Andrew – Page 7 – Financial Memos

This article, part of our accounting tutorial series, reviews the journal entry required when an insurance premium is paid in advance. We have a quick look at prepayments and the difference between cash and accrual accounting systems. We even have a quick look at conceptual frameworks - which might be a first for some of you. If you don't have time for the background, the quick answer is credit insurance expense and debit prepaid insurance. For more details, please read on. What Are Expenses Paid in Advance? Insurance paid in advance is an example of a prepayment or often called a prepaid expense. Although you would expense these payments when made, they are subject to balance day adjustments under the accrual system. A balance day adjustment is required when an entity has paid for goods and services, like insurance, in advance. But they have yet consumed the economic benefits from that payment at the balance date. This is fancy accounting speak for when you have paid for something you have yet used; this might be an asset rather than an expense at the balance date. Conceptual Frameworks and Assets Why an asset? Because under our conceptual accounting frameworks, what an asset is is very important to readers of financial statements. For example, under para. 4.3 of the International Financial Reporting Standards (IFRS) Conceptual Framework, an asset is "... a present economic resource controlled by the entity due to past events". And para 4.3 goes onto defining an economic resource as "... a right that has the potential to produce economic benefits". So back to insurance paid in advance. We treat the part that has yet to be "consumed" as an asset in the accounts of an entity. Because the entity is still entitled to receive those economic benefits, insurance cover has arisen because it has been paid for already - this is a current asset in the entity's accounts. We go into balance day adjustments in much greater detail in our accounting tutorial series here. Cash Accounting and Balance Day Adjustments A quick note about our comment regarding cash-based accounting systems: no adjustments are required for payments in advance under a cash system. All it is concerned with is when cash changes hands, unlike the accrual system, which looks at changes in economic benefits. So a cash system records when insurance is paid in advance but does not concern itself with any balance day adjustments for the prepaid component. Have a look at the example below, and this will become clearer. Example Journal Entry for Insurance Premium Paid in Advance Initial Insurance Payment So now it's time for the debits and credits. Let us assume on January 25, ABC Ltd pays for its annual building and contents insurance. This costs them $6,500 this year. The journal entry we would make is: DateAccount NameDebitCreditJan 25Insurance Expense$6,500Bank$6,500 The debit of $6,500 increases the insurance expense account, while the credit to the bank reflects the cash payment made by ABC to their insurance provider. We would make this entry under either a cash or accrual system, reflecting both cash and economic benefits movements. Balance Day Adjustment ABC's end of financial year is March 31. As part of their accounts preparation, they process balance day adjustments; in our case, they will process a journal entry for the prepaid insurance premium that ABC paid in January. Their accounts team would prepare the following calculation and journal entry. The amount of cover left for the next financial year: 365 days - (January 25 to March 31 = 65 days) = 300 days of insurance cover remaining (300 days / 365 days) / $6,500 = $5.342 (0 dp) DateAccount NameDebitCreditMarch 31Prepaid Insurance Asset$5,342Insurance Expense$5,342 The debit of $5,342 creates the insurance paid in advance (or prepaid) account - a current asset in ABC's balance sheet (statement of financial position). The credit of the same amount reduces the insurance in their accounts, reflecting that only $1,158 of the insurance cover has been consumed in the financial year ending March 31. Of course, the expense account will include the expense of the previous year's insurance cover. Note that this second journal entry would not be recorded under a cash-based accounting system - the simple reason being no cash changes hands. The purpose of this second entry is to reflect the economic benefits due to ABC Ltd, which a cash system doesn't concern itself with (it's about the cash!). Opening Balance Adjustment The balance day adjustment journal entry above will create the correct balances in the expense and asset accounts. However, this entry is only used to reflect adjustments at a specific point in time - in this case, ABC's balance date. All balance day adjustments are "reversed out" following balance day. This ensures the accounting system is kept clean of adjusting entries and it saves having to keep track of them between reporting periods. So on April 1, ABC's accounts team would perform the following reversal entry: DateAccount NameDebitCreditApril 1Insurance Expense$5,342Prepaid Insurance Asset$5,342 The debit entry increases the insurance expense for the new financial year, reflecting ABC's consumption of insurance cover over that period. The credit eliminates the prepaid insurance current asset that is no longer applicable. Conclusion Insurance paid in advance comes under prepayments or prepaid expenses, forming part of the group of transactions classed as balance day adjustments. The journal entry we worked through illustrates the reduction in expense but keeps the accounting equation in balance and creates a prepaid expense current asset account. Although not always required say in an exam answer. Still, in real life, we also showed a reversal entry of the adjustment - this ensures the integrity of the general ledger system. Remember, these adjustments are only required under accrual accounting systems.