Are you unclear on where prepaid insurances belong? Read on ahead to clear out your confusion.
Table of Contents
- 1 Introduction
- 2 Prepaid Insurances
- 3 How Prepaid Insurances Work?
- 4 Is Prepaid Insurance Debit Or Credit?
- 5 Prepaid Insurance Account Type
- 6 Amortization Of Prepaid Expenses
- 7 GAAP Prepaid Expenses
- 8 Prepaid Insurance Accounting Equation
- 9 Conclusion
Any ambiguities in the insurance world can be quite damaging as one will not be able to make an informed decision, it is necessary to be aware of all the insurance lingo. Not only that but being aware of all the definitions can also help in taking you a long way when you are studying insurance-related topics, these can help in making sure that your foundation and base on the subject are stabilized and you can then proceed to work on further advanced topics ahead.
Down below we will not just clear queries like is prepaid insurance an asset, is prepaid insurance debit or credit, etc but also help you in defining what it is, the prepaid insurance account type, details on amortization of prepaid expenses, the prepaid insurance accounting equation and other things as well. Take a look down below to learn how prepaid insurance works
We all are aware of the term prepaid. Prepaid means to pay for some product or service in advance, in a similar manner, this term is used with insurances as well, When you are getting insurance, you will be required to pay a certain amount as premium. This premium is known as the insurance premium. When an individual chooses to pay some part of this amount in advance, it is known as prepaid insurance. Simply speaking, prepaid insurance is the portion of the total amount of premium which has been paid in advance. This amount is one that has not expired as of the data of the company’s balance sheet recordings.
Companies normally tend to ask for the premium to be paid a complete year, meaning 12 months in advance but sometimes this time duration can be increased to more than a year as well. It depends on company to company. In some cases, the lenders have it mandatory for the insured person to pay their premium amount in advance. This is usually in the case of health or auto insurances.
While prepaid expenses are the ones that are made beforehand when one wants to continue using a product or service for a specific amount of time, accrued expenses are the complete opposite. Accrued expenses are the liabilities, of a company and are made up of the amount which has to be paid and is a responsibility or a liability for the firm.
One cannot completely ignore prepaid expenses whilst studying or going through accounting because there are certain products whose nature makes it necessary for there to be prepaid expenses.
How Prepaid Insurances Work?
Now that we are clear on what prepaid insurance is, let’s look at the working of it in a little more detail. Any time an individual decides to pay for a product or a service in advance, they are choosing to tackle it beforehand. Similar can be done with insurances as well, a lot of companies who give out health insurances or auto insurances operate on a prepaid basis. So, the client is asked to pay the insurance premium amount for a specific time in the future. These companies and insurers prefer that their clients pay them the premium amount upfront and then continue getting benefits from that insurance for the remainder of their contract.
The reason why companies tend to ask their clients to pay the premium in advance is that this advance payment can be used as a sort of backup in case there are any claims. The advance payment helps in giving the companies a sort of cushion and helps to mitigate and to lessen the amount of risk for them. With regards to the recording of this prepaid expense, take a look down below to learn in more detail about where it gets recorded in the balance sheet for a company’s balance sheet.
Is Prepaid Insurance Debit Or Credit?
The one major question that we keep hearing regarding this topic goes, “is prepaid insurance debit or credit?” To identify prepaid expenses that are turned into actual expenses, we use adjusting entries to alter it. Whenever you will use the prepaid expense product, the prepaid expense account will be decreased and at the same time, the actual expense account will be increased.
Now, to do this, those with a little accounting background know that when the account is decreased or lessened, we credit in our entries and the other one will be automatically debited. The same is the case here with the prepaid expense account and the actual account. The actual account expense account will be debited and the prepaid expense account will be credited as it has been lessened.
We know that prepaid insurance is charged over some time over an insurance contract. While making a journal entry, the insurance expense account will be debited while the prepaid insurance account will be credited. All of this will be done when the asset will be charged as an expense.
So the answer to your question is that prepaid insurance is credited.
Prepaid Insurance Account Type
Prepaid insurance is considered to be an asset in the accounting world and is said to be a business asset. This business asset is recorded on the left-hand side of the balance sheet as an asset account. When the payment of prepaid insurance is made for a particular product or service or even for insurance, you can think of it as having a certain amount of money in your bank. As time passes and you use up your insurance, each month the amount will be deducted from your prepaid insurance account as you would expect your bank amount money to get lessened after every transaction you make,
A very easy and basic example of prepaid insurance is prepaid rent. Both operate in the same way. When you pay for rent beforehand, the rent amount will be deducted from your prepaid account as you live in your house or use that location each month. This prepaid insurance account is termed as a current asset. You can either choose to convert this amount into cash for your usage or you can choose to use this amount in a short period.
There are various types of prepaid expenses and some of the major ones are mentioned below.
