However, prepaid insurance is usually classified as a current asset since the benefit is used quickly. Contrast this with a long-term asset, which may not be used until one year or further in the future. When the insurance premium payment is ordinarily due, that expense is deducted from the asset side and moved to the expense side. However, that $1.4 billion is used to reduce the balance of gross accounts receivable.
- Contra accounts are used to reduce the value of the original account directly to keep financial accounting records clean.
- In other words, the amount allocated to expense is not indicative of the economic value being consumed.
- To adjust this, the accountant will need to debit the refund amount to the prepaid insurance account by crediting the insurance expense.
- We then divide the $2,000 over the 24 months of the subscription term to arrive at a monthly subscription cost of $83.33, to be recognized on the income statement each month the subscription is utilized.
- As prepaid insurance is an asset that will expire through the passage of time, the cost of expiration will need to be recognized as an expense during the period.
- Understanding how to properly account for prepaid expenses is critical for accurate financial reporting, ensuring that revenues and expenses are reported in the correct periods in accordance with GAAP.
- As the company pays for them, they are reported as expense items on the income statement.
How are Contra Accounts Used and Reported?
As the company pays for them, they are reported as expense items on the income statement. A business buys one year of general liability insurance in advance, for $12,000. The initial entry is a debit of $12,000 to the prepaid insurance (asset) account, and a credit of $12,000 to the cash (asset) account. In each successive month for the next twelve months, there should be a journal entry that debits the insurance expense account and credits the prepaid expenses (asset) account. From a financial accounting perspective, prepaid insurance is considered a prepayment.
What Is the 12-Month Rule for Prepaid Expenses?
This reduces the prepaid expense balance but increases the expense balance. Likewise, the journal entry for the insurance expense that is converted from the expiration cost of prepaid insurance is the debit of the insurance expense account and the credit of the prepaid insurance account. Likewise, the company can make insurance expense journal entry by debiting insurance expense account and crediting prepaid insurance account. Assume that on December 1, a newly formed company pays $600 for insurance coverage for the six months ending on June 1. As of December 31, the company will report Insurance Expense of $100 and its current asset Prepaid Insurance will report $500. The prepaid amount informs the readers of the December 31 balance sheet that the company will not have to pay $500 in cash for insurance during the next five months.
What’s the difference between prepaid insurance and an insurance expense?
Contra accounts are used to reduce the value of the original account directly to keep financial accounting records clean. A current asset representing the cost of supplies on hand at a point in time. The account is usually listed on the balance sheet after the Inventory account. The process of reducing the prepaid expense balance and increasing the expense contra expense account balance over time is called amortization of prepaid expenses or prepaid expense recognition. Amortization means the allocation of the cost of an asset over its useful life. As the prepaid insurance expires throughout the passage of time, the company needs to transfer the prepaid insurance that has expired in the period to the insurance expense.
By keeping the original dollar amount intact in the original account and reducing the figure in a separate account, the financial information is more transparent for financial reporting purposes. For example, if a piece of heavy machinery is purchased for $10,000, that $10,000 figure is maintained on the general ledger even as the asset’s depreciation is recorded separately. You may want to set up an amortization table to track the decrease in the account over the policy term and to determine what the journal entries will be. Would you rather pay $200 each month for one year or prepay $1,500 for the entire year and save $900? The software that’s sold with this type of arrangement is often referred to as SaaS, or “Software as a Service,” because of its similarity to service contracts. A visual aid used by accountants to illustrate a journal entry’s effect on the general ledger accounts.
- The balance in the asset Supplies at the end of the accounting year will carry over to the next accounting year.
- For example, on September 01, 2020, the company ABC Ltd. pays $1,200 for one year of fire insurance which covers from September 01, 2020.
- This means that the preliminary balance is too high by $375 ($1,100 minus $725).
- Equipment will be depreciated over its useful life by debiting the income statement account Depreciation Expense and crediting the balance sheet account Accumulated Depreciation (a contra asset account).
It is assumed that the decrease in the amount prepaid was the amount being used or expiring during the current accounting period. The balance in Insurance Expense starts with a zero balance each year and increases during the year as the account is debited. The balance at the end of the accounting year in the asset Prepaid Insurance will carry over to the next accounting year. Prepaid expense is an accounting line item on a company’s balance sheet that refers to goods and services that have been paid for but not yet incurred. Recording prepaid expenses must be done correctly and according to accounting standards. They are first recorded as an asset and then, over time, expensed onto the income statement.
- Contra equity reduces the total number of outstanding shares on the balance sheet.
- A visual aid used by accountants to illustrate a journal entry’s effect on the general ledger accounts.
- As the prepaid insurance expires throughout the passage of time, the company needs to transfer the prepaid insurance that has expired in the period to the insurance expense.
- Those who are struggling with recording contra accounts may benefit from utilizing some of the best accounting software currently available.
- When a company pays its insurance payments in advance, it makes a debit entry to its prepaid insurance asset account.
- A less common example of a contra asset account is Discount on Notes Receivable.