This is because each month represents one-twelfth of the coverage period. When a business purchases and pays for insurance coverage, it is considered a prepaid expense. Since the business is paying in advance for the insurance coverage, the expense has not yet been incurred. Therefore, the prepaid expense is treated as an asset on the balance sheet until it is used.

Thus, prepaid expenses aren’t recognized on the income statement when paid because they have yet to be incurred. Finally, businesses must ensure that they reflect the appropriate account titles, dates, and amounts in their journal and ledger entries. By ensuring accurate and timely recording of prepaid insurance transactions, businesses can provide reliable financial information that helps stakeholders make informed decisions. Each month, a portion of the prepaid insurance is recognized as an expense on the income statement. For example, if a business pays $12,000 for a year-long insurance policy, each month $1,000 can be recognized as an expense.

If a business were to pay late, it would be at risk of having its insurance coverage terminated. As the benefits of prepaid insurance are realized over time, the asset value decreases, and the amount is shown as an expense in the income statement of the organization. The adjustment related to prepaid insurance in the financial statements is carried out at the appropriate time i.e. both in the current period and in the future period (when it becomes due). This entry reduces the balance of the prepaid insurance account by $1,000 and increases the insurance expense account by the same amount. Prepaid insurance is a significant expense for many businesses, and it often involves substantial amounts of money.

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. In summary, prepaid insurance is a current asset that represents the amount of insurance that has been paid for but has not been utilized or expired. Prepaid insurance can be recorded in the balance sheet of a company as a current asset and subject to decrease each month until fully utilized. It is important to note that prepaid insurance helps ensure the company has sufficient coverage and may also enhance its creditworthiness, thus resulting in a lower insurance premium. – The cash account would be debited for $1,200, reflecting the fact that the business owner paid money out of their cash account to pay for the insurance premium.

Since adjusting entries involve a balance sheet account and an income statement account, it is wise to monitor the balances in both Prepaid Insurance and Insurance Expense throughout the year. The amount that has not yet expired should be the balance in Prepaid Insurance. An asset is something of value that is owned by a company, such as cash, accounts receivable, supplies, or inventory. Assets are critical components of financial analysis and are commonly presented in the balance sheet.

Prepaid insurance definition

Suppose there are additional insurance expenses, say on business vehicles, that have both liability and physical damage coverage for 3 years, totaling $6,000. Prepaid insurance is listed on the balance sheet as a current asset because it will be used, or expire, within one year end of year bookkeeping of the date of the balance sheet. This means that the company will have to renew its insurance policies each year, making it a short-term asset. As soon as coverage for that period expires, then the funds that once made up the prepaid insurance become an insurance expense.

Although providers do issue prorated refunds, you may have to wait days or weeks to receive the money. Prepaid insurance is coverage you pay for in full before you receive its benefits. For example, if you take out a mortgage to buy a new home, the lender may require you to pay a one-year homeowners premium at closing. When the policy goes into effect, you’ll then get the benefits of the coverage over a 12-month period. The debit to prepaid insurance increases the asset’s balance, while the credit to cash reduces the asset’s value. After her payment is recorded, Jill will then need to record the legal expense each month until the retainer is used and the Prepaid Legal Fees account has a $0 balance.

For example, assets, such as cash, are increased by debits and decreased by credits. Conversely, liabilities, such as loans, are increased by credits and decreased by debits. Additional expenses that a company might prepay for include interest and taxes.

What Is the 12-Month Rule for Prepaid Expenses?

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. This entry reduces the prepaid insurance account by $6,000, which now represents the remaining unused coverage. The insurance expense account now represents the actual insurance expense incurred by the business during the period.

Example of a Credit Balance in Prepaid Insurance

The easiest way to manage prepaid expenses is by using accounting software, which will automatically post a journal entry each month to reduce the balance in your prepaid accounts. But even if you simply use a spreadsheet to calculate your monthly expenses, managing prepaid expenses is one of the easier things you’ll need to manage. This starts with determining if the amount should be expensed over multiple accounting periods, how much should be expensed each period, and for how long. For example, if you prepay accounting fees for $1,650, to cover the next six months, you would need to expense $275 each month for six months. Prepaid expenses aren’t included in the income statement per generally accepted accounting principles (GAAP).

When the insurance coverage comes into effect, it is moved from an asset and charged to the expense side of the company’s balance sheet. In this case, the company’s balance sheet may show corresponding charges recorded as expenses. In the world of accounting, debits and credits are two concepts that are fundamental to the practice of keeping accurate financial records. These terms refer to the way in which financial transactions are recorded in accounts, and understanding how to use them is critical to managing your finances effectively.


If not, you’ll need to create an amortization schedule to help you determine how much you need to pay each month and for how many months. 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. Examples of prepaid expenses include insurance, rent, leases, interest, and taxes. The rules of debit and credit are based on the principle of double-entry accounting, which states that every financial transaction must record both a debit and a credit. This means that the total amount of debits for a given transaction must always be equal to the total amount of credits. In addition to the rules of debit and credit, it is also important to understand the concept of balance.

This account will remain on the balance sheet until the insurance coverage has been used or expires. A prepaid expense, in general, refers to a payment made by a company for goods and services that have not yet been consumed or received. This could include prepaid rent, prepaid advertising, and prepaid subscriptions. In the case of prepaid insurance, the payment is made in advance to cover for potential future losses or claims, before any loss has occurred. Your next step would be to record the insurance expense for the next 12 months. You may be able to set up a recurring journal entry in your accounting software that will complete this automatically.

Is prepaid insurance a debit or credit?

A debit is an entry made on the left-hand side of an account, while a credit is an entry made on the right-hand side of an account. Every financial transaction involves at least two accounts, and every account affected by a transaction must have at least one entry on either the debit or credit side. The spreadsheet would continue through December, displaying the amount that will need to be expensed each month.

These entries will also affect your financial statements, with your asset account (Prepaid Insurance) steadily reduced while your Insurance Expense amount will increase. Throughout the home insurance policy’s term, you will reduce the value of the asset. For example, the $1,200 prepaid policy will reduce in value by $100 each month, which you adjust in your ledger. Here, only the amount for 3 months is prepaid and it is recorded on the asset side of the balance sheet. This is a rule of accounting that cannot be broken under any circumstances. Therefore, as per the modern rules of accounting for assets an increase in assets will be debited.

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