1. Prepaid Insurance
Prepaid insurance is the sort that is seen all over the business and the insurance world. For such expenses, advance payment of insurance premiums takes place in a company that is offering insurance coverage. These insurances can be of various types as well such as life, vehicle, travel, home, etc. They are recorded as current assets when a balance sheet is curated.
2. Prepaid Rent
The second most common type of prepaid expense is prepaid rent. Since you know what a prepaid expense is, this term will be pretty self-explanatory. In prepaid rent, a part of the rent is paid in advance for the borrower to use for a particular amount of time. In the accounting records, this expense will be noted down as prepaid expense since more than the required sum is paid off because it is supposed to cover months of the future period as well.
3. Prepaid Advertising
The third one in this list of prepaid expense account types is prepaid advertising. This is not as common for the general public but people in the corporate sector should be well aware of it. It is present in the current section whilst creating the balance sheet. The process of prepaid advertising is that a company or organization, etc who wants to advertise its offerings will have to pay in advance to the TV channel or agency.
Amortization Of Prepaid Expenses
Either it is a small business or a big corporation, everyone needs to know how the amortization of prepaid expenses is carried out. Mostly, hoped for when there is an accrual basis accounting system, prepaid expenses are advance payments. These advance payments are recorded in the journal as prepaid expenses and it is crucial to go through the amortization of these expenses to learn when they are incurred.
Amortization is the identification and expansion of an expense in a particular period depending on the exact time when the expense was incurred in the first place. When we talk about the amortization, spreading, or even expanding of an expense by the end of each month, it is known as adjusting entries.
Whilst recording the amortization of prepaid expenses, it is crucial to identify each expense wherever it incurs. After each schedule for each month, the amortization expenses can be recorded together in one month. this is an efficient method as you will not be constantly making and adjusting new entries and there will be no further requirement to record each entry one by one.
GAAP Prepaid Expenses
Like all other things in the universe, there are certain rules and regulations for accounting as well. Before we jump into GAAP for prepaid expenses, let’s first take a look at what GAAP is.
GAAP is the short form for generally accepted accounting principles. These are a set of rules and regulations that revolve around various accounting concepts. It includes details of legalities of business, complexities, and legalities of corporate business.
GAAP is most commonly used by the FASB which is the Financial Accounting Standards Board. They made GAAP a set of founding rules and principles and used it to lay the foundation for the various accounting methods and principles.
Now that we are aware of what GAAP is, let’s learn a little bit about Non-GAAP. Non-GAAP is used to report deviations made from the standard system and helps make various adjustments that are required to present information about an entity in a more accurate manner.
Out of all the rules, the 12-month rule is one that everyone should be acquainted with. The 12-month rule for prepaid expenses states that dedication can be made for a prepaid expense in the current year if the benefit paid for or the right does not extend more than the earlier of 12 months. Or, the end of the taxable year following the taxable year in which the payment or the expense was incurred.
It is also dictated by GAPP that expenses that are paid for before they are due will always be placed, mentioned, and recorded in the balance sheet. The time when an audit client chooses to pay expenses in the period which is taking place now which won’t be the same with revenue until subsequent periods then it will be termed as a deferred charge of a prepaid expense.
These are the Standard U.S accounting guidelines which are crucial and mandatory for reporting financial statement transactions.
Prepaid Insurance Accounting Equation
The accounting equation is a major foundation for the accounting system which is known as the double-entry accounting system. Without the accounting equation, it would be nearly impossible to proceed with creating the recordings. While creating a balance sheet for a particular company, the accounting equation portraits that a company’s complete assets will be equal to the total liabilities and shareholders’ equity.
The purpose of this equation is to make sure that the balance sheet is balanced and that each entry recorded on the debit side has an entry on the credit side as well to balance it out. The assets will be all the resources that a company or business owns. The liabilities on the other h and will be representing the obligations of the company. The liabilities and the shareholders’ equity will be shown to identify the process of financing a company’s assets.
Now that we know how crucial an accounting equation is, the same situation and equation also have to be kept in mind while prepaid expenses are dealt with. For prepaid expenses, people are often confused as to how a prepaid insurance accounting equation will be formed. Take a look down below and learn the recording of prepaid expenses in the accounting equation.
When we are making the balance sheet, it has been made clear that prepaid expenses will be recorded as an asset on the debit side of the sheet. The equations explain that assets are equal to liability and equity. Now, when making the accounting equation, the prepaid insurance amount is credited from the assets and debited in the liability.
Admittedly, the accounting world can get quite complicated at times because of the abundance of rules, regulations, and equations but is extremely essential in the business sector. The only way one can succeed in managing their finances aptly and accurately is by ensuring that their recordings and calculations are correct. Take a look above at the detailed analysis of prepaid expenses and get your answer to “is prepaid insurance an asset?”