Insurance is a prevalent expense for businesses and individuals. It is a contract between two parties, including a policyholder and the insurer. Essentially, the policyholder receives a form of protection against a specific event or loss. In exchange, they must pay a premium to the insurance company. Both parties benefit from this contract.
The premium paid on the insurance contract can occur in different periods. In most cases, the policyholder must pay the company before their insurance term. It is known as prepaid insurance.
What is Prepaid Insurance?
Prepaid insurance refers to the insurance premium paid before their insurance term. It is an asset that companies record to recognize the future coverage they will receive from the contract. In accounting, prepaid insurance records the insurance premium that hasn't expired at the reporting date. Any portion of the amount used during the period becomes an expense for the company.
Prepaid insurance payments may occur every month or quarter. Companies record this asset under current assets on the balance sheet. After that period, the insurance premium may expire, converting it to an expense. Therefore, it will no longer stay as prepaid insurance on the balance sheet. Prepaid insurance is also relevant for individuals. However, they don’t need to worry about the accounting implications.
Is Prepaid Insurance an asset or expense?
Due to its nature, people may wonder whether prepaid insurance is an asset or an expense. Essentially, it occurs due to the insurance premium paid by companies. In most cases, this premium is an expense. However, due to the nature of this transaction, companies cannot classify it as such. The primary reason companies must classify this insurance as prepaid is that it relates to the unexpired portion.
Essentially, prepaid insurance is an asset till the insurance premium expires. Until then, companies must keep classifying the amount under current assets on the balance sheet. Once the premium expires, they must move the relevant portion to insurance-related expenses in the income statement. At that point, it no longer falls under prepaid insurance. Therefore, the term prepaid insurance only relates to assets.
What is the journal entry for Prepaid Insurance?
The accounting treatment for prepaid insurance must consider two aspects of the account. The first is when a company pays an insurance premium. At this point, this premium has not expired. Therefore, the company must classify it as prepaid insurance. The journal entry for this transaction usually occurs as follows.
| Dr | Prepaid insurance |
| Cr | Cash or bank |
As time goes by, the prepaid insurance expires. During this period, companies must transfer the expired portion of the premium to the income statement. This amount becomes an expense, as mentioned above. The journal entry for this aspect of prepaid insurance is as follows.
| Dr | Insurance expense |
| Cr | Prepaid insurance |
Example
A company, Red Co., pays an insurance premium of $10,000 through its bank account. The company records this transaction as follows.
| Dr | Prepaid insurance | $10,000 |
| Cr | Bank | $10,000 |
During this period, prepaid insurance of $5,000 from the previous period expired. Red Co. records this transaction using the following journal entry.
| Dr | Insurance expense | $5,000 |
| Cr | Prepaid insurance | $5,000 |
Conclusion
Companies pay their insurance before the insurance term begins. At this point, the insurance premium has not reached maturity and is unexpired. Companies must record this payment as prepaid insurance. Once the amount expires, companies must move it to the insurance expense account in the income statement.
Originally Published Here: Prepaid Insurance: Definition, Asset or Expense, Journal Entry, Example
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