Accounting Fundamentals Certification (AFC) 2025 – 400 Free Practice Questions to Pass the Exam

When an annual insurance policy is paid for with a check, the corresponding transaction is recorded with a debit to Prepaid Insurance and a credit to Cash. This is because the payment represents a prepayment for future insurance coverage.

Prepaid Insurance is an asset account that reflects the value of insurance coverage that the business has already paid for but has not yet consumed. Since the policy covers a full year and provides benefits over that period, it is appropriate to categorize it as an asset rather than an immediate expense. Meanwhile, the Cash account is credited to reflect the outflow of cash resulting from the payment, reducing the cash balance of the business. This treatment ensures that the financial statements accurately reflect the company's resources and obligations over time.

In contrast, options that suggest debiting Insurance Expense would imply an immediate recognition of the expense without accounting for the future benefit. This method would not align with the accrual accounting principle, which aims to match expenses to the periods they benefit. Overall, using Prepaid Insurance properly matches the cost with the benefits received over the insurance coverage period.