Prepaid insurance can be a complex process in accounting. Often, insurance is paid for more than one period, such as a two-year liability policy. According to the accrual method of accounting, the cost of the policy is spread throughout the years, which can create some confusion and extra work for accountants. Many firms use worksheets to keep track of prepaid insurance numbers.
Capitalize the full cost of the insurance. When a firm buys a two-year policy with a premium of $10,000, that amount is recognized as an asset -- prepaid insurance. The expense account is not involved at the purchase time. It affects cash flows, because the premium needs to be paid, but not net income. The journal entry is usually to credit cash and to debit prepaid insurance in the balance sheet.
Amortize the cost of prepaid expenses through the year. This means that you recognize insurance expense a bit at a time, decreasing the prepaid account slowly. On a two-year $12,000 policy, you recognize $6,000 as expense each year. If the policy was for three years, then you would recognize $4,000 as expense each of the three years. The journal entry to amortize prepaid insurance is to debit insurance expense and credit prepaid insurance (asset).
Correct credit balances on the prepaid insurance account if applicable. This may happen when policies are canceled or modified and the amortization schedule remains the same. The credits with the journal entries may not be adjusted to reflect actual costs. Usually research and analysis are required to identify the problem and correct it.