What are the adjusting entries for prepaid insurance? (Example and Explanation)

Introduction

A prepaid expense by definition is an expense that has been paid for by the business in advance, that is, before the services for that expense have been availed. In this case, the business must record such expenses as prepaid expenses. As the business begins to use the service, the expense begins to accrue, and the prepaid amount gets deducted accordingly.

Similarly, a prepaid insurance expense is a prepaid expense that has been paid for by the company. Prepaid insurance is essentially a part of the insurance premium or a fee that is paid by the company in advance as a part of the insurance agreement for an extended period of time.

It is included as a current asset on the balance sheet of the company and the amount of prepaid insurance that is included is the one which is unexpired insurance as of the date on which, the balance sheet is being prepared.

As the insurance expense accrues, and the prepaid insurance amount begins to expire, part of the prepaid insurance expense will be gradually moved from the current asset account under the balance to the income statement under the expenses as insurance expense.

The company must continue to make appropriate journal entries to apportion the prepaid insurance expense according to the time period during which the expense will continue to accrue. This is usually done by the accounting department at the end of each financial year by using an adjusting journal entry.

The prepaid insurance expense is almost always classified as a current asset due to the fact that the insurance fee usually covers a period of up to 1 year after which the company makes the payment again for the next period.

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However, if in case the company pays for more than a year, then the prepaid expense will no longer be a part of the current asset. Regardless, the company must make adjusting entries to record insurance expense matched to each month and transfer it from prepaid insurance to insurance expense account.

Journal Entry for Prepaid Insurance

When a company pays for insurance in advance, this will be recorded in the balance sheet of the company as prepaid insurance. Since the amount paid for insurance will either come from a bank or cash, which is also a balance sheet item, prepaid insurance does affect the income statement. The journal entry that must be made to account for the purchase of prepaid insurance is:

DateDetailsDebitCredit
xxxPrepaid Insurancexxx 
  Cash         xxx
Paid in advance for the insurance cover for next year.

Here, the prepaid insurance account is debited as it increases and there is a counter decrease in cash or bank account.

When a journal entry has to be made for the prepaid insurance to be adjusted for insurance expense which has already accrued, the total amount of the insurance cover is divided equally over the number of months covered as a part of the insurance coverage period stated in the agreement.

However, since now interest expense is a part of the income statement, the journal entry will now affect the current asset section of the balance sheet, as well as the expense section of the income statement. 

When the prepaid insurance is being apportioned, the prepaid insurance account is credited while the insurance expense account is debited by the same amount. This amount will be one that is matched to the period which has just ended. This journal entry can be written as:

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DateDetailsDebitCredit
xxxInsurance expense Accountxxx 
  Prepaid Insurance account xxx
To account for the insurance expense for the current financial year.

Example of Prepaid Insurance Journal Entry

A business pays $24000 on 31st December 2020 in advance to buy the insurance cover for the next year. The journal entry for this will include:

DateDetailsDebitCredit
31-DecPrepaid Insurance$24,000 
  Cash         $24,000
Paid in advance for the insurance cover for next year.

Consequently, at the end of the month of January, when the company wants to record the insurance expense for the month, they will need to divide the amount paid ie. $24,000 by 12 months which will give the insurance expense for each month that is $2,000.

Let’s say now that the financial year of the company ends on 30th April 2020. To record insurance expenses for 4 months the company will make the following journal entry:

DateDetailsDebitCredit
30-AprilInsurance Expense$8,000 
  Prepaid Insurance $8,000
To account for the insurance expense for the current financial year.

The debit entry to insurance expense will result in adding the expenses whereas credit to the prepaid expense account will result in decreasing the current asset.

By making this journal entry, the company will be able to record the insurance expense which has been incurred already and the part of prepaid insurance which has now already expired.

The prepaid insurance expense account under the current assets in the balance sheet will still show the amount of $16,000. This is the part of the insurance which has not yet expired. In each of the successive months, equal parts insurance will continue to be credited from the prepaid insurance account.

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Conclusion

To conclude what has been explained above, prepaid insurance is a part of the current assets of the business because it has been paid off by the business already for future use.

Like other prepaid expenses, when insurance has been paid in advance, it will be recorded in the balance sheet under current assets and at the end of each month, the appropriate amount matching to that month must be deducted from the prepaid insurance account by crediting it, and this would be posted as a debit to the insurance expense account.

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