Prepayments or prepaid expenses are one of the four main balance day adjustments that an accounting student needs to learn in their progress through any accounting syllabus. The other adjustments being revenue received in advance (unearned revenue), accrued revenue (unbilled revenue) and accrued expenses. However, today’s article focuses on prepayments and, in particular, two often asked questions; what type of account and what is the normal balance of prepaid insurance?
If you are here for the quick answer to the two questions, then prepaid insurance is a current asset account and therefore, its normal or natural account balance is a debit. If you would like a fuller explanation, please read on.
Prepaid Expenses Defined
Also known as prepayments, prepaid expenses are payments for operating expenditure paid now for goods or services yet to be received by the reporting entity. 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. Remember, if the business is operating a purely cash-based system, these adjustments are not required.
Balance and Account Type for Prepaid Insurance
The classification of prepayments as an asset comes down to how the conceptual accounting frameworks define an asset. I like to refer to the definition set out in the International Financial Reporting Standards, which represents an asset as:
“… a present economic resource controlled by the entity as a result of past events”. (para 4.3)
And an economic resource is:
“… a right that has the potential to produce economic benefits”. (para 4.4)
So let’s take these definitions and look at why we classify prepaid insurance as an asset.
Potential Economic Benefits
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.
Control
In accounting, control of something is more important in defining an asset than ownership – the reason being those economic benefits again. From a reporting on how an entity uses resources, such as money, it is much more important to focus on the money an entity controls for its benefit than what it owns in a legal sense.
And it’s essential to remember control may not be in the form of an obvious economic benefit to the reporting entity (although most often it is). Still, it can also take the form of denying or controlling others access to those economic benefits.
Past Events
The result of a past event is required for an asset because:
- it enables the amount to be known;
- the timing of the event is established, and;
- and there is certainty of economic measurement.
Otherwise, one ends up with a contingent asset, which, although it may need to be disclosed by a reporting entity it will not be recognised in the financial statements. See our article on contingent assets if you would like to read more in this area.
Prepaid Insurance Example Journal Entries
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.
Prepayment of Insurance
ABC Ltd pays for its building and contents insurance each year on January 1 for the whole of the calendar year. ABC has a balance date of March 31. The journal entries to bring to account these transactions are as follows.
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| Jan 1 | Insurance Expense | $10,000 | |
| | Bank | | $10,000 |
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.
Prepaid Insurance Balance Day Adjustment
Now comes the end of the financial year, March 31, and the ABC accounting team have to prepare the annual set of accounts. As part of the accounts preparation, all required balance day adjustments must be made. And for us, this involves prepaid insurance. The first step to working out is how much of the payment has yet to be consumed. In other words, how much of the payment of $10,000 is still an asset for ABC due to the economic benefits having not yet been received. The simple calculation for this is:
- January 1 to March 31 = 3 months;
- Total payment on January 1 was for 12 months;
- Therefore there are still 9 months worth of economic benefits to ABC (this is our prepaid asset balance).
9 months / 12 months x $10,000 = $7,500 prepaid insurance
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| March 31 | Prepaid Insurance | $7,500 | |
| | Insurance Expense | | $7,500 |
This second journal entry creates the prepaid insurance asset with a debit of $7,500. 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.
Opening Balance Adjustment
For completeness, we should discuss the reversal of the balance day adjustments in the new financial year. These adjustments are not carried on through the new financial year because their purpose is to provide accrual adjustments purely for the balance date. So on April 1, the accounting team would prepare the following entry (although accounting systems nowadays do tend to automate this process):
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| April 1 | Insurance Expense | $7,500 | |
| | Prepaid Insurance | | $7,500 |
This reversal entry creates an insurance expense for the new financial year with the debit. Although ABC Ltd paid the cash in the last financial year, what the accrual system is doing reflects the flow of economic benefits. So in the new financial year, that benefit is worth $7,500 to ABC Ltd, and the credit entry removes the prepaid insurance current asset. This account is no longer required as we are expensing the economic benefits for the rest of the year.
Quarterly Reporting Adjustments
If ABC produced quarterly management reports, this type of balance day adjustment process would be required for each quarter. Let’s look quickly at the end of the first quarter of their current year – the three months ending June 30.
We would run through the same calculation and journal process:
9 months (of prepaid insurance to start with) – 3 months (expensed in the current quarter) = 6 months (of prepaid insurance left)
And for the dollar amount, we would perform the next calculation:
6 months / 12 months x $10,000 = $5,000
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| June 30 | Prepaid Insurance | $5,000 | |
| | Insurance Expense | | $5,000 |
As before, the debit to prepaid insurance creates a current asset – in this case, now one only worth $5,000. This is because, as of June 30, ABC Ltd has consumed six months worth of the insurance it prepaid on January 1. And the credit of $5,000 to the insurance expense account reduces the insurance expense line in the profit and loss statement down to $2,500 ($7,500 – $5,000). Remember, these accrual financial statements reflect the flow of economic resources (benefits and obligations), not the movement of money.
And finally, the accounts team on July 1 would perform a reversal process of all balance day adjustments made in the June 30 quarterly accounts. As before, the debit and credit would be:
| Date | Account Name | Debit | Credit |
|---|---|---|---|
| July 1 | Insurance Expense | $5,000 | |
| | Prepaid Insurance | | $5,000 |
Conclusion
We trust this article has helped in your understanding of prepayments. In particular, the type of account and normal balance of prepaid insurance is a current asset and a debit balance, respectively.
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