Considering prepared insurance, is it an asset? This is what we will be covering in this article – “Is Prepaid Insurance An Asset”?
Before we continue, What is Prepaid Insurance?
What Is Prepaid Insurance
Prepaid insurance refers to an accounting arrangement in which a business pays for insurance coverage in advance, typically for a future period of time, such as a year. This payment is recorded as an asset on the company’s balance sheet because it represents a future benefit. As time progresses and the insurance coverage period elapses, a portion of the prepaid amount is recognized as an expense on the income statement. This gradual recognition aligns the expense with the period in which the insurance protection is actually utilized, helping to match costs with revenues and maintain accurate financial reporting.
How Prepaid Insurance Works
Here is a detailed explanation of how prepaid insurance works:
1. Initial Payment: When a business purchases insurance coverage, it typically pays the insurance premium upfront. This payment covers a specific period, such as a year, and is usually paid to an insurance company.
2. Recording the Transaction: Initially, the entire amount paid for insurance is recorded as an asset on the company’s balance sheet. This is because the business has essentially pre-paid for a service that will provide future benefits.
3. Amortization: Over the course of the coverage period, the prepaid insurance amount is gradually recognized as an expense on the income statement. This recognition process is known as amortization or expense recognition.
4. Monthly or Periodic Adjustments: To accurately match expenses with the time period in which insurance benefits are received, businesses make periodic adjustments. This is typically done monthly or quarterly. The adjustment involves transferring a portion of the prepaid insurance amount from the balance sheet (asset) to the income statement (expense).
5. Journal Entries: The journal entries to record this adjustment are as follows:
- Debit (Increase) Insurance Expense: This reflects the portion of the prepaid insurance that should be recognized as an expense in the current period.
- Credit (Decrease) Prepaid Insurance: This reduces the prepaid insurance asset on the balance sheet, reflecting that a portion of it has been utilized.
6. Gradual Expense Recognition: As time passes and more adjustments are made, the prepaid insurance account on the balance sheet decreases, while the insurance expense on the income statement increases. This gradual recognition ensures that expenses are matched with the corresponding revenue or period in which insurance coverage is provided.
7. Year-End Adjustment: At the end of the coverage period, the entire prepaid insurance amount should have been recognized as an expense. Therefore, the balance in the prepaid insurance account on the balance sheet should be zero.
8. Repeat for Each Coverage Period: This process is repeated for each period the business has prepaid insurance coverage.
By using prepaid insurance and the process of amortization, businesses can accurately account for their insurance expenses over time, which helps in financial reporting, budgeting, and decision-making. It ensures that expenses are recognized when they are incurred, providing a more accurate picture of a company’s financial performance.
Let us consider a life scenario of a prepaid insurance for a small business to illustrate how it works:
Sarah owns a small bakery called “Sweet Delights.” She understands the importance of insurance to protect her business from unforeseen events like fire or theft. To secure her bakery, she decides to purchase an annual insurance policy from a local insurance company for $3,600. This policy covers her bakery for potential losses and liabilities for the entire year.
How Prepaid Insurance Works in Sarah’s Scenario:
1. Initial Payment: In January, Sarah makes the full payment of $3,600 to the insurance company for the annual policy, covering her bakery for the entire year.
2. Recording the Transaction: On her bakery’s financial records, Sarah records this initial payment as a prepaid insurance asset. So, her balance sheet now shows a prepaid insurance asset of $3,600.
3. Monthly Adjustments: At the end of each month, Sarah reviews her financial statements and makes a monthly adjustment to recognize a portion of the prepaid insurance as an expense. Let’s say she amortizes $300 each month.
- She records a journal entry:
– Debit (Increase) Insurance Expense: $300
– Credit (Decrease) Prepaid Insurance: $300
4. Gradual Expense Recognition: Over the course of the year, Sarah continues to make these monthly adjustments. By the end of each month, the prepaid insurance asset on her balance sheet decreases by $300, and her income statement shows $300 in insurance expenses.
5. Year-End Adjustment: After 12 months, the entire prepaid insurance amount of $3,600 has been recognized as an expense. Her prepaid insurance asset account is now reduced to zero.
6. Repeat for Each Coverage Period: In subsequent years, Sarah repeats this process. She pays for her annual insurance policy, records it as a prepaid insurance asset, and then amortizes it monthly over the course of the policy period.
This scenario demonstrates how prepaid insurance helps Sarah manage her bakery’s insurance expenses effectively. It ensures that she spreads the cost of insurance coverage over time, matching the expense with the periods during which she receives the insurance protection. It also provides a clear picture of her bakery’s monthly and annual expenses, aiding in budgeting and financial planning.
Is Prepaid Insurance An Asset?
From the steps on how prepaid insurance works, it can be clearly seen why prepaid insurance is seen as an asset.
So if you are asked – Is Prepaid Insurance An Asset? The answer is YES, here is the reason;
Prepaid insurance payment is recorded as an asset on the company’s balance sheet because it represents a future benefit. As time progresses and the insurance coverage period elapses, a portion of the prepaid amount is recognized as an expense on the income statement.