Explanation of Prepaid Insurance with Example

Prepaid Expenses

Insurance is obviously an expense to a business. Thus, before we look at prepaid insurance, let’s look at a definition of prepaid expenses. Prepaid expenses are an asset, which means it is something that your business owns and have not spent yet. These are future expenses that have been paid for in advance. In accounting, it means that a business made a payment in the past accounting periods and does not actually receive the underlined goods or services until a future accounting period.

There are typically two different scenarios when you would see a prepaid expense. One would be if you get a discount. For instance, suppliers often motivate businesses to pay for purchases faster to get a discounted price. So, a lot of time, companies will take advantage of that.

Another time that you will a prepaid expense is when your business pays for a service or goods in advance. There are numerous examples of this and most businesses will have at least some kind of prepaid expense, whether it is rent paid upfront, utilities, or, in our case, insurance.

Example

Your company owns three trucks that you use to carry lawn mowing equipment. In order to be able to drive these vehicles, you need to have insurance. As a rule, insurance needs to be paid upfront. Thus, you choose an insurance company of your preference and pay $1,500 in insurance for each car for the whole year. To enter this in your bookkeeping records you will simply multiply $1,500 by three to get a total amount of $4,500.

To post this transaction according to the accrual basis of accounting. Since you did not yet use the insurance you paid for, it is a future expense that you paid for in advance. Thus, you are dealing with a prepaid expense, which is an asset account. Accordingly, to increase this account (you have more prepaid insurance expenses now), you would credit the Prepaid Insurance Expense account. Since you already paid for this expense, your Cash balance has also decreased by $4,500.

Every month, you will use a portion of that insurance payment you made at the beginning of the year. Accordingly, this prepaid insurance expense that is recorded as an asset in your accounting books will be transferred to an expense account. To do this, your will need to make adjusting entries every single month. The amount you will need to adjust the Prepaid Insurance account for every single month will equal $1,500 / 12 months x 3 vehicles or $375.the adjusting entry in your books will look as follows:

You will make these adjusting entries every month until your Prepaid Insurance Expense will have a zero balance.