What is 'Prepaid Insurance'
Prepaid Insurance payments are made in advance for insurance services or coverage. The period for which insurance is prepaid is generally one year, but may exceed a year in certain cases. Prepaid insurance that expires in a year is classified as a current asset on a corporation's balance sheet.
BREAKING DOWN 'Prepaid Insurance'
Unless a claim has been made, prepaid insurance is usually renewable by the policyholder shortly before the expiry date on the same terms and conditions as the original insurance contract. However, the premiums may be marginally higher to account for inflation and other operating factors.
How Prepaid Insurance Accounting Works
A prepaid expense is an expenditure paid for in one accounting period, but for which the underlying asset will not be consumed until a future period. Prepaid insurance is considered as such. When the asset is eventually consumed, it is charged to expense. If consumed over multiple periods, there may be a series of corresponding charges to expense.
A prepaid expense is carried on the balance sheet of an organization as a current asset until it is consumed. The reason why is because most prepaid assets are consumed within a few months of being recorded. If a prepaid expense were likely to not be consumed within the next year, it would instead be a long-term asset (this is not common). The payment of the insurance expense is similar to money in the bank, and as the money is used up, it is withdrawn from the account in each month or accounting period. Prepaid insurance is usually considered a current asset, as it will be converted to cash or used within a fairly short time.
To illustrate prepaid insurance, let's assume that on November 20, a company pays an insurance premium of $2,400 for the six-month period of December 1 through May 31. On November 20, the payment is entered with a debit of $2,400 to prepaid insurance and a credit of $2,400 to cash. As of November 30, none of the $2,400 has expired and the entire $2,400 will be reported as prepaid insurance. On December 31, an adjusting entry will debit insurance expense for $400 (the amount that expired: one-sixth of $2,400) and will credit prepaid insurance for $400. This means that the debit balance in prepaid insurance at December 31 will be $2,000 (five months of insurance that has not yet expired times $400 per month; or five-sixths of the $2,400 insurance premium cost).