Prepaid insurance is a common example of prepaid expenses. What is a prepaid expense? A prepaid expense is the payment of an expense that the benefit will expand over more than one accounting period. Although we call it “expense”, accrual accounting treats a prepaid expense initially as an asset.
This post is part of the “how to debit and credit” tutorials that describe how to record accounting transactions. In the basic accounting tutorials, we use the transactions of Frontier Advertising Company (FAC). For simplicity, we assume that FAC uses accounting period of one month. Three levels of transaction analysis will be adopted (that is, the basic analysis, analysis using accounting equation, and debit-credit analysis). According to those analyses, you will easily understand how transactions are recorded in the general journal.
Index of how to debit and credit tutorial
- Investment by owner
- Purchase of equipment
- Unearned revenue
- Payment of rent expenses
- Insurance as prepayment
What is a prepaid expense?
A prepaid expense arises when a company pays cash advance to cover some expenses that the benefit will expand over more than one accounting period. Although it is called an “expense”, accrual-based accounting should record a prepaid expense or prepayment initially as an asset. At the end of the period, prepaid expense accounts usually require adjustments to reflect the “consumed” or “used-up” portion as expenses in the current period.
The most common examples of prepaid expenses are insurance expense, rent expense, and supplies expense.
How to debit and credit payment of prepaid insurance?
On January 4, FAC pays $600 for insurance policy. The insurance policy covers one-year period that means it will expire on December 31. How to debit and credit this transaction?
Basic transaction analysis
The asset in the form of prepaid insurance of $600 arises. The other asset, cash, decrease $600. The payment is recognized as an asset since it extends to more than the current accounting period (the month of January).
Accounting equation analysis
Accounting equation can be used to show the economic effects of an accounting transaction. It states that the total value of a company's assets must always equal the combined value of its liabilities and its owners' equity.
In this illustration, the effects of the cash payment and the increase in prepaid insurance can be shown in terms of the accounting equation as follows:
The amount in parentheses means it has a subtracting effect or minus sign.
According to the debit-credit rule, the increase in assets is debited. Since the payment is related to more than the accounting period of one month, we treat the payment as having future benefit. From the accounting point of view, the Prepaid Insurance account is debited $600.
According to the debit-credit rule, the decrease in assets is credited. The payment in cash means that the cash paid is no longer held by the company. Technically, the Cash account is credited $600.
In a manual accounting system, the journal entry is recorded in a general journal book. The general journal is made of pages with several columns for date, account title, account code, reference, and debit and credit amounts. Periodically, a batch of debit and credit amounts in the general journal are posted to the relevant accounts in the general ledger.