Is prepaid insurance an asset?
Is prepaid insurance an asset? Due to the various risks associated with owning valuable items such as buildings, vehicles, machinery, artworks, etc. individuals and companies alike subscribe to various kinds of insurance to mitigate the risk of loss or damage to these valuable items.
Prepaid insurance is usually paid to cover a particular time.It is usually a monthly payment although most individuals and corporate organizations prefer making a lump payment to cover for a quarter or a year. Asides from the payment of insurance to cover valuable items, a lot of Americans also subscribe to various health and life insurance packages. Payments for home insurance have also been common among American homeowners.
When companies make an insurance payment in advance, they have to record this transaction in order to keep track of their finances and how money goes out of the company. These transaction records known as journal entries affect the overall financial statements of companies in the long run as inaccurate records of transactions will ultimately affect the company’s statement of financial position, cash flow statement, and income statement. Here, we shall discuss both prepaid insurance and asset. This will guide us in understanding whether prepaid insurance is an asset or not.
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Understanding prepaid insurance and asset
Prepaid insurance has already become an inescapable expense for most American individuals and corporate entities but what does it even mean? This we shall discuss below. We shall also discuss what asset means.
What is prepaid insurance?
Although most insurance payments cover one month, a lot of insurance companies encourage their patrons to make a lump sum payment which will cover a period of one year or six months. These insurance companies generally offer a payment discount for patrons who choose to make this lump sum payment instead of the regular monthly payment.
For instance, an insurance company might offer a 10% or 5% discount to clients who pay for a year or six months subscription. The lump sum payment serves as a means of increasing the working capital of the insurance company and a strategy for customer retention. Furthermore, some insurance companies may charge a cancellation fee when a client chooses to cancel their subscription and discontinue using the insurance company’s services.
Companies that subscribe for insurance coverage generally make this lumpsum payment instead since it covers a longer period, lets them budget and plan ahead, cancels the need to incur monthly expenses, and also reduces the overall amount compared to the monthly option, thus saving money that would have been spent by the company on insurance. When the insurance payment is paid in advance for the insurance coverage, it is known as prepaid insurance.
Prepaid insurance is so named because the client pays for the insurance in advance before getting the insurance coverage. Insurance payments are a recurring and inescapable expense in today’s dynamic world. This is because they cushion the effect of loss that will be experienced by the individual or company that subscribed to the insurance coverage. For example, American hotel can have prepaid insurance on their building, this will cushion the loss that would otherwise be experienced by the hotel in an event of a fire accident.
Prepaid insurance is generally renewed by companies shortly before their current insurance coverage expires. The terms and conditions of most insurance coverage rarely change over the years unless a new contract is signed by both the company paying for the insurance coverage and the insurance company. The insurance fees paid per year might however change with time, this is usually a result of inflation or other factors in insurance. The insurance company will however inform their clients of any changes in the amount to be paid prior to subsequent payments. Companies that have experienced an accident on the item insured can file an insurance claim. Additionally, they may cancel their subscription and discontinue the insurance contract.
What is an asset?
When recording assets on the balance sheet, it is recorded on the left column while liabilities and equity are recorded on the right column. Advancements and the use of software in making the balance sheet have however made assets, liabilities, and equity all presented on one page with assets appearing first.
An asset can be generally classified as either a current or non-current asset. Current assets are generally considered very liquid because they can be easily converted to cash; usually in less than 12 months. Non-current assets are long-term assets such as land which generally require over one year before they can be converted to cash. Thus, they are not as easily liquid.
See also: Is accounts receivable a current asset?
Is prepaid insurance an asset?
Prepaid insurance is an asset because the prepayment reduces the amount that the company will spend monthly, this is especially true for yearly prepaid insurance payments. The amount paid as prepaid insurance is usually recorded in one account period but it gets used in a different accounting period. This is because the prepayment is made in advance. For instance, when a company makes a yearly insurance payment, the payment may occur in January 2022 but the period covered under the contract might be from February 2022 to January 2023.
Thus, the prepaid insurance payment will be recorded as an asset on the company’s balance sheet. It will specifically be recorded as a current asset since it will be used up within one year. In rare instances, companies could make a prepaid insurance payment that gives them insurance coverage for more than one year. When this happens, the insurance balance that will be used up in subsequent years is recorded as a non-current asset.
Once the period of insurance comes into effect, monthly deductions are made from the prepaid insurance to record the reduction in the amount that is still considered a current asset. The part that has been consumed gets recorded as an expense.
Benefits of prepaid insurance as an asset
- Prepaid insurance brings future economic benefits to the company by reducing its future monthly expenses. This in turn reduces the overall cost incurred by the business monthly.
- It provides coverage for the item insured, thus the loss that would have been incurred from accidental damage to the item is reduced.
- The company that made the prepayment could choose to cancel their insurance subscription and get refunded the amount paid that has not yet been used up. For instance, if a company paid for one-year prepaid insurance but canceled after 4 months, they could get refunded the remaining 8 months that have not been used up.
See also: Is accumulated depreciation a current asset?
Conclusion
Is prepaid insurance an asset? Yes, prepaid insurance is an asset because it is a payment in advance for a service that has not yet been received. It thus appears in the assets section of the company’s balance sheet. Depending on the period that the prepaid insurance covers, it could be classified as either a current or non-current asset. It is a current asset if it covers a month or one year and a non-current asset if it covers more than one year.
Companies generally make yearly prepaid insurance payments to enjoy the discounts which the insurance companies offer for such advance payments. It also allows the companies to enjoy insurance coverage for a longer period without having to source money for monthly payments every other month. It additionally reduces the probability of defaulting on monthly payments either due to a downturn in business or a lack of available cash to cover the monthly payment.
As the time covered by the prepaid insurance comes into effect, the used-up portion gets deducted from the assets account and is recorded as an expense. Companies generally renew their insurance a few days or weeks before its expiration. The terms of insurance coverage are usually the same upon renewal unless otherwise stated by the insurance company and have to be agreed on by the client before a new contract ensures.
