not used in the same accounting period and have yet to be recorded in the company's books of accounts.read more throughout the amortization. This prepaid account will come to the NIL balance at the end of the accounting period and all the expenses accruedExpenses Accrued An accrued expense is the expenses which is incurred by the company over one accounting period but not paid in the same accounting period. In the books of accounts it is recorded in a way that the expense account is debited and the accrued expense account is credited.read more in the income statement.

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Prepaid Insurance