The expenses of an organization are recognized as a decrease in economic benefits as a result of the disposal of assets (cash, other property) and (or) the occurrence of liabilities, leading to a decrease in the capital of this organization.
Prepaid expenses are expenses that we have taken into account in the current period, but we plan to receive the benefit in this regard in the future. In other words, you spent money today in order to get goods, services, or other benefits tomorrow. There are numerous examples of cases when companies and individuals pay for expenses they are sure they will incur in the future ahead of time.
Prepaid insurance is something that not only businesses face on regular basis, but also everyone who has an automobile, a house, or anything else they would like to have covered. As with any expense paid in advance, in the periods of actual receipt of these insurance services, the company will recognize the actual expense and reduce the prepaid insurance account by an appropriate amount. If the insurance policy is annual, then we write off prepaid expenses evenly on a monthly (quarterly) basis.
When you are ready to prepare financial statements, which is typically done at the end of the accounting period, you need to make sure that all accounts have the correct balance. This also concerns the Prepaid insurance account. Check if the portion of the service you have used so far is written off. If you find that it has already been 9 months since you prepaid the insurance policy and you have accounted only for 6 months under your Insurance Expense, you need to make an adjusting prepaid insurance journal entry. This will bring down the balance of the Prepaid Insurance account and increase your Insurance Expense.
Your business paid business liability insurance on June 1st, 2020. The insurance payment was $1,392 for the whole year. On June 1st, 2020, you will make the following journal entry to reflect this advance payment for insurance.
At the end of June, your bookkeeper will need to make an adjusting journal entry to reflect that now you only have 11 months of Prepaid Insurance. The monthly Insurance Expense is equal to $1,392 / 12 months or $116. Your business has now actually incurred the Insurance Expense, so you can record that. Since you already paid for it, there will be no reduction in your cash on the Bank account or increase in Insurance Payable liability. Instead, you will reduce the Prepaid Insurance account.
Now, let’s assume it is the end of the year, and you need to prepare all the financial reports. You know that before you do that, you need to make sure that all the account balances are correct. When you check the Prepaid Insurance account, the balance on the account is $928. Six months have passed since you have paid for the business liability insurance on June 1st.
We know that the monthly Insurance Expense is $116 or $696. If we subtract this amount from the initial payment for the whole year, we should get a $696 balance on the Prepaid Insurance account. It turns out that you have forgotten to make adjusting entries for the past two months. Let’s do one Prepaid Insurance journal entry to account for that.
As you can see the remaining balance on the Prepaid Insurance account is $696 (debit) because we first reduced it by $116 for four months ($116×4=$464) and then recorded the last credit entry, further reducing it by $232 for a total of $696. As of December 31st, 2020, your business still has 6 months of business liability insurance that it can use the next year without having to pay anything.
Author: Charles Lutwidge