The ins and outs, literally, of prepaid expenses are an important concept when it comes to bookkeeping. Common examples of prepaid expenses would be a prepaid insurance account, prepaid rent account, utilities, legal fees, and subscriptions. Let’s focus here on prepaid insurance. Prepaid insurance is considered as any insurance premium paid in advance for insurance coverage received in a future period.
Where And How Is Prepaid Insurance Recorded?
As an example of prepaid insurance, a company pays, in cash, an insurance premium in advance of $12,000 for 12 months of insurance coverage that will run the following year from January 1st to December 31st. The payment of the insurance expense is made now for services that will be received later or in another accounting period. The initial entry will be a payment entered as a debit of $12,000 to prepaid insurance and a credit of $12,000 to cash. At the end of January, one month of coverage or a portion of an insurance premium will be used up so there must be an adjustment made to the prepaid insurance account. One month of insurance is equivalent to a $1,000 (12,000 divided by 12 months) premium. On January 31st, you would debit insurance expense in the amount of $1,000 and credit $1,000 to the prepaid insurance expense account. This adjusting entry is recorded at the end of each month through December 31st which at that time all coverage will have been used up and the prepaid insurance balance should be zero.
Asset vs. Expense
Prepaid insurance would initially be considered an asset because it offers a future economic benefit to the company. The prepaid insurance becomes an expense account as the coverage is used up on a monthly basis. There is no longer any economic benefit to the company as there is none left.
How Does Prepaid Insurance Affect Financial Statements?
Now, how do these entries affect the company’s financial statements? The initial journal entry doesn’t affect a company’s financial statement because prepaid insurance and cash are both asset accounts. Neither one will increase or decrease the balance sheet. However, the adjusting journal entry does affect the income statement and balance sheet. The expense would be included on the income statement while the decrease in prepaid insurance would reduce the current asset account on the balance sheet. In summary, the balance sheet reflects the unexpired cost of the prepaid insurance while the income statement reflects the used-up or expired portion.
The Benefits Of Prepaid Insurance
We’ve discussed journal entries and financial statements. We may as well go full circle. Ultimately, all of this will be reflected in the company’s taxes. Prepaid insurance, prepaid rent expense and other prepaid expenses are a great way for companies to take advantage of tax deductions. Also, in some cases, it will cut down on the expense if a cheaper price is offered by paying in full up-front versus making several payments. After all, our job as a bookkeeper, accounting consultant or CPA is to save the company money!