Although providers do issue prorated refunds, you may have to wait days or weeks to receive the money. 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. When the policy goes into effect, you’ll then get the benefits of the coverage over a 12-month 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 to expenses over the full 12 months.
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- For example, assume ABC Company purchases insurance for the upcoming 12-month period.
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- That’s because most prepaid assets are consumed within a few months of being recorded.
The payment of the insurance expense is similar to money in the bank—as that money is used up, it is withdrawn from the account in each month or accounting period. Each month, the business’s accounting department would make an adjusting journal entry of $1,000, representing the amount of one month’s premium payment in the general ledger. It would be entered as a credit in the asset account and as a debit to the insurance expense account. On December 31, an adjusting entry will show a debit insurance expense for $400—the amount that expired or one-sixth of $2,400—and will credit prepaid insurance for $400. This means that the debit balance in prepaid insurance on December 31 will be $2,000. This translates to five months of insurance that has not yet expired times $400 per month or five-sixths of the $2,400 insurance premium cost.
Prepaid Insurance: Definition, How It Works, Benefits, and Example
A prepaid asset is a type of asset that has economic value to the business because of its future benefit. Your success is our success.From onboarding to financial operations excellence, our customer success management team helps you unlock measurable value. Through workshops, webinars, digital success options, tips and tricks, and more, you will develop leading-practice processes and strategies to propel your organization forward. While the responsibility to maintain compliance stretches across the organization, F&A has a critical role in ensuring compliance with financial rules and regulations.
On November 20, the payment is entered with a debit of $2,400 to Prepaid Insurance and a credit of $2,400 to Cash. Prepaid expense is an accounting line item on a company’s balance sheet that refers to goods and services that have been paid for but not yet incurred. Recording prepaid expenses must be done correctly according to accounting standards.
What are Prepaid Expenses?
If you keep a ledger, enter the prepaid insurance payment as both a debit and credit. Let’s say you purchase a one-year home insurance policy for $1,200. Each month, an adjusting entry will be made to expense $10,000 (1/12 of the prepaid amount) to the income statement through a credit to prepaid insurance and a debit to insurance expense. In the 12th month, the final $10,000 will be fully expensed and the prepaid account will be zero. The business’s records would show four months of insurance policy as a current, prepaid asset. At the end of twelve months, the asset account would show a balance of zero for the insurance premium and a total of $12,000 in the insurance expense account.
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In this way, the asset value of the prepaid insurance will be reduced to zero at the end of the time period which was paid for in advance. Similarly, the expense will reach the total of the prepaid amount at the end of that same period. To sustain timely performance of daily activities, banking and financial services organizations are turning to modern accounting and finance practices.
- It would be entered into the general ledger as a debit of $12,000 to the asset account and a credit for the same amount to the cash account.
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Prepaid Expenses
While prepayment and monthly billing are standard ways to pay an insurance premium, some auto insurance companies offer pay-per-mile policies. Throughout the home insurance policy’s term, you will reduce the value of the asset. For example, the $1,200 prepaid policy will reduce in value by $100 each month, which you adjust in your ledger. Upon signing the one-year lease agreement for the warehouse, the company also purchases insurance for the warehouse.
It would be entered into the general ledger as a debit of $12,000 to the asset account and a credit for the same amount to the cash account. Prepaid insurance is recorded in the general ledger as a prepaid asset under current assets. A current asset is a financial resource that can be easily liquidated, or converted to cash, in a year or less. In contrast, a non-current or fixed asset, like real estate, cannot be easily liquidated in a year or less.
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Streamline and automate detail-heavy reconciliations, such as bank reconciliations, credit card matching, intercompany reconciliations, and invoice-to-PO matching all in one centralized workspace. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. Company A signs a one-year lease on a warehouse for $10,000 a month.