Prepaid Insurance: Definition, How It Works, Benefits, and Example

Accruing revenue is vital for service businesses that typically bill clients after work has been performed and revenue earned. Deferred revenue is used when your company receives a payment in advance of work that has not been completed. This can often be the case for professional firms that work on a retainer, such as a law firm or CPA firm. The point is that adjusting entry for prepaid insurance a business has to select payment options that are reasonable and appropriate for their situations and circumstances and require payments in reasonable increments. What is suitable for one type of business may not work for another. During the month you will use some of these taxes, but you will wait until the end of the month to account for what has expired.

  1. The credit part of the adjusting entry is the asset account, whose value is reduced by the amount used up.
  2. Any time that you perform a service and have not been able to invoice your customer, you will need to record the amount of the revenue earned as accrued revenue.
  3. Other less common prepaid expenses might include equipment rental or utilities.
  4. On 1 September 2019, Mr. John bought a motor car and got it insured for one year, paying $4,800 as a premium.
  5. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets.
  6. The balance in Accounts Receivable also increases if the sale was on credit (as opposed to a cash sale).

Here is the Insurance Expense ledger where transaction above is posted. Here is the Supplies Expense ledger where transaction above is posted. Prepaid expenses are classified as assets as they represent goods and services that will be consumed, typically within a year. First, debit the Prepaid Expense account to show an increase in assets.

Business License Tax – Deferred Expense

In the second illustration, it was explicitly stated that financial statements were to be prepared at the end of March, and that necessitated an end of March adjustment. Once you complete your adjusting journal entries, remember to run an adjusted trial balance, which is used to create closing entries. Payroll is the most common expense that will need an adjusting entry at the end of the month, particularly if you pay your employees bi-weekly. The journal entry is completed this way to reverse the accrued revenue, while revenue entry remains the same, since the revenue needs to be recognized in January, the month that it was earned.

It turns out that you have forgotten to make adjusting entries for the past two months. The balance in the Unearned Service Revenues liability account established when MicroTrain received the cash will be converted into revenue as the company performs the training services. Before MicroTrain prepares its financial statements, it must make an adjusting entry to transfer the amount of the services performed by the company from a liability account to a revenue account.

In other words, prepaid expenses are expenditures paid in one accounting period, but will not be recognized until a later accounting period. Prepaid expenses are initially recorded as assets, because they have future economic benefits, and are expensed at the time when the benefits are realized (the matching principle). Prepaid expenses may need to be adjusted at the end of the accounting period. The adjusting entry for prepaid expense depends upon the journal entry made when it was initially recorded.

Accrued Salaries

Regardless of whether it’s insurance, rent, utilities, or any other expense that’s paid in advance, it should be recorded in the appropriate prepaid asset account. On December 31, an adjusting entry will show a debit insurance expense for $400—the amount that expired or one-sixth of $2,400—and will credit prepaid insurance for $400. This means that the debit balance in prepaid insurance on December 31 will be $2,000. This translates to five months of insurance that has not yet expired times $400 per month or five-sixths of the $2,400 insurance premium cost. Prepaid insurance is usually considered a current asset, as it becomes converted to cash or used within a fairly short time. But if a prepaid expense is not consumed within the year after payment, it becomes a long-term asset, which is not a very common occurrence.

Supplies – Deferred Expense

Company-B paid 60,000 rent (5,000 x 12 months) in the month of December which belongs to the next year and doesn’t become due until January of the following year. Some insurers prefer that insured parties pay on a prepaid schedule such as auto or medical insurance. Before moving on to the next topic, consider the entry that will be needed on the next payday (January 9, 20X9). Suppose the total payroll on that date is $10,000 ($3,000 relating to the prior year (20X8) and another $7,000 for an additional seven work days in 20X9).

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.

If you’re still posting your adjusting entries into multiple journals, why not take a look at The Ascent’s accounting software reviews and start automating your accounting processes today. If you earned revenue in the month that has not been accounted for yet, your financial statement revenue totals will be artificially low. For instance, if Laura provided services on January 31 to three clients, it’s likely that those clients will not be billed for those services until February.

The correct amount is the amount that has been paid by the company for insurance coverage that will expire after the balance sheet date. If a review of the payments for insurance shows that $600 of the insurance payments is for insurance that will expire after the balance sheet date, then the balance in Prepaid Insurance should be $600. Be aware that there are other expenses that may need to be accrued, such as any product or service received without an invoice being provided. These include interest, wages, taxes, rent and many operating expenses. Therefore, the $100,000 cost must be spread over the asset’s five-year life.

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 most common examples of prepaid expenses are prepaid rent and prepaid insurance. Prepaid expenses are considered current assets because they are amounts paid in advance by a business in exchange for goods or services to be delivered in the future.

How long can prepaid expenses be reported as an asset?

This is particularly important when accruing payroll expenses as well as any expenses you have incurred during the month that you have not yet been invoiced for. This above entry transfers $200 from Prepaid Insurance to Insurance Expense. The account in question is debited to record the related journal entry. They are expenses paid in advance for benefits yet to be received. To truly transform your finance and accounting processes, you need the guidance of a trusted partner. Note that the amount adjusted monthly is the total insurance payment divided by 12 which is the number of months in a year.

Adjusting journal entries are used to (you guessed it) adjust the balances in certain accounts due to the passage of time. Since the Accumulated Depreciation account was credited in the adjusting entry rather than the Equipment account directly, the Equipment account balance remains at $6,000, its cost. The adjusting entry above is made at the end of each month for 60 months. In this case, assume that the equipment depreciates at a rate of $100 per month, which is determined by dividing its cost of $6,000 by 60 months (five years). It has lost $100 of its initial value, so it is now worth only $5,900. Repeat the process each month until the policy is used and the asset account is empty.