It also enables the company’s management to make informed decisions about financial strategy and planning for the future. For example, if a large copying machine is leased by a company for a period of 12 months, the company benefits from its use over the full time period. Recording an advanced payment made for the lease as an expense in the first month would not adequately match expenses with revenues generated from its use. Therefore, it should be recorded as a prepaid expense and allocated out to expense over the full twelve months. Each journal entry requires a debit to Insurance Expense and a credit to Prepaid Expenses.

• If it is classified as an asset, it will be recorded on the balance sheet and will increase the company’s total assets.
• Firstly, prepaid insurance provides protection to the buyer against potential losses which could cost a lot of money to replace in the future.
• Meanwhile, some companies pay taxes before they are due, such as an estimated tax payment based on what might come due in the future.
• On the balance sheet, it would list prepaid insurance as a current asset with a value of $12,000.
• Then, when the expense is incurred, the prepaid expense account is reduced by the amount of the expense, and the expense is recognized on the company’s income statement in the period when it was incurred.
• As the insurance will not be used until and unless the first quarter of next year arrives, it will be reflected under the Asset side of the company as prepaid insurance.

To estimate the amount of a prepaid asset’s monthly benefit, divide the total cost of the asset by the number of months of benefits the asset represents. Prepaid insurance is a current asset because its benefits are usually realized within one year of payment. It is also an intangible asset because it does not have physical properties, like real estate or commercial equipment. No matter the industry or size, every business faces significant financial risks from liability, and these risks are especially prominent for small businesses, making liability insurance important. In accounting, liabilities are obligations that a company owes to its creditors or other third parties.

Definition of a Short-term or Current Asset

When it comes to the income statement, prepaid insurance can have a few different impacts depending on the company’s accounting method. Prepaid insurance (and how it’s accounted for in the balance sheet) isn’t something the majority of us need to worry about. However if you are using the accrual basis accounting method at your company, then prepaid insurance might come into play. Simply add it as a current asset as long as it’ll be used up within the year.

• A common example is paying a 6-month insurance premium in December that provides coverage from December 1 through May 31.
• Travelers could also opt for prepaid travel insurance that caters to the possibility of things like trip cancellation or medical expenses while away from home.
• An entry will then be created on the books to move this amount from current assets to the expense side.
• Companies that take care of assets and employees by paying reasonable advance insurance premiums are considered strong financial companies.
• It represents the amount that has been paid but has not yet expired as of the balance sheet date.

For example, when prepaid insurance provides benefits that positively affect the company, promoting long-term growth and profitability, it can be regarded as equity. In this context, prepaid insurance can be seen as a cash investment in the company that helps to enhance its overall financial performance. The Importance of Understanding Prepaid Insurance in Accounting
Accounting and finance professionals need to understand the concept of prepaid insurance fully. This knowledge is essential because the use of prepaid insurance can impact a company’s financial statements in several ways. Understanding prepaid insurance can help organizations to ensure that their financial statements accurately reflect their financial position.

A small company has an insurance contract under which the total premium of $48,000 must be paid in advance for 12 months of coverage under a general liability insurance policy. In this example, the journal entry initial expense would be recorded as a debit to Prepaid Expenses and a credit to Cash. 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.

II. Prepaid Insurance as an Asset

The liability will gradually decrease as the insurance coverage is being used on services such as claims management, repairs or replacements. Companies make prepayments for goods or services such as leased office equipment or insurance coverage that provide continual benefits over time. Goods or services of this nature cannot be expensed immediately because the expense would not line up with the benefit incurred over time from using the asset. Prepaid insurance also helps individuals and businesses to mitigate their risks and manage their finances effectively. Since prepaid insurance spreads the risk of loss across a large pool of policyholders, it becomes an efficient way of spreading the cost of damages, rather than shouldering the entire burden of financial loss.

Prepaid Assets

In conclusion, prepaid insurance can be seen as both an asset and a form of equity depending on the stage of coverage. Businesses must analyze their financial objectives and long-term sustainability goals while evaluating the advantages and disadvantages of prepaid insurance as equity. The costs that have expired should be reported in income statement accounts such as Insurance Expense, Fringe Benefits Expense, etc. Unexpired insurance premiums are reported as Prepaid Insurance (an asset account). A current asset which indicates the cost of the insurance contract (premiums) that have been paid in advance.

Therefore, the entire prepaid insurance expense is recorded on the “asset” side of the balance sheet. Prepaid insurance is considered a current asset and refers to paying your insurance premiums in advance in a lump sum. Many businesses will have one or more prepaid expenses due to the way that some goods and services are sold, such as prepaid rent or when legal services are retained. Examples of how prepaid insurance affects the financial statements can vary depending on the specific circumstances of the company. For example, let’s say a company paid $12,000 in advance for a 12-month insurance policy.

It is important because it has an impact on a company’s financial statements. Prepaid insurance can be considered an asset or a liability depending on the company’s balance sheet. The monthly adjusting the 8 best bookkeeping apps for small business owners in 2021 journal entries will be shown on both the company’s income statement (as a $4,000 expense) and on the company’s balance sheet as a $4,000 reduction to the prepaid expense asset account.

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 the prepaid insurance that will not be charged to expense within one year as a long-term asset. Prepaid insurance is commonly recorded, because insurance providers prefer to bill insurance in advance. If a business were to pay late, it would be at risk of having its insurance coverage terminated.

What is Prepaid Insurance?

Prepaid insurance is considered a prepaid expense because you are paying upfront for a benefit your business will not immediately use. To help illustrate this point, let’s use a six-month insurance policy that charges premiums monthly. If you pay for all six months in advance, you are technically not using the second, third, fourth, fifth or sixth month of coverage until you reach that point in your policy term. In other words, you are paying upfront for a benefit that will be used later. After this first expense, your balance sheet will show that there is $1,100 left in your prepaid insurance account.

Part 2: Your Current Nest Egg

The balance at the end of the year is shown on the asset side of the balance sheet and the amount is carried forward to the next year. At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Our panel of insurance experts has reviewed the content to ensure that our reporting and statistics are accurate, easy to understand and unbiased.

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Double-entry accounting requires both a debit and credit in each expense accounting entry. It is a good sign for the company, as it likes to pay off expenses before the due date. It reflects the strong earning power of the company and creates goodwill in the market. Companies that take care of assets and employees by paying reasonable advance insurance premiums are considered strong financial companies. There should always be a check regarding the period for advance in insurance.