In this article, part of our accounting tutorial series, we review the journal entry required when an insurance premium is paid in advance. We have a quick look at what a prepayment is, why cash based accounting system don’t worry about the balance day adjustments required, where as accrual systems do. We even have quick look at conceptual frameworks – which might be a first for some of you.
If you don’t have time for all of the background, the quick answer is the expense of the insurance paid in advance needs to be reduced with a credit, matched by a corresponding debit to a prepaid expense account. For more details … please read on.
What Are Expenses Paid in Advance?
Insurance or any other expense paid in advance is often referred to as a prepayment or prepaid expenses. Although these payments are expensed when made (a debit is applied to an expense account), if you are using an accrual accounting system, as opposed to a cash basis system, they are subject to balance day adjustments when required.
A balance day adjustment is required when an entity has paid for goods and services, like insurance, in advance but at a specific balance date they have yet consumed the economic benefits of that payment. This is fancy accounting speak for saying when you have paid for something you have yet used, this might be an asset rather than an expense at balance date.
Why an asset? Because under our accounting conceptual 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, they define an asset as “… a present economic resource controlled by the entity as a result of past events”. And in para 4.3 goes onto define 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, that is insurance cover, and this 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.
A quick note about our comment above regarding cash based accounting systems. No adjustments are required for payments in advance under a cash system because all it is concerned with is when cash changes hands. Unlike the accrual system that 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
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:
|Jan 25||Insurance Expense||$6,500|||
The debit of $6,500 increases the insurance expense account, while the credit to bank reflects the cash payment made by ABC to their insurance provider. This entry would be made under either a cash or accrual system as it reflects both movement in cash and economic benefits.
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 was 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)
|March 31||Prepaid Insurance Asset||$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 under a cash based accounting system this second journal entry would not be recorded – 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!).
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:
|April 1||Insurance Expense||$5,342|||
|||Prepaid 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 of time. The credit eliminates the prepaid insurance current asset that is no longer applicable.
Insurance paid in advance comes under what we call 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 keeping the accounting equation in balance, creates a prepaid expense current asset account. Although not always required say in an exam answer, but certainly in real life, a reversal entry of the adjustment was also shown – this ensures the integrity of the general ledger system. Remember, these adjustments are only required under accrual accounting systems.