Prepaid Insurance: Definition, How It Works, Benefits, and Example

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Meanwhile, some companies pay taxes before they are due, such as an estimated tax payment based on what might come due in the future. Other less common prepaid expenses might include equipment rental or utilities. Hence, it is important to record actual expenses for the year, so that the correct amount of profit is calculated. When an account has a balance that is opposite the expected normal balance of that account, the account is said to have an abnormal balance.

  • Premiums are normally paid a full year in advance, but in some cases, they may cover more than 12 months.
  • Then you would enter a debit to the insurance expense account, increasing the value of the expenses.
  • This reversal entry creates an insurance expense for the new financial year with the debit.

When the $2,400 payment is made on January 1, the company debits Prepaid Insurance and credits Cash. 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. Generally, Prepaid Insurance is a current asset account that has a debit balance. The debit balance indicates the amount that remains prepaid as of the date of the balance sheet. As time passes, the debit balance decreases as adjusting entries credit the account Prepaid Insurance and debit Insurance Expense. Certain expenses, such as taxes and insurance, are paid in lump sums during one particular accounting period.

contra asset, credit

However, once you make the premium payment, the policy’s coverage becomes an asset, which diminishes over time during the coverage period. Each of the accounts in a trial balance extracted from the bookkeeping ledgers will either show a debit or a credit balance. 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. 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.

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. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University. When canceling an insurance policy, you may incur a cancellation fee. Insurance companies often offer incentives to customers who prepay their premiums, but this type of plan requires making a large lump-sum payment.

However, the best way to keep the information in your mind is to work with it. For instance, you might pay $1.50 each day you drive plus $0.06 per mile. If ABC produced quarterly management reports, this type of balance day adjustment process would be required for each quarter. Let’s look quickly at the end of the first quarter of their current year – the three months ending June 30. Otherwise, one ends up with a contingent asset, which, although it may need to be disclosed by a reporting entity it will not be recognised in the financial statements.

Prepaid Insurance and the Asset Account

Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. Since your mileage varies from month to month, pay-per-mile programs do not offer a prepay option, only monthly billing. Debit simply means on the left side of the equation, whereas credit means on the right hand side of the equation as summarized in the table below. What is financial literacy and why do you need it

Financial literacy is the ability to understand and use financial concepts in order to make better decisions.

This is primarily because of the fact that business are supposed to follow accrual basis of accounting. But, at the end of the financial year, this would then be carried down to the next year, as a prepaid expense. Therefore, in accordance to this principle, prepaid insurance would be treated as a Current Asset in the year when the advance payment is made. In the subsequent year, when insurance is lapsed, then the amount will be deducted as an expense from the Income Statement.

Example of Prepaid Insurance

Although ABC Ltd paid the cash in the last financial year, what the accrual system is doing reflects the flow of economic benefits. So in the new financial year, that benefit is worth $7,500 to ABC Ltd, and the credit entry removes the prepaid insurance current asset. This account is no longer required as we are expensing the economic benefits for the rest of the year. Prepaid insurance is usually considered a current asset, as it becomes converted to cash or used within a fairly short time.

How Are Prepaid Expenses Recorded on the Income Statement?

Alternatively, if the organization has paid in advance for a particular service, it is disclosed as a Current Asset. For this reason the account balance for items on the left hand side of the equation is normally a debit and the account balance for items on the right side of the equation is normally a credit. Prepaid expenses are classified as assets as they represent goods and services that will be consumed, typically within a year. 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. Even though it may happen that an account has a certain balance type, whereas it should have another one, it’s usually a rare thing. In order to see what balance each account type should have, we present you with the table below.

Question: 1. The type of account and normal balance of Prepaid

Therefore, the monthly charge of insurance for Abdul Co. amounts to $200. Prepaid insurance is insurance paid in advance and that has not yet expired on the date of the balance sheet. Knowing what a normal balance gives you the basics of double-entry bookkeeping. It’s not that difficult to figure out to what account type each transaction belongs to. If you memorize our table mentioned above, you’ll already make a huge progress.

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. Also known as prepayments, prepaid expenses are payments for operating expenditure paid now for goods or services yet to be received by the reporting entity. In our case, we will be looking how to answer interview questions about overcoming adversity at prepaid insurance, a pretty standard balance day adjustment businesses have to make if they are using an accrual accounting system. Remember, if the business is operating a purely cash-based system, these adjustments are not required. This reversal entry creates an insurance expense for the new financial year with the debit.

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