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 others being revenue received in advance (unearned revenue), accrued revenue (unbilled revenue) and accrued expenses. However, today’s article is focusing 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 that is being paid now (the cash is being paid over) for goods or services yet to be received by the reporting entity. In our case we will be looking at prepaid insurance, a quite common 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 then these types of adjustments are not required.
Balance and Account Type for Prepaid Insurance
The classification of prepayments as an asset comes down to how the accounting conceptual frameworks define an asset. I like to refer to the definition set out in the International Financial Reporting Standards, where an assets is defined 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 have a look at why prepaid insurance is classified as an asset.
Potential Economic Benefits
For prepaid insurance this would relate to the insurance cover the reporting entity has in place. Insurance, ie another party taking on a risk you don’t want to cover yourself, is an economic benefit – whether a claim is made or not.
In accounting control of something is more important in defining an asset compared to ownership – the reason being those economic benefits again. From a reporting on how an entity is using resources, such as money, it is much more important to focus on the money an entity controls for its own benefit rather than what it owns in a legal sense.
And it’s important to remember control may not be in the form of an obvious economic benefit to the reporting entity (although most often it is), but can also take the form of being able to deny or control others access to those economic benefits.
The result of a past event is required for an asset because it enables the amount to be known, the timing of the event to be established and reliability in the economic measurement of the event to be certain. Otherwise one ends up with a contingent asset, which although 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 theory behind prepayments, in particular 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.
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.
|Jan 1||Insurance Expense||$10,000|||
The first journal reflects the increase in expenses (debit) due to the annual insurance being paid. 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 the insurance has been paid for.
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 the prepaid insurance. The first step to work 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
|March 31||Prepaid Insurance||$7,500|||
This second journal entry creates the prepaid insurance asset with a debit of $7,500. This amount will be disclosed under current assets in the balance sheet (statement of financial position). While 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.
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 balance date. So on April 1 the accounting team would prepare the following entry (although accounting systems now days do tend to automate this process):
|April 1||Insurance Expense||$7,500|||
This reversal entry creates an insurance expense for the new financial year with the debit. Yes, although the cash was paid in the last financial year what the accrual system is doing is reflecting 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.
Now if ABC say did 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
|June 30||Prepaid Insurance||$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 at June 30 ABC Ltd has consumed 6 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 are trying to 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 system for the June 30 quarterly accounts. As before, the debit and credit would be:
|July 1||Insurance Expense||$5,000|||
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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