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Prepaid Expenses Examples, Accounting for a Prepaid Expense

This is due to one asset increases $1,200 and another asset decreases $1,200. Hence, it is important to record actual expenses for the year, so that the correct amount of profit is calculated. 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.

  • This simply means that the company records revenue as the money is received and expenses as it pays them.
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  • In accordance with the accrual basis of accounting, organizations are only supposed to record expenses and revenues that are pertinent to the period where the financial statements are actually being prepared.
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Prepaid Expense Accounting

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. A related account is Insurance Expense, which appears on the income statement. The amount in the Insurance Expense account should report the amount of insurance expense expiring during the period indicated in the heading of the income statement.

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  • On December 31, anadjusting entrywill show a debit insurance expense for $400—the amount that expired or one-sixthof $2,400—and will credit prepaid insurance for $400.
  • The amount in the Insurance Expense account should report the amount of insurance expense expiring during the period indicated in the heading of the income statement.
  • This is primarily because of the fact that business are supposed to follow accrual basis of accounting.
  • Like all financial products, prepaid insurance has both advantages and disadvantages to consider.

You don’t need a bank account to use prepaid cards, which is why they appeal to people who are unable to access traditional banking. Insurance companies often offer incentives to customers who prepay their premiums, but this type of plan requires making a large lump-sum payment. However, the second part of the payment corresponds to the next year, and therefore, it is supposed to be treated as a Current Asset in the financial statements that are prepared for this year. In the example above, it can be seen that Abdul Co. has made an annual payment for insurance, amounting to $2,400.

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Red Co. records this transaction using the following journal entry. A company, Red Co., pays an insurance premium of $10,000 through its bank account. Prepaid insurance is also considered an asset because of its redeemable value. 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.

An Example of Prepaid Insurance Accounting

Prepaid insurance is nearly always classified as a current asset on the balance sheet, since the term of the related insurance contract that has been prepaid is usually for a period of one year or less. 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. Prepaid insurance is the portion of an insurance premium that has been paid in advance and has not expired as of the date of a company’s balance sheet. This unexpired cost is reported in the current asset account Prepaid Insurance.

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The business’s records would show four months of insurance policy as a current, prepaid asset. It would be entered into the general ledger as a debit of $12,000 to the asset account and a credit for the same amount to the cash account. If you keep a ledger, enter the prepaid insurance payment as both a debit and credit. Let’s say you purchase a one-year home insurance policy for $1,200. BlackLine is a high-growth, SaaS business that is transforming and modernizing the way finance and accounting departments operate. Our cloud software automates critical finance and accounting processes.

As the policy is consumed from month to month, the policy’s value for those months will be recorded as a credit, and the entries in the two columns will eventually cancel out or total zero. Prepaid insurance is important because a business should correctly record all of its transactions and resources to have accurate financial statements. Global and regional advisory and consulting firms bring deep finance domain expertise, process transformation leadership, and shared passion for customer value creation to our joint customers. Our consulting partners help guide large enterprise and midsize organizations undergoing digital transformation by maximizing and accelerating value from BlackLine’s solutions. The path from traditional to modern accounting is different for every organization. BlackLine’s Modern Accounting Playbook delivers a proven-practices approach to help you identify and prioritize your organization’s critical accounting gaps and map out an achievable path to success.

Increase accuracy and efficiency across your account reconciliation process and produce timely and accurate financial statements. Drive accuracy in the financial close by providing a streamlined method to substantiate your balance sheet. Generally, https://personal-accounting.org/prepaid-insurance-definition/ is a current asset account that has a debit balance.

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