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 freshbooks vs wave comparison per month or five-sixths of the $2,400 insurance premium cost. Each month, you will need to move the used portion of the insurance payment to an expense account.
The adjusting journal entry for a prepaid expense, however, does affect both a company’s income statement and balance sheet. The adjusting entry on January 31 would result in an expense of $10,000 (rent expense) and a decrease in assets of $10,000 (prepaid rent). The adjusting journal entry is done each month, and at the end of the year, when the insurance policy has no future economic benefits, the prepaid insurance balance would be 0. To illustrate how prepaid insurance works, let’s assume that a company pays an insurance premium of $2,400 on November 20 for the six-month period of December 1 through May 31. The payment is entered on November 20 with a debit of $2,400 to prepaid insurance and a credit of $2,400 to cash. As of November 30, none of the $2,400 has expired and the entire $2,400 will be reported as prepaid insurance.
- For reference, the chart below sets out the type, side of the accounting equation (AE), and the normal balance of some typical accounts found within a small business bookkeeping system.
- In our case, we will be looking at prepaid insurance, a pretty standard balance day adjustment businesses have to make if they are using an accrual accounting system.
- Nonetheless, it may happen that a debit account has a credit balance as well.
- The adjusting journal entry is done each month, and at the end of the year, when the insurance policy has no future economic benefits, the prepaid insurance balance would be 0.
- Now it’s time to look at some simple journal entries that would be made to account for prepaid insurance.
As a rule, one of the major indicators that something goes wrong is the fact that an account has an abnormal balance, which is the opposite of the normal one. In this case, there might be an error or other issue that requires an urgent investigation.Keep in mind that if an account is usually a debit one, any debit entry increases the balance. If an account is usually credit, any credit entry increases the balance. Therefore, it’s so important to make only the right entries, as they influence the balance directly. If they’re filled out incorrectly, the company will eventually suffer inevitable losses.
How Are Prepaid Expenses Recorded on the Income Statement?
Although each account has a normal balance in practice it is possible for any account to have either a debit or a credit balance depending on the bookkeeping entries made. While prepayment and monthly billing are standard ways to pay an insurance premium, some auto insurance companies offer pay-per-mile policies. ABC Ltd pays for its building and contents insurance each year on January 1 for the whole of the calendar year. The journal entries to bring to account these transactions are as follows.
- Prepaid insurance is usually considered a current asset, as it becomes converted to cash or used within a fairly short time.
- It should be noted that if an account is normally a debit balance it is increased by a debit entry, and if an account is normally a credit balance it is increased by a credit entry.
- When the $2,400 payment is made on January 1, the company debits Prepaid Insurance and credits Cash.
Throughout the home insurance policy’s term, you will reduce the value of the asset. For example, the $1,200 prepaid policy will reduce in value by $100 each month, which you adjust in your ledger. In the example above, it can be seen that Abdul Co. has made an annual payment for insurance, amounting to $2,400. This amount corresponds to 12 months, beginning on 1st July 2019, and ending on 30th June 2020.
Using the Normal Balance
For example, if an asset account which is expected to have a debit balance, shows a credit balance, then this is considered to be an abnormal balance. It should be noted that if an account is normally a debit balance it is increased by a debit entry, and if an account is normally a credit balance it is increased by a credit entry. So for example a debit entry to an asset account will increase the asset balance, and a credit entry to a liability account will increase the liability. So for example there are contra expense accounts such as purchase returns, contra revenue accounts such as sales returns and contra asset accounts such as accumulated depreciation. When the insurance coverage comes into effect, it is moved from an asset and charged to the expense side of the company’s balance sheet.
Normal Balance of Accounts
ABC will disclose this amount under current assets in the balance sheet (statement of financial position). At the same time, the credit part of the entry reduces the insurance expense with a credit. If we didn’t have this credit, the profit and loss account (statement of financial performance) would overstate the insurance expense by $7,500. So far, we have worked through some of the theories behind prepayments, particularly the type of account, a current asset, and the normal balance of prepaid insurance being a debit. Now it’s time to look at some simple journal entries that would be made to account for prepaid insurance.
About the Author
One of the more common forms of prepaid expenses is insurance, which is usually paid in advance. This means that the premium you pay is allotted to the upcoming time period. If you keep a ledger, enter the prepaid insurance payment as both a debit and credit. Prepaid insurance is a future expense, which you must pay upfront and receive its benefits over time.
Pros and Cons of Prepaid Insurance
For example, you might buy a one-year magazine subscription and receive one magazine per month for 12 months. The first journal reflects the increase in expenses (debit) due to ABC paying its annual insurance bill. While the other side of the entry, to keep it all in balance, is to reduce the bank account asset (credit) to reflect the reduction in funds now held. Mostly, these expenses, if prepaid, are utilized within the course of the forthcoming year only.
Some insurers prefer that insured parties pay on a prepaid schedule such as auto or medical insurance. The landlord requires that Company A pays the annual amount ($120,000) upfront at the beginning of the year. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. Double Entry Bookkeeping is here to provide you with free online information to help you learn and understand bookkeeping and introductory accounting. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more.
What categories are included in different account types?
For prepaid insurance, this would relate to the insurance cover the reporting entity has in place. Insurance, i.e. another party taking on a risk you don’t want to cover yourself, is an economic benefit – whether a claim is made or not. 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. However, the premiums may be marginally higher to account for inflation and other operating factors. As mentioned earlier, recording prepaid insurance does hold tantamount importance from an organizational perspective.