Prepaid Insurance Journal Entry

Overview

The company usually purchases insurance to protect itself from unforeseen incidents such as fire or theft. And the company is usually required to pay an insurance fees for one year or more in advance. In this case, it needs to account for prepaid insurance by properly making journal entries in order to avoid errors that could lead to misstatement on both balance sheet and income statement.

At the payment date of prepaid insurance, the net effect is zero on the balance sheet; and there is nothing to record in the income statement. However, after adjusting entry at the end of the period for the insurance expense, the asset account will decrease while the expense account will increase. Likewise, the adjusting entry at the end of the period is necessary for the company to recognize the cost that expires through the passage of time.

Prepaid insurance journal entry

When the company makes an advance payment for insurance, it can make prepaid insurance journal entry by debiting prepaid insurance account and crediting cash account.

Account	Debit	Credit
Prepaid insurance	000
Cash		000

Prepaid insurance and cash are both balance sheet items. Hence, prepaid insurance journal entry does not affect the total assets because it increases one asset account and decreases another asset account at the same amount.

Insurance expense journal entry

At the end of each month, the company usually make the adjusting entry for insurance expense to recognize the cost of that has expired during the period.

Likewise, the company can make insurance expense journal entry by debiting insurance expense account and crediting prepaid insurance account.

Account	Debit	Credit
Insurance expense	000
Prepaid insurance		000

This adjusting entry is necessary for the company to not overstate its total assets as well as to not understate its total expenses during the period.

Example

For example, on September 01, 2020, the company ABC Ltd. pays $1,200 for one year of fire insurance which covers from September 01, 2020.

In this case, the company can make prepaid insurance journal entry on September 01, 2020, as below:

Account	Debit	Credit
Prepaid insurance	1,200
Cash		1,200

Likewise, the net effect of the prepaid insurance journal entry in this example is zero on the balance sheet. This is due to one asset increases $1,200 and another asset decreases $1,200.

As prepaid insurance is an asset that will expire through the passage of time, the cost of expiration will need to be recognized as an expense during the period.

In this case, on 30 September 2020, one month of insurance with the amount of $100 (1,200 / 12) will be expired. Hence, the company will need to make journal entry for insurance expense as below:

Account	Debit	Credit
Insurance expense	100
Prepaid insurance		100

In this case, if the company does not make the insurance expense journal entry above in the month-end adjusting entry, the September expenses will be understated by $100 while the total assets will be overstated by $100 as at September 30, 2020.