Prepaid Insurance Definition, Journal Entries Is it an Asset?

Assume that on December 1, a newly formed company pays $600 for insurance coverage for the six months ending on June 1. As of December 31, the company will report Insurance Expense of $100 and its current asset Prepaid Insurance will report $500. The prepaid amount informs the readers of the December 31 balance sheet that the company will not have to pay $500 in cash for insurance during the next five months.

How Is Prepaid Insurance Recorded?

This is due to, under the accrual basis of accounting, the expense should only be recorded when it occurs. Now if this were a short-term lease, then a prepaid asset would be recognized on the balance sheet for is prepaid insurance an asset prepaid rent expense. However, under the new lease accounting pronouncements, the guidance eliminates recognizing prepaid assets on the balance sheet related to leases exceeding a total lease term of 12 months. Rather, any prepaid rent pertaining to a long-term lease would be rolled into the ROU asset balance recognized on the balance sheet.

Prepaid expenses aren’t included in the income statement per generally accepted accounting principles (GAAP). In particular, the GAAP matching principle requires accrual accounting, which stipulates that revenue and expenses must be reported in the period that the spending occurs, not when cash or money exchanges hands. According to generally accepted accounting principles (GAAP), expenses should be recorded in the same accounting period as the benefit generated from the related asset. Insurance contracts specify how prepaid premiums apply, including the duration of coverage and the insurer’s obligation to provide protection. Standardized policy forms, such as those issued by the Insurance Services Office (ISO), define how prepaid amounts are allocated and when they are recognized as earned.

Treasury & Risk

Proper asset management requires classifying prepaid insurance based on coverage timeframes. Only policies with coverage extending beyond 12 months qualify as long-term assets; all others remain current assets. This distinction matters greatly for working capital calculations and liquidity analysis.

HighRadius stands out as an IDC MarketScape Leader for AR Automation Software, serving both large and midsized businesses. The IDC report highlights HighRadius’ integration of machine learning across its AR products, enhancing payment matching, credit management, and cash forecasting capabilities. When insurance is due for each quarter, i.e., $2,000 will be subtracted from the prepaid account and is shown as an expense in the income statement for that reporting quarter. It refers to the portion of the outstanding insurance premium paid by the company in advance and is currently not due. The second journal entry shows how 1/12th of this amount is charged to expense in the first month of the coverage period. Typically, when an organization obtains a software subscription, the software vendor incentivizes the organization with favorable pricing if they sign a longer-term commitment and pay for the total contract upfront.

• Since prepaid insurance provides future economic benefits, it is recorded as an asset and gradually expensed as the coverage period progresses.
• 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 balance sheet will typically show prepaid insurance with a debit balance that represents the unexpired portion of your insurance coverage.
• In return, the insurer agrees to provide financial compensation in the event of covered losses, such as accidents, illnesses, or property damage.
• This is especially significant for general liability or professional malpractice insurance, where claims may arise months after an incident.

The company usually purchases insurance to protect itself from unforeseen incidents such as fire or theft. And the company is usually required to pay an insurance fees for one year or more in advance. In this case, it needs to account for prepaid insurance by properly making journal entries in order to avoid errors that could lead to misstatement on both balance sheet and income statement. This can also help reduce risk by avoiding overstating contingent liabilities if an organization finds itself involved in litigation or regulatory scrutiny down the road.

For example, if a company pays $12,000 for a one-year policy, it initially records the full amount as a prepaid asset and recognizes $1,000 as an expense each month. When a business pays its insurance premiums upfront, typically for coverage spanning the next 12 months, the total amount paid is recorded as a current asset under the “Prepaid Expenses” category. This asset represents the future economic benefit of risk protection that the business has acquired through the insurance policy. Prepaid insurance is usually charged to expense on a straight-line basis over the term of the related insurance contract.

• For example, if a business had purchased six months of insurance and decided to cancel the policy after two months, it could redeem the value of the four remaining unused months of coverage.
• For instance, the Internal Revenue Service (IRS) allows businesses to deduct insurance expenses only in the period they are incurred.
• The short-term subscription prepaid represents the value of the subscription to be used over the immediately following 12 months and is amortized after the long-term portion of the prepaid subscription is reduced to zero.
• IFRS’s flexibility may lead to variances that companies need to manage carefully to ensure stakeholders understand the financial statements’ implications.

