When individuals or cooperate organizations own items that they consider valuable, they usually subscribe to different kinds of insurance packages to ensure some level of guarantee for them in an event of a loss of the item due to theft or accidents such as fire outbreaks. These payments are referred to as insurance and are made to insurance companies. When this payment is made in advance as is often the case, it is referred to as prepaid insurance. When this prepayment is made, companies will have to make an adjusting entry for prepaid insurance at the end of every accounting cycle.
The adjusting entry is necessary as it records the amount of insurance that has been used up by the company and also ensures accurate reporting of the company’s financial standing in its various financial statements. In this article, we shall have a closer look at what prepaid insurance means and why adjusting entries for prepaid insurance are made.
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What is prepaid insurance?
Prepaid insurance refers to the payment made for insurance in advance. It is an expense that has not yet been recorded as an expense because it has not expired yet. This means that the payment for prepaid insurance is made in a different accounting period from the accounting period when it will be used. Hence, it is first recorded as an asset on the company’s balance sheet because it has the potential, like other assets, of bringing future benefits to the company. This future benefit is in the form of the insurance coverage that the company gets for the period covered by the prepayment. The payment gets expensed when the benefits have been realized by the company based on the matching principle.
Prepaid insurance can be paid monthly, quarterly, or yearly depending on the insurance plan and policies as well as the company’s preference. The prepayment will hence, provide insurance coverage for the company within the period covered by the prepayment. Generally, companies make prepayments for insurance for buildings, equipment, machinery, vehicles, and other valuable items. They may also have life insurance for their employees especially if the job is a high-risk one that may expose workers to life-and-death situations such as the military, paramilitary organizations, and private protection outfits that offer protection services for individuals or property.
Prepaid insurance appears in a company’s statement of financial position in the current asset segment as part of the prepaid expenses. As the insurance gets used up, an adjusting entry for prepaid insurance is made to account for the reduction in assets and the resultant increase in expenses. This increase in expenses reflects in the company’s income statement within the accounting period when it has been used up.
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Adjusting entry for prepaid insurance
The portion of an insurance premium that was paid for in advance and has not yet expired is recorded as part of the current assets of a company and is prepaid insurance. The unexpired insurance prepayment is reported as part of prepaid expenses on the company’s balance sheet. As time passes and the insurance premium begins to expire, making an adjusting entry for prepaid insurance becomes pertinent. The adjusting entry is made so as to transfer the expired portion of the prepaid insurance from the asset account (prepaid insurance) to the expense account (prepaid expense).
The adjusting entry for prepaid insurance is usually made at the end of each accounting cycle or prior to the issuing of financial statements by a company. If the adjusting entry is made at the end of each accounting cycle, then, it means adjusting entries for prepaid insurance are made either monthly, quarterly, or yearly depending on the accounting cycle that the company uses. They could also choose to make the adjusting entry once, at the end of each fiscal year.
Therefore, companies that issue monthly financial statements make adjusting entries for prepaid insurance at the end of each month while those that issue quarterly or yearly financial statements make adjusting entries quarterly or yearly respectively.
One thing that is common in all these adjusting entries for prepaid insurance is that irrespective of when the adjusting entry is made, it must be done accurately and in a timely manner such that the financial statements of the company accurately report that portion of the prepaid insurance that is still an asset and the part that is expired and has thus become an expense. Failure to accurately make this distinction results in having incorrect final statements with either understated or overstated assets and expenses.
How do you adjust entries for prepaid insurance?
In order to adjust the entry for prepaid insurance, the amount of expired insurance has to be determined. Once this is done, the amount is recorded as a debit to insurance expense and a credit to prepaid insurance. This adjusting entry effectively increases the amount recognized as expenses and reduces the amount left as assets within the allotted period.
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Journal entry for prepaid insurance
The journal entry for prepaid insurance is the journal entry made by a company when it makes payments in advance for insurance premiums. This journal entry records the dollar amount that is spent to purchase the insurance cover. When making this journal entry, the prepaid insurance has not yet expired and is thus an asset to the company. The journal entry for this transaction is a debit to the prepaid insurance account and a credit to the cash account. This indicates that the prepaid insurance has increased since it has not been used yet while the cash account has decreased since money was used to make the purchase. This journal entry can be recorded as shown below:
What is the journal entry for prepaid insurance?
The journal entry for prepaid insurance is a debit to the prepaid insurance account and a credit to the cash account or the company’s bank account. This journal entry records the transaction concerning the purchase of insurance premiums by a company within a specified accounting cycle.
Adjusting journal entries for prepaid insurance
Once portions of the prepaid insurance have expired or the company needs to issue financial statements, an adjusting entry for prepaid insurance has to be made to record the true position of the company’s assets and liabilities as well as its income and expenses. This adjusting journal entry adjusts the prior journal entry that records the prepaid insurance payment and would be similar to the one below:
Note that before the adjusting entry for prepaid insurance is made, the dollar equivalent of the portion of insurance that has expired has to be determined. It is only after this that the adjusting entry for the month, quarter, or year can be made.
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Adjusting entries for prepaid insurance examples
Assuming a fast food chain such as McDonald’s purchased an insurance premium costing $30,000 for one of its outlets. Suppose the insurance is for one year and the payment was made on March 1, 2023. Since this is an upfront payment, it means that it will be recorded as prepaid insurance as shown below:
To keep track of the monthly portion of the insurance that has expired, an adjusting entry for prepaid insurance will be made on April 1, 2023, as follows:
Note that the amount adjusted monthly is the total insurance payment divided by 12 which is the number of months in a year. That is $30,000/12 to arrive at the $2,500 adjusting entry for prepaid insurance that will be made monthly. In an instance where the company does not make monthly adjusting entries, then they will make only one adjusting entry for prepaid insurance on the first day of the month when the 12-month period that the insurance payment covers have expired.
Suppose a logistics company such as DHL purchased an insurance premium for one of its trucks at $1,500 per month. If the insurance was paid for on December 29, 2022, but covers from January to December 2023, then DHL would record the transaction as shown below:
The monthly insurance amount of $1,500 is multiplied by 12 to arrive at the $18,000 that was made at the time of purchase. Now, suppose DHL issues financial statements at the end of every quarter, it means that at the beginning of the second quarter, the insurance cover for the first quarter would have expired. Thus, an adjusting entry for prepaid insurance has to be made and it will be as follows:
To arrive at the $4,500 that is recorded as the quarterly adjusting entry for prepaid insurance on the delivery truck, the monthly insurance payment is multiplied by 3. This indicates the first quarter which is from January to March. In subsequent quarters, further adjusting entries for prepaid insurance will be made as each quarter ends and the insurance for that particular quarter expires.
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Why is prepaid insurance adjusted?
Prepaid insurance is adjusted from time to time to account for the gradual expiration of the insurance premium that had been previously prepaid for by a company. These adjusting entries are necessary because they have a direct impact on the company’s financial statements which get issued either monthly, quarterly, or yearly.
If the prepaid insurance account is not adjusted in tandem with the portion of the insurance that has expired, it will lead to errors in reporting the assets and expenses of the company. This is because prepaid insurance before its expiration reflects on the company’s statement of financial position as part of the current assets whereas, upon the expiration of the prepaid insurance, it reflects as part of the company’s expenses on its income statement. Therefore, timely and accurate adjustments to the prepaid insurance account are essential for correct financial statements per time.
Video: What is the adjusting entry for prepaid insurance?
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