How to Account for Prepaid Insurance? (Definition, Classification, Journal Entries, and Example)

Definition

Prepaid Insurance can be defined as the charge that is associated with the insurance contract, which has been paid in advance by the company the insurance company for the coverage period and sum insured based on insurance policeis. In other word, prepaid insurance is simply the amount expended for a given insurance contract, the utility of which has not been utilized as yet. In other words, the company has paid in advance for a service that is going to be utilized later on.

Prepaid insurance is not considered an expense and it is treated in the accounting records as a current asset. However, it must be noted that this charge is then gradually charged to the expense account across the period when the charge is actually incurred.

Insurance expense, as an expense is treated in the same way as other expenses that are incurred. Similarly, the treatment of prepaid (as well as accrued) insurance is also similar to that of prepaid (and accrued) expenses. However, during normal course of the business, insurance is generally a prepaid expense, because it is paid in advance, in most cases.

Classification of Prepaid Insurance

Prepaid Insurance, by definition is an expense that has been paid in advance by the organization. Therefore, it is treated as a Current Asset in the company’s balance sheet. This is primarily because of the fact that the utility against this advance payment is going to be availed within a timeline of one year.

In accordance with the accrual basis of accounting, organizations are only supposed to record expenses and revenues that are pertinent to the period where the financial statements are actually being prepared.

This implies that only the current charge is going to be recorded as an expense in the Income Statement. Anything that is owed by, or owed to the organization is subsequently declared in the Balance Sheet.

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In the case where there are payments that need to be made by the organization to the suppliers (or service providers), it is regarded as a Current Liability in the Balance Sheet. Alternatively, if the organization has paid in advance for a particular service, it is disclosed as a Current Asset.

The reason as to why Prepaid Insurance is treated as a Current Asset is primarily because of the fact that the benefits against prepaid insurance are supposed to be utilized within a shorter timeline. Mostly, these expenses, if prepaid, are utilized within the course of the forthcoming year only.  

During the forthcoming year, when the service against this Current Asset would be utilized, the company would then declare it as an expense in the Income Statement.

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.

Alternative Approach to Prepaid Insurance Classification

Rather than maintaining a separate Prepaid Insurance Account, organizations can also record prepaid insurance in the insurance expense account.

This requires them to record prepaid insurance as an expense only. But, at the end of the financial year, this would then be carried down to the next year, as a prepaid expense.

This implies, that rather than Insurance Expense being a yearly account, it would be a running account. The ending balance, either debit or credit, would be classified as Prepaid or Accrued Insurance, at the end of the period.

This alternative method of recording and classifying prepaid insurance is also legitimate, and a lot of organizations choose this methodology since it is more convenient. This is explained in the following T-account format:

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ParticularAmountParticularAmount
Insurance ExpensexxxBankxxx
 Balance Carried Forward (Prepaid)xxx  

In the illustration above, it can be seen that the carrying balance in the Insurance Expense account is going to be regarded as a prepaid expense, and the balancing figure is also going to be declared on the balance sheet.

Journal Entries to record Prepaid Insurance

During normal course of business, when insurance is incurred (or any other expense), the following journal entry is made:

ParticularDebitCredit
Insurance Expensesxxx 
 Bank  xxx

However, in case of prepaid insurance, the following journal entries are made:

ParticularDebitCredit
Prepaid Insurancexxx 
 Bankxxx

At the end of the next year, when the company would have utilized insurance, the following journal entries are made:

ParticularDebitCredit
Insurance Charge for the yearxxx 
 Prepaid Insurancexxx

Example of Prepaid Insurance – Classification and Treatment

The concept of prepaid insurance is illustrated via the following example:

Abdul Co. has a new insurance policy that requires them to pay $2,400 per year, in a lump sum manner. The policy beginning date was settled as 1st July 2019. Abdul Co. prepares their financial statements at the end of every year, i.e. 31st December. Therefore, the financial statements for Abdul Co. would be prepared as at 31st December 2019.

In the example above, it can be seen that Abdul Co. has made an annual payment for insurance, amounting to $2,400. This amount corresponds to 12 months, beginning on 1st July 2019, and ending on 30th June 2020. Therefore, the monthly charge of insurance for Abdul Co. amounts to $200.

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Since the financial statements are prepared on a yearly basis, and the financial year ends on 31st December 2019, it can be seen that 6 months are paid for the current year, whereas the remaining 6 months are for the next year, i.e. 2020. Therefore, the aggregated sum of $2,400 can be broken down into two components:

  • Payment corresponding to the current year (ending on 31st December 2019) – $1,200
  • Payment corresponding to the next year (ending on 30th June 2020) – $1,200

Based on this, the first component is the current year’s expense, since it is relevant to the timeline for which the financial statements are being prepared. Therefore, it is supposed to be treated as an expense for the current year.

However, the second part of the payment corresponds to the next year, and therefore, it is supposed to be treated as a Current Asset in the financial statements that are prepared for this year.

The journal entries corresponding to the example above are as follows:

ParticularDebitCredit
Insurance Expense$1,200 
Prepaid Insurance $1,200 
  Bank $2,400

In the next year, when Prepaid Insurance is lapsed in the organization, the following journal entry will be made:

ParticularDebitCredit
Insurance Expense$1,200 
 Prepaid Insurance $1,200

The journal entries above shows how insurance expense is treated, in case of prepayments.

Importance of Recording Prepaid Insurance

As mentioned earlier, recording prepaid insurance does hold tantamount importance from an organizational perspective. This is primarily because of the fact that business are supposed to follow accrual basis of accounting.

Using this methodology, investors, as well as accountants are able to gauge the actual level of profitability of the company, since revenues and expenses that are compared under accrual basis correspond to the same timelines.

Hence, it is important to record actual expenses for the year, so that the correct amount of profit is calculated. Similarly, it is also important to declare the remaining amount as a prepaid insurance as Current Assets of the company, so that the users of the financial statements also know the amount that has been paid in advance to the company.