The company has paid $10,000 of the insurance premium for the entire year at the beginning of the first quarter. Some process refunds within a few weeks, while others take longer, particularly if the policyholder paid through a broker. If an insurer delays payment beyond a reasonable period, policyholders can escalate the issue by filing a complaint with their state’s insurance department.

Many states require insurers to issue refunds within a set timeframe, often 30 to 45 days from the cancellation date. For example, on December 18, 2020, the company ABC make an advance payment of $6,000 for the fire insurance that it purchase to cover the whole year of 2021. You may want to set up an amortization table to track the decrease in the account over the policy term and to determine what the journal entries will be. Ultimately, by the end of the subscription term, both the long-term and short-term portions of the prepaid subscription account balances will be zero. This blog covers the ins and outs of prepaid insurance, its importance, advantages, examples, ways of recording, calculations, and much more.

Order to Cash

The short-term subscription prepaid represents the value of the subscription to be used over the immediately following 12 months and is amortized after the long-term portion of the prepaid subscription is reduced to zero. The proceeding amortization schedule illustrates the appropriate amortization of the short-term and long-term portions of the prepaid subscription. The accounting treatment reflects the temporal allocation of economic benefits, ensuring your financial statements accurately represent resources available to generate future revenue. Any remaining prepaid portion of the premium could be redeemed or refunded to the business if the business cancels the policy before the period covered by those premiums has expired. Insurance providers may allow a business to pay multiple monthly premiums in advance, in the form of one lump sum.

Prepaid Insurance Is What Type of Account?

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However, the premiums may be marginally higher to account for inflation and other operating factors. 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. There are several potential ways to treat prepaid insurance from a financial standpoint; however each case should be examined individually when preparing balance sheets or other documents for accurate classification results. Note that in this example we established a short-term and long-term prepaid component because the initial payment was for a two-year subscription. The long-term subscription prepaid represents the value of the subscription paid for in advance beyond 12 months and is amortized at the beginning of the subscription term.

Likewise, the net effect of the prepaid insurance journal entry in this example is zero on the balance sheet. It involves paying for part or all of the policy upfront in order to reduce the amount of money spent on future premiums. Generally, this type of coverage will provide more comprehensive protection than other forms of insurance, as well as more cost-effective terms for long-term customers. However, it may not be suitable for all types of coverage, such as short-term disability or life insurance policies.

The value assigned to any particular policy depends upon its life span along with how much money is typically charged up front. Accounting treatment of records is a significant factor when deciding if prepaid insurance should be recorded as an asset, liability, or equity. As with most other assets and liabilities on financial statements, prepaid insurance policies require consistent tracking and recording.

In this journal entry, the company records the prepaid insurance as an asset since it is an advance payment which the company has not incurred the expense yet. In this example, let’s assume we purchase a 12-month cyber insurance policy for $1,800 on January 1st, 2023. The term of the policy is only 12 months, therefore we will not recognize any long-term prepaid asset.

Businesses and individuals record prepaid insurance as an asset on their balance sheets until the coverage period elapses. Unlike balance sheet accounts that display prepaid insurance as an asset, your income statement only recognizes these expenses through systematic amortization. When you initially pay premiums, no immediate expense hits your financial reporting preserving current-period net income. Prepaid insurance is considered a prepaid asset because it benefits future accounting periods. It relieves them of the monthly premium expense, and in doing so, reduces their costs, while at the same time still conferring the benefit of having coverage for the business.

When a company incurs costs related to this type of agreement, those expenses may not become immediately payable until later on when a claim has been filed and funds released to pay off said debt. In most cases, this is the correct entry to book, however, in certain transactions we are paying upfront for the right to use an asset or receive a service over a defined period of time. The relationship between prepaid insurance and insurance expense illustrates the matching principle in action. As coverage periods elapse, you’ll transfer portions from the asset account to expense, maintaining accurate financial representation while preserving the asset’s value until its benefits are consumed. Under GAAP, you can recognize prepaid insurance as an asset when it represents a probable future economic benefit that you control and can reliably measure.