Prepaid Insurance

Prepaid insurance is the amount a business has paid for insurance coverage that relates to future periods. Insurance policies, such as property, liability, vehicle and business interruption cover, are usually paid for in advance, often for six or twelve months at a time. At the date of payment, the business has bought a future benefit, the right to be covered, so the cost is recorded as an asset rather than an expense. As each month of coverage passes, part of the asset is used up and transferred to insurance expense.

Prepaid insurance is one of the most common types of prepaid expenses, also called deferred expenses. It is reported as a current asset on the balance sheet when the remaining coverage will be used within a year, which is usually the case. Recording it this way follows accrual basis accounting, which recognizes expenses in the periods that benefit from them.

There are two common approaches, which give the same result after adjustment:

• Asset method: the payment is debited to prepaid insurance. At each period end, an adjusting entry debits insurance expense and credits prepaid insurance for the coverage used.
• Expense method: the payment is debited to insurance expense. At period end, an adjusting entry moves the unexpired portion back to prepaid insurance.

Both are deferral-type adjusting entries, part of the routine month-end and year-end adjusting entries.

On 1 October, a retailer pays $18,000 for a twelve-month property and liability policy. Using the asset method, it debits prepaid insurance $18,000 and credits cash $18,000. The monthly expense is:

Here $\text{Total premium}$ is the amount paid for the policy and $\text{Months of coverage}$ is the policy term. The monthly expense is $18,000 divided by 12, or $1,500. At the 31 December year end, three months have passed, so the retailer debits insurance expense $4,500 and credits prepaid insurance $4,500. The balance sheet shows prepaid insurance of $13,500, the cost of the nine months of coverage remaining, and the income statement shows insurance expense of $4,500.

If the retailer had instead debited insurance expense $18,000 on 1 October and made no adjustment, its expenses for the year would have been overstated by $13,500 and its profit and assets understated by the same amount.

• Multi-year policies: if a three-year policy is paid upfront, the portion relating to coverage more than twelve months away is shown as a noncurrent asset.
• Cancellation: if a policy is cancelled early, any refund due from the insurer replaces part of the prepaid balance, and any non-refundable amount is expensed.
• Premium financing: some businesses spread the cost through insurance premium finance, borrowing to pay the premium; the prepaid asset is still recorded, along with a loan liability and interest expense.
• Production insurance: for manufacturers, insurance on factory buildings and equipment is part of manufacturing overhead and flows into inventory rather than directly into expense.

For US tax purposes, businesses using the accrual or cash method can often deduct prepaid insurance in the year paid if the coverage does not extend beyond the earlier of twelve months after the benefit begins or the end of the following tax year, under the 12-month rule; otherwise the cost is deducted over the coverage period, creating book-tax differences. Common accounting mistakes include forgetting the monthly adjustment, which leaves the asset overstated, expensing an annual premium entirely in the month paid, and continuing to amortize a policy that has been cancelled or replaced.