But if a prepaid expense is not consumed within the year after payment, it becomes along-term asset, which is not a very common occurrence. The payment of the insurance expense is similar to money in the bank—as thatmoney is used up, it iswithdrawn from the account ineach month oraccounting period. A prepaid expense is anexpenditurethat a business or individual pays for before using it.
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. For example, if an asset account which is expected to have a debit balance, shows a credit balance, then this is considered to be an abnormal balance. It should be noted that if an account is normally a debit balance it is increased by a debit entry, and if an account is normally a credit balance it is increased by a credit entry. So for example a debit entry to an asset account will increase the asset balance, and a credit entry to a liability account will increase the liability. Each of the accounts in a trial balance extracted from the bookkeeping ledgers will either show a debit or a credit balance.
As you move through the year and consume the insurance, your prepayment gets used up. The term «prepaid» means the portion of the insurance premium that has not been used up as at the date of the balance sheet. Likewise, the company can make insurance expense journal entry by debiting insurance expense account and crediting prepaid insurance account. 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. Meanwhile, some companies pay taxes before they are due, such as an estimated tax payment based on what might come due in the future.
The company records the refund with a debit to Cash and a credit to Prepaid Insurance. At December 31, the balance in Prepaid Insurance will be a credit balance of $120, consisting of the debit of $2,400 on January 1, the 12 monthly credits of $200 each, and the $120 credit on July 1. Prior to issuing the December 31 financial statements, the company must remove the $120 credit balance in Prepaid Insurance by debiting Prepaid Insurance and crediting Insurance Expense. To illustrate how prepaid insurance works, let’s assume that a company pays an insurance premium of $2,400 on November 20 for the six-month period of December 1 through May 31. The payment is entered on November 20 with adebitof $2,400 to prepaid insurance and a credit of $2,400 to cash. As of November 30, none of the $2,400 has expired and the entire $2,400 will be reported as prepaid insurance.
In the subsequent year, when insurance is lapsed, then the amount will be deducted as an expense from the Income Statement. Insurance is not the only expense that must be accounted for over multiple reporting periods. Any salaries earned in one month but paid in the next month must be accounted for in a similar manner so that the expense is accounted for in the month that the pay was earned. Property taxes are often paid every six months, and require the same treatment. A business may collect a prepayment for sales on product that has not been delivered, and these sales must be entered as deferred revenue. As prepaid insurance is an asset that will expire through the passage of time, the cost of expiration will need to be recognized as an expense during the period.
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. Hence, prepaid insurance journal entry does not affect the total assets because it increases one asset account and decreases another asset account at the same amount. When the company makes an advance payment for insurance, it can make prepaid insurance journal entry by debiting prepaid insurance account and crediting cash account. Whenever your business buys insurance, you will pay the premium in advance for a specific coverage period. For example, you might pay an entire year’s worth of premium on Jan. 1, for the whole of 2019, or you might pay an insurance premium for the six-month period of Jan. 1 through June 30.
For example, you might buy a one-year magazine subscription and receive one magazine per month for 12 months. Prepaid expenses are amounts paid in advance by a business in exchange for goods or services to be delivered in the future. They usually relate to the purchase of something that provides value to the business over the course of multiple accounting periods. Prepaid expenses are expenses that will occur in the future but are paid for upfront. Prepaid insurance refers to premiums for insurance that are paid in advance. A premium is a regular, recurring payment made to a provider for the benefit of having insurance coverage.
Recall that prepaid expenses are considered an asset because they provide future economic benefits to the company. Regardless of whether it’s insurance, rent, utilities, or any other expense that’s paid in advance, it should be recorded in the appropriate prepaid asset account. Prepaid expenses represent expenditures that have not yet been recorded by a company as an expense, but have been paid for in advance. In other words, prepaid expenses are expenditures paid in one accounting period, but will not be recognized until a later accounting period. Prepaid expenses are initially recorded as assets, because they have future economic benefits, and are expensed at the time when the benefits are realized (the matching principle). On July 1, the company receives a premium refund of $120 from the insurance company.
As mentioned above, the premiums or payment is recorded in oneaccounting period, but the contract isn’t in effect until a future period. A prepaid expense is carried on an insurance company’s balance sheetas acurrent assetuntil it is consumed. That’s becausemost prepaid assets are consumed within a few months of being recorded.
If the premium were $1,200 per year, for instance, you would record the check for $1,200 as a credit to the cash account in your journal, decreasing the value of that account. Then you would enter a debit of $1,200 to the prepaid insurance asset account, increasing its value. At the payment date of prepaid insurance, the net effect is zero on the balance sheet; and there is nothing to record in the income statement. However, after adjusting entry at the end of the period for the insurance expense, the asset account will decrease while the expense account will increase.
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. Prepaid insurance is a credit to the insurance company at the time that it is made. In the previous example, the premium that is received for six months of car insurance coverage is initially recorded as a credit. Certain expenses, such as taxes and insurance, are paid in lump sums during one particular accounting period. The benefits from these payments extend past the single accounting period, so it is not accurate to charge the full payment to an expense account at that time. Generally, Prepaid Insurance is a current asset account that has a debit balance.
Like all financial products, prepaid insurance has both advantages and disadvantages to consider. Insurance companies often offer incentives to customers who prepay their premiums, but this type of plan requires making a large lump-sum payment. Some insurers prefer that insured parties pay on a prepaid schedule such as auto or medical insurance. Insurance becomes an asset when you experience a risk covered in your insurance plan, which activates your coverage, allowing you to make a claim and receive a successful payout. For example, on September 01, 2020, the company ABC Ltd. pays $1,200 for one year of fire insurance which covers from September 01, 2020.
When someone purchases prepaid insurance, the contract generally covers a period of time in the future. For instance, many auto insurance companies operate under prepaid schedules, so insured parties pay their full premiums for a 12-month period before the coverage actually starts. The same applies to many medical insurance companies—they prefer being paid upfront before they begin coverage. But if a prepaid expense is not consumed within the year after payment, it becomes a long-term asset, which is not a very common occurrence.
Subsequently, it is essential to adjust entry to change the prepaid insurance figure at the end of every month and expense the appropriate amount in the Income Statement. If the company makes an advance payment to a supplier for any particular good or service, they are building up an asset. This is because they have already paid the amount, yet the service is yet to be utilized.
The initial journal entry for a prepaid expense does not affect a company’s financial statements. The initial journal entry for prepaid rent is a debit to prepaid rent and a credit to cash. The payment is entered on November 20 with a debit of $2,400 to prepaid insurance professional virtual bookkeepers and a credit of $2,400 to cash. Assume that a company’s annual premium on its liability insurance policy is $2,400 and is due on the first day of each year. When the $2,400 payment is made on January 1, the company debits Prepaid Insurance and credits Cash.
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. Prepaid expenses are classified as assets as they represent goods and services that will be consumed, typically within a year.
Common prepaid expenses may include monthly rent or insurance payments that have been paid in advance. But if a prepaid expense is not consumed within the year after payment, it becomes a long-term asset, which is not a very common occurrence. The adjusting journal entry is done each month, and at the end of the year, when the insurance policy has no future economic benefits, the prepaid insurance balance would be 0. When there is a payment that represents a prepayment of an expense, a prepaid account, such as Prepaid Insurance, is debited and the cash account is credited. This records the prepayment as an asset on the company’s balance sheet. As noted above, prepaid expenses are payments made for goods and services that a company intends to pay for in advance but will incur sometime in the future.