How Does Insurance Accrual Work in Accounting?

Insurance accrual is an accounting process for handling the cost of insurance coverage. The method ensures that the expense of a policy is recognized gradually over its coverage period, not as a single lump sum when the premium is paid. This process adheres to the matching principle, which dictates that expenses should be recorded in the same accounting period as the revenues they help generate. By spreading the insurance cost, a business accurately reflects its profitability for each specific period.

The Concept of Prepaid Insurance

When a business pays for an insurance policy in advance, the payment is not immediately recorded as an expense. Instead, the transaction is captured on the balance sheet as an asset in an account titled “Prepaid Insurance.” This is classified as a current asset because the benefit, the insurance coverage, represents a future economic benefit to the company and is expected to be used within one year.

To record the initial payment, a journal entry is made in the company’s general ledger. The entry involves a debit to the Prepaid Insurance account, which increases its balance, and a credit to the Cash account, which decreases its balance. For example, if a company pays $12,000 for a one-year policy, the entry would be a $12,000 debit to Prepaid Insurance and a $12,000 credit to Cash.

Calculating the Periodic Insurance Expense

After recording the payment as a prepaid asset, the next step is to determine how much of that asset is expensed during each accounting period. The formula for the periodic expense is the total cost of the insurance premium divided by the number of coverage periods in the policy term. The period is most commonly a month, as businesses prepare financial statements monthly.

To illustrate, consider a business that pays a $2,400 premium for a 12-month general liability policy. The monthly insurance expense is calculated by dividing the total premium by the policy term ($2,400 / 12 months). This results in a monthly expense of $200, which is the amount used in the adjusting entry at the end of each month the policy is active.

The Accrual Adjusting Entry

At the end of each accounting period, an adjusting journal entry is required to recognize the portion of the insurance premium that has been used. This non-cash transaction moves a portion of the prepaid insurance asset’s value to an expense account. The entry consists of a debit to an account called “Insurance Expense” and a credit to the “Prepaid Insurance” asset account, which transfers the cost from the balance sheet to the income statement.

Using the previous example with a $200 monthly expense, the adjusting entry at the end of the first month would be a debit to Insurance Expense for $200 and a credit to Prepaid Insurance for $200. This action records the $200 of insurance coverage consumed during the month as an operating expense. The same entry is posted at the end of each subsequent month for the duration of the policy’s 12-month term.

Reporting on Financial Statements

The process of recording insurance accruals impacts how costs are presented on the balance sheet and income statement. On the balance sheet, the “Prepaid Insurance” account is reported within the current assets section. Following the initial payment of a $2,400 premium, this account would show a balance of $2,400. After the first monthly adjusting entry of $200 is posted, the balance in Prepaid Insurance decreases to $2,200, reflecting the remaining value of the coverage.

The income statement reflects the recognized expense for the period. The “Insurance Expense” account appears in the operating expenses section. After the first month, the Insurance Expense for that period would be $200. Unlike the balance sheet account, the income statement account is cumulative for the fiscal year. Therefore, after the second month, the year-to-date Insurance Expense reported on the income statement would be $400, and after three months, it would be $600.