Prepaid Insurance: Definition, How It Works, Benefits, and Example 2025

A “prepaid asset” is the result of a prepaid Accounts Payable Management expense being recorded on the balance sheet. Prepaid expenses result from one party paying in advance for a service yet to be performed or an asset yet to be delivered. When you purchase prepaid insurance, you essentially pay the premium upfront instead of making monthly or periodic payments.

prepaid insurance

• A current asset is a financial resource that can be easily liquidated, or converted to cash, in a year or less.
• A related account is Insurance Expense, which appears on the income statement.
• As mentioned above, the premiums or payment is recorded in oneaccounting period, but the contract isn’t in effect until a future period.
• This is usually done at the end of each accounting period through an adjusting entry.
• Prepaid insurance refers to premiums for insurance that are paid in advance.

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. 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.

Benefit Coverage:

• Some insurers prefer that insured parties pay on a prepaid schedule such as auto or medical insurance.
• Adjustments must be recorded consistently to comply with accounting standards.
• Discrepancies signal potential errors needing investigation, such as incorrect initial entries, miscalculated adjustments, or unrecorded policy changes like cancellations or refunds.
• The accounting rule applied is to debit the increase in assets” and “credit the decrease in expense” (modern rules of accounting).
• For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online.
• In simple terms, prepaid insurance is the money you pay upfront to your insurance company before you get to enjoy any of their coverage.

Likewise, the adjusting entry at the end of the period is necessary for the company to recognize the cost that expires through the passage of time. Adjustments must be recorded consistently to comply with accounting standards. At the end of each period, an adjusting journal entry transfers the appropriate portion of prepaid insurance to the expense account. This entry debits the insurance expense account and credits the prepaid insurance asset, ensuring only the remaining unused portion remains classified as an asset. cash flow If a policy is canceled or modified, additional adjustments may be necessary to reflect refunds, extra charges, or changes in coverage duration. This adjustment is recorded through amortization, systematically expensing a portion of the prepaid amount each period.

Monthly Financial Reporting Template for CFOs

A detailed schedule, often called an amortization schedule, aids this process. It typically lists each policy, its premium, coverage dates, amounts previously expensed, the current period’s expense, and the prepaid insurance remaining unexpired premium. The sum of the unexpired premiums from this schedule should match the Prepaid Insurance account balance in the general ledger. Learn how to accurately record, adjust, and reconcile prepaid insurance in accounting to ensure financial statements reflect true expense timing.

The Initial Journal Entry

In this way, the asset value of the prepaid insurance will be reduced to zero at the end of the time period which was paid for in advance. Similarly, the expense will reach the total of the prepaid amount at the end of that same period. 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. This adjusting entry is necessary for the company to not overstate its total assets as well as to not understate its total expenses during the period. In preparing the adjusting entry, our goal is to transfer the used part from the asset initially recorded into expense – for us to arrive at the proper balances shown in the illustration above.

• In layman’s terms, prepaid expense is recognized on the income statement once the value of the good or service is realized, i.e, the service or good is delivered.
• The insurance company is legally bound to provide the coverage outlined in your policy during the prepaid period.
• By definition, current prepaid assets would be included in the numerator, or current assets portion of the current ratio, and positively affect the results.
• Individuals benefit from prepaid expenses to make sure they will not miss payments for things like health insurance.
• You decide to purchase prepaid insurance for this machinery for a period of one year.