A common financial question we see asked is related to prepaid insurance. Specifically, is prepaid insurance an asset? But maybe that’s getting ahead of ourselves a bit. Let’s start with the basics before addressing that question. Prepaid insurance is exactly what it sounds like – insurance that’s been prepaid. Individuals generally don’t need to worry too much about it. Just pay the bill when it arrives, then rest easy knowing that you’re protected.
It’s only insurance companies, with the need to have pristine financial statements, that need to make sure every dollar is accounted for. For these businesses, any unused insurance that’s been received but haven’t expired count as an asset. Let me give you an example to explain this in more detail.
Prepaid Insurance, Explained
Let’s say a delivery company takes out some commercial auto insurance for its fleet of cars. It costs them $24,000 every six months. In month one, the delivery company pays out the full amount. However, it not until month six that the company has used all of the $24,000 worth of insurance.
When the full amount is received by the insurer, accounting will treat the payment as an asset. By the second month, $8,000 is used. An entry will then be created on the books to move this amount from current assets to the expense side. The leftover ($16,000 in this case) will be counted as prepaid insurance for the insurer. Naturally, the leftover will still be counted as an asset on the balance sheet, with the understanding that the full amount will be used up by the end of the six-month term.
Doesn’t This Apply to Individuals Too?
Technically, we can argue that prepaid insurance counts as an asset for individuals too. For example, I prepay my home insurance once a year. I also prepay my auto insurance every six months. I get a slight discount from my insurance company doing it this way, as opposed to paying monthly. Technically, I could claim the unused portion when I calculate my net worth. However, I don’t bother. It’s just not enough money to justify the effort.
I do keep track of my net worth so I have a rough indication of how much wealth I’ve accumulated over the years. Counting an asset that amounts to less than a week or two of my salary (and continues to drop) won’t make a difference in the grand scheme of things. It’s the same reason why I don’t count the cents when I add up my savings and investment portfolio. There’s really no need to be that accurate.
Why Companies Count Prepaid Insurance
We talked about how insurance companies treat prepaid insurance and how individuals can most likely ignore it altogether. But what about the companies who are make use of the insurance? In our example, does the delivery company need to worry about factoring prepaid insurance on its books? The answer, like most things financial, is “it depends.”
Most businesses won’t have to worry about the accounting side of prepaid insurance. That’s because the vast majority of businesses in the United States use the “cash basis” accounting method. This simply means that the company records revenue as the money is received and expenses as it pays them. My small business runs on the cash basis accounting method. If I pay for insurance, for example, I simply log the expense as any other bill when I pay it. There’s no need for me to keep it on the balance sheet and then “use it up” over the period of the insurance contract.
Things change if a business is using the “accrual basis” accounting method. These companies, usually larger corporations, will need to count prepaid expenses (like insurance) as an asset until it’s used up. If the delivery company in our example is using the accrual basis accounting method, then it’ll treat the prepaid insurance that hasn’t been used as an asset on its balance sheet until that amount is used up. When the numbers get high enough, you can understand why this matters. A company spending six or seven figures a year on insurance costs will want to count that cash as an asset until it’s actually used. In theory, they could cancel the insurance early and receive a huge cash refund.
Why Can’t Insurers Use the Cash Basis Accounting Method?
You may be wondering why we singled out insurance companies as not having the option to treat the prepaid insurance as revenue right away and move on. That’s because the IRS requires larger corporations to use the accrual basis accounting method. While the qualifications are out of the scope of this article, it’s safe to say that no insurer will ever qualify to use the cash basis accounting method. So prepaid insurance is not an asset for insurance companies.
The Bottom Line
Prepaid insurance (and how it’s accounted for in the balance sheet) isn’t something the majority of us need to worry about. However if you are using the accrual basis accounting method at your company, then prepaid insurance might come into play. Still, it’s relatively simple to implement. Simply add it as a current asset as long as it’ll be used up within the year. Then subtract the appropriate portion off every accounting period — likely monthly, but possibly quarterly or annual. That’s it! It’s actually quite easy.