What Is Insurance Expense in Accounting?
Understand how insurance costs are accounted for in business, from payment to expense recognition on financial statements.
Businesses operate with various uncertainties, from potential property damage to employee health issues. To mitigate these risks, companies often acquire insurance policies. The financial impact of these policies is accounted for as an insurance expense, representing the cost of coverage used over a specific period. Understanding how this expense is treated in accounting provides clarity on a company’s financial health and operational costs, offering valuable insights into its risk management.
What Insurance Expense Is
Insurance expense represents the portion of an insurance premium that has been consumed during a particular accounting period. It is the cost a business incurs for the protection and coverage received from an insurance policy over time. While a company may pay an insurance premium upfront, the full payment is not immediately recorded as an expense.
Instead, the upfront payment for future coverage is initially recorded as a “prepaid insurance” asset on the balance sheet. This asset reflects the economic benefit of having insurance coverage available for future periods. As time passes and the insurance coverage is utilized, a portion of this prepaid asset is systematically converted into an expense. This conversion recognizes the cost of the protection that has been used. This distinction separates the cash outflow of paying the premium from the actual cost recognized over the period the coverage is active.
When Insurance Expense Is Recognized
The recognition of insurance expense adheres to the accrual basis of accounting, which requires expenses to be recorded in the period they are incurred, regardless of when cash is exchanged. This principle is closely tied to the matching principle, which aims to match expenses with the revenues they help generate in the same accounting period. For insurance, this means the cost of coverage is recognized as an expense over the policy’s effective period, not just when the premium is paid.
When a business pays for an insurance policy that covers a future period, such as an annual policy, the entire premium is initially recorded as a prepaid insurance asset. For instance, if a company pays $12,000 for a one-year policy on January 1, this $12,000 is an asset. Then, at the end of each month, an adjusting entry is made to recognize one-twelfth of the annual premium as insurance expense. In this example, $1,000 ($12,000 / 12 months) would be expensed each month, reducing the prepaid insurance asset and increasing the insurance expense. This ensures that the financial statements accurately reflect the cost of insurance for the specific period being reported.
Where Insurance Expense Appears
Insurance expense appears on a company’s income statement. It is categorized as an operating expense, reflecting a cost incurred in normal business operations. The inclusion of insurance expense on the income statement directly reduces a company’s net income for the reporting period.
The related asset, prepaid insurance, is reported on the balance sheet. Prepaid insurance is classified as a current asset, particularly when the coverage period is 12 months or less from the balance sheet date. As the insurance coverage is used and a portion is recognized as an expense, the balance in the prepaid insurance asset account decreases.
Types of Insurance Leading to Expense
Businesses acquire various types of insurance policies that lead to the recognition of insurance expense. These policies are designed to protect a business from a range of financial risks. Common examples include general liability insurance, which covers legal costs due to accidents or negligence claims. Property insurance protects against damage or loss to company assets from events like fire or storms.
Businesses also incur expenses for workers’ compensation insurance, which provides benefits to employees injured on the job. Other types include professional liability insurance, covering errors or negligence in services provided, and health insurance premiums for employees.