Certain expenses, such as taxes and insurance, are paid in lump sums during one particular accounting period. The benefits from these payments extend past the single accounting period, so it is not accurate to charge the full payment to an expense account at that time. These types of payments are handled using a prepaid expense account.
TL;DR (Too Long; Didn't Read)
Prepaid insurance represents coverage you've bought in advance. It's considered an asset to the business and is listed as a current asset on the left side of the balance sheet
What Is Prepaid Insurance?
Whenever your business buys insurance, you will pay the premium in advance for a specific coverage period. For example, you might pay an entire year's worth of premium on Jan. 1, for the whole of 2019, or you might pay an insurance premium for the six-month period of Jan. 1 through June 30. As you move through the year and consume the insurance, your prepayment gets used up. The term "prepaid" means the portion of the insurance premium that has not been used up as at the date of the balance sheet.
Prepaid Insurance and the Asset Account
Prepaid insurance is considered a business asset, and is listed as an asset account on the left side of the balance sheet. The payment of the insurance expense is similar to money in the bank, and the money will be withdrawn from the account as the insurance is "used up" each month or each accounting period. Prepaid insurance is usually considered a current asset, as it will be converted to cash or used within a fairly short time. Other prepayments, like prepaid rent, work the same way.
Entering Expense Payments
If your business insurance premium is due in February, and your accounting period is the same as the calendar year, with monthly closeouts of your financial statements, you will need to need to account for the premium payment when you write the check. If the premium were $1,200 per year, for instance, you would record the check for $1,200 as a credit to the cash account in your journal, decreasing the value of that account. Then you would enter a debit of $1,200 to the prepaid insurance asset account, increasing its value.
Accounting for Use of Prepaid Expenses
Each month, you will need to move the used portion of the insurance payment to an expense account. At the end of the month, before the books are closed for the month, make one double entry to the journal. If the premium were $1,200 per year, you would enter a credit of $100 to the prepaid insurance asset account, decreasing its value. Then you would enter a debit to the insurance expense account, increasing the value of the expenses. This reflects the depletion of the asset by the amount of one month's insurance, and it correctly enters the expense on the income statement.
Other Accrued and Deferred Expenses
Insurance is not the only expense that must be accounted for over multiple reporting periods. Any salaries earned in one month but paid in the next month must be accounted for in a similar manner so that the expense is accounted for in the month that the pay was earned. Property taxes are often paid every six months, and require the same treatment. A business may collect a prepayment for sales on product that has not been delivered, and these sales must be entered as deferred revenue.
Craig Woodman began writing professionally in 2007. Woodman's articles have been published in "Professional Distributor" magazine and in various online publications. He has written extensively on automotive issues, business, personal finance and recreational vehicles. Woodman is pursuing a Bachelor of Science in finance through online education.