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Which of the following entries records the payment of insurance for the current month?
A. Cash, debit; Insurance Expense, credit
B. Prepaid Insurance, debit; Cash, credit
C. Insurance Expense, debit; Cash, credit
D. Insurance Expense, debit; Accounts Receivable, credit
The Correct Answer is B. Prepaid Insurance, debit; Cash, credit
Prepaid insurance is an insurance that is paid in advance and has not yet expired on the date of the balance sheet. Prepaid insurance is usually charged to expense on a straight-line basis over the term of the related insurance contract. Insurance premiums are amounts that an organization pays on behalf of its employees and other policies it has taken out. In general, insurance premiums are paid on a monthly or quarterly basis. Expenses that are unexpired and prepaid are recorded under current assets in the books of accounts. On the profit and loss statement, the expense for that period is shown. When the asset is charged to expense, the journal entry is to debit the insurance expense account and credit the prepaid insurance account.
A company usually buys insurance to protect itself against unforeseen events such as fires or thefts. The company is required to pay an insurance fee for one year or more in advance. In this case, it needs to account for prepaid insurance using proper journal entries to avoid errors that could cause misstatements on both the balance sheet and income statement. As prepaid insurance is paid in advance, the balance sheet and income statement reflect zero. In the end, after adjusting entry for the insurance expense, the asset account decreases and the expense account increases. A proper adjusting entry is also needed to recognize the expiring costs at the end of a period.
Prepaid insurance is an accounting method used to ensure that funds are available to pay for future insurance premiums. By prepaying for insurance, businesses can deduct the cost of the premium in the current year, while still having the coverage in place when it is needed.
This method of paying for insurance can be helpful for businesses that have large and/or unpredictable expenses from one year to the next. It can also be used to smooth out cash flow by front-loading expenses into a year when money is available, instead of waiting until the premium is due and paying it all at once.However, there are some drawbacks to prepaid insurance. First, it can tie up a lot of cash that could be used for other purposes.
Journal Entry for Prepaid Insurance
Insurance is typically a prepaid expense, with the full premium paid in advance for a policy that covers the next 12 months of coverage. This is often the case for health, life, hazard, automotive, liability and other forms of coverage required by a business. A prepaid insurance contract is recorded initially as an asset. Adjusting journal entries are then needed each month so that (1) the current month’s expense is recorded on each month’s income statement; and (2) the unexpired amount of the prepaid insurance is reduced each month in the asset account.
The company can create a prepaid insurance journal entry by debiting the prepaid insurance account and crediting the cash account when it makes an advance payment for insurance. Both prepaid insurance and cash are balance sheet items. Thus, the prepaid insurance journal entry does not affect the total assets since it increases one asset account and decreases another asset account by the same amount.