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In exchange, the insurance company usually offers the customer a discount on the premium price, so the business saves money on the policy. XYZ company needs to pay its employee liability insurance for the fiscal year ending December 31, 2018, which amounted to $10,000. The company has paid $10,000 prepaid insurance of the insurance premium for the entire year at the beginning of the first quarter. It refers to the portion of the outstanding insurance premium paid by the company in advance and is currently not due. Like all financial products, prepaid insurance has both advantages and disadvantages to consider. For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online.

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That’s because most prepaid assets are consumed within a few months of being recorded. Prepaid insurance is usually charged to expense on a straight-line basis over the term of the related insurance contract. When the asset is charged to expense, the journal entry is to debit the insurance expense account and credit the prepaid insurance account. Thus, the amount charged to expense in an accounting period is only the amount of the prepaid insurance asset ratably assigned to that period. For example, the following journal entry shows an initial payment of $12,000 for one year of insurance, which is recorded as an asset.

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Prepayment risk is the risk involved with the premature return of principal on a fixed-income security. When debtors return part of the principal early, they do not have to make interest payments on that part of the principal. Let us look at the balance sheet at the end of one month on December 31, 2017. Pay-per-mile car insurance policies are designed to benefit customers who maintain low annual mileage, such as people who work from home, are stay-at-home parents, or are retirees. Since your mileage varies from month to month, pay-per-mile programs do not offer a prepay option, only monthly billing.

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From a financial accounting perspective, prepaid insurance is considered a prepayment. This method makes sure that the expenses match the revenues related to them, following the matching principle in accounting. A prepaid expense is anexpenditurethat a business or individual pays for contribution margin before using it. When someone purchases prepaid insurance, the contract generally covers a period of time in the future.

The insurance company is legally bound to provide the coverage outlined in your policy during the prepaid period. Prepaid insurance is an asset account on the balance sheet, in which its normal balance is on the debit side. The company should not record the advance payment as the insurance expense immediately. This is due to, under the accrual basis of accounting, the expense should only be recorded when it occurs. 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. Passing adjustment entries to balance the books of accounts is often helpful, preventing one from making an entry for new business transactions.

• In other words, it could get a refund of the premiums for those four months.
• The second journal entry shows how 1/12th of this amount is charged to expense in the first month of the coverage period.
• But if a prepaid expense is not consumed within the year after payment, it becomes along-term asset, which is not a very common occurrence.
• 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.
• During the prepaid period, if you experience a loss covered by the insurance policy, you can file a claim and receive compensation as per the terms and conditions of the policy.
• When insurance is due for each quarter, i.e., $2,000 will be subtracted from the prepaid account and is shown as an expense in the income statement for that reporting quarter.

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It’s important to review the policy carefully before purchasing to understand the coverage limits, deductibles, and exclusions. Prepaid expenses, such as prepaid rent and prepaid insurance, represent assets for a business until they are used. At the end of each month, an adjusting entry of $400 will be recorded to debit Insurance Expense and credit Prepaid Insurance.

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For example, if a company pays $12,000 for an annual insurance coverage, their monthly prepaid insurance expense is $1,000 ($12,000/12 months). This method guarantees that expenses are accurately allocated during the prepaid period, reflecting the steady utilization of insurance coverage. When you purchase prepaid insurance, you essentially pay the premium upfront instead of making monthly or periodic payments. This arrangement ensures that you have coverage for the specified period, regardless of any changes in the insurance market or your financial situation.

• 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.
• This means the company should record the insurance expense at the period end adjusting entry when a portion of prepaid insurance has expired.
• The same applies to many medical insurance companies—they prefer being paid upfront before they begin coverage.
• Insurers commonly offer prepayment for many types of insurance, including auto and homeowners insurance.
• Unless an insurance claim is filed, prepaid insurance is usually renewable by the policyholder shortly before the expiry date on the same terms and conditions as the original insurance contract.

Assume that on December 1, a newly formed company pays $600 for insurance coverage for the six months ending on June 1. As of December 31, the company will report Insurance Expense of $100 and its current asset Prepaid Insurance will report $500. The prepaid amount informs the readers of the December 31 balance sheet that the company will not have to pay $500 in cash for insurance during the next five months. Each month, the business’s accounting department would make an adjusting journal entry of $1,000, representing the amount of one month’s premium payment in the general ledger.