A common prepaid expense is prepaid insurance. 

Companies often pay for insurance in advance (such as 1 year terms)

When you first pay for the insurance, the amount that has been prepaid is an asset

As you “use up” the asset each month, the asset is reduced and an expense is recorded for the amount of the reduction

Let’s walkthrough an example:

A company pays an insurance company 1,200,000 Rwf on January 1 for 12 months of car insurance on their delivery vehicles.

Qs: Thinking back to our asset definition. Can someone remind us the 3 criteria that need to be met?

Qs: Using those criteria, why is it an asset?

When the company prepays 1,200,000 for insurance for a 1 year term, what is the impact on the accounting equation?

+1,200,000

 -1,200,000

We use one asset (cash) to purchase another asset (prepaid insurance).

Qs: What is the impact of the transaction on the accounting equation?

Since we are paying for a service in advance, we are giving up one asset (cash) for another (future service). We can think of it as the insurance supplier owing us a service.

We increase prepaid insurance (asset), so we debit

We decrease cash (asset), so we credit

Qs: What is the related journal entry?

It is now the end of January and the company has used up 1 month of its prepaid insurance (100,000 Rwf). What is the impact on the accounting equation?

    -100,000                                                      -100,000

When we use one month of the prepaid insurance (asset), we recognize insurance expense (expense).

Qs: What is the impact on the accounting equation?

Qs: How do we know the amount is 100K?

If needed, go through the calculation on the write-board – (1.2M / 12 months = 100K)

We increase insurance expense (expense), so we debit

We decrease prepaid insurance (asset), so we credit

At the end of January, the prepaid insurance balance is now 1,100,000 (1,200,000 less 100,000). The asset now provides less future benefits than when the company acquired it.

Qs: What is the related journal entry?

Now that we have expensed 100K, the remaining prepaid asset balance is 1.1M. This 1.1.M will decrease each month over the year, until it is 0 at the end of December.