Jane Dotson
When an individual or business purchases insurance, they are protecting themselves against financial loss. In the event of a loss, the insured files a claim, which the insurance company evaluates before paying out any proceeds. Accounting for insurance proceeds is a specific process, and the most reasonable approach is to record the gain once the proceeds have been received. However, this may constitute accrued revenue, so an alternative is to record the gain when payment is probable and the amount can be determined. In the case of property damage, the loss should consider the salvage or resale value of the property, and the insurance recovery should be evaluated and accounted for separately.
| Characteristics | Values |
|---|---|
| Definition | Insurance proceeds are benefit proceeds paid out by any type of insurance policy as a result of a claim. |
| Timing of payment | Insurance proceeds are paid out once a claim has been verified. |
| Payee | Insurance proceeds are sometimes paid directly to a care provider (as with health insurance), but usually, they are sent to the insured in the form of a check. |
| Accounting procedure | An accountant should record the full amount of the insurance proceeds and the full amount of the loss. |
| Accounting example | Consider a fire that destroys $15,000 of inventory that belongs to Company X. Since the insurance company covers the entire loss, the first entry is a $15,000 debit to fire damage, and a $15,000 credit to inventory to remove the inventory from your accounting books. The second entry is a $15,000 debit to cash-fire damage reimbursement, and a $15,000 credit to fire damage. |
| Recognition of gain or loss | A gain or loss should be recognized when a nonmonetary asset (such as property or equipment) is involuntarily converted to monetary assets (such as insurance proceeds). |
| Accounting for casualty loss | When PPE Corp's warehouse was heavily damaged by a tornado, the company recorded an insurance recoverable asset of $7 million (equal to the amount of the recognized loss) and recognized the excess insurance proceeds of $1 million as a gain. |
| Accounting for property damage | When a business suffers a loss that is covered by an insurance policy, it recognizes a gain in the amount of the insurance proceeds received. The most reasonable approach is to wait until the proceeds have been received by the company. |
| Bookkeeping for an insurance claim | If the claim is not related to a fixed asset, the bookkeeping is straightforward. Record the repair expenses as you normally would, and once you deposit the insurance check, credit the repair expense account. |
| Bookkeeping for fixed assets | If the claim is related to a fixed asset, you may need to create a new account in your chart of accounts, such as "Gain from Insurance Claim" or "Loss from Insurance Claim," depending on whether your Asset Disposal account has a profit or loss. |
| Tax implications | In general, insurance proceeds are tax-free, although there may be exceptions. |
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What You'll Learn
Involuntary conversion
When accounting for insurance proceeds involving involuntary conversion, there are several key steps and considerations to keep in mind. Firstly, it's important to determine the book value of the asset that has been converted. This involves reviewing the asset's original cost, as well as any accumulated depreciation or impairment losses that have been recorded against it. The book value of the asset represents its current value on the balance sheet before the involuntary conversion takes place.
Another important aspect is to assess the insurance proceeds received or expected to be received. Insurance policies typically cover either the actual cash value or the replacement cost of the asset. Actual cash value takes into account the asset's depreciation, while replacement cost provides funds to replace the asset with a similar one. It's crucial to carefully review the insurance policy terms and conditions to accurately determine the expected insurance proceeds.
The accounting treatment for involuntary conversion can vary depending on whether the asset is replaced or not. If the asset is replaced, the insurance proceeds are typically recorded as a reimbursement of the asset's book value. Any excess proceeds over the book value may be recognized as a gain, and the new asset is recorded at its cost. Conversely, if the asset is not replaced, the insurance proceeds are recorded as a gain, and the asset's book value is removed from the balance sheet.
In scenarios where there is a loss, it's important to recognize and record that loss separately. A loss may occur if the insurance proceeds are insufficient to cover the book value of the asset. This loss should be reflected in the income statement as an expense or loss, separate from any gains or reimbursements related to the involuntary conversion.
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Timing of recording insurance proceeds
The timing of recording insurance proceeds depends on the context and nature of the insurance claim. Here are some scenarios and considerations for timing:
When an insurance claim involves property, plant, and equipment (PPE), accounting for the insurance proceeds may be necessary to recognise both the loss and the potential insurance recovery. For example, if a company's warehouse is damaged by a natural disaster, the company would first record the loss of the warehouse's value as a total loss. Then, if there is an insurance policy in place, the expected insurance recovery can be recorded as an insurance recoverable asset. This timing ensures that the loss and the potential recovery are reflected simultaneously.
In cases where the insurance proceeds are expected to exceed the recognised loss, it is important to wait until all contingencies related to receiving the excess amount are resolved. Only then should the excess amount be recognised as a gain. This approach aligns with the principle of conservatism, where the recognition of gain or income is discouraged unless there is a high degree of certainty.
For prepaid insurance arrangements, the timing of recording insurance proceeds may be periodic. For instance, if a company purchases business insurance for a one-year period in advance, the insurance payments will likely span multiple financial statement periods. In such cases, adjusting entries are made at the end of each accounting period to match the insurance expense with the appropriate period on the income statement. This ensures that the prepaid insurance amount is accurately reflected over time.
When recording insurance claims, it is generally advisable to wait until the insurance company approves the claim before recording the gain. This approach minimises the risk of recording a gain related to a payment that may never be received. However, if there is a high degree of certainty that the payment will be received, it is acceptable to record the gain as soon as the payment amount can be determined. This alternative approach, however, constitutes accrued revenue and is generally discouraged unless there is a strong probability of payment.
In summary, the timing of recording insurance proceeds can vary depending on the specific circumstances of the claim and the level of certainty associated with receiving the payment. It is important to consider the potential gain or loss, the approval status of the claim, and the accounting principles guiding conservatism and probability.
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Accounting for insurance proceeds as a derivative
Insurance proceeds refer to the cash payment received by an insured party from its insurer in response to a claim made. The amount received is usually less than the loss suffered by the insured party, as the insurer will usually insist that the insured party bear some of the risk associated with the loss. When a business suffers a loss covered by an insurance policy, it recognises a gain in the amount of the insurance proceeds received.
The most reasonable approach to recording these proceeds is to wait until they have been received by the company. This ensures there is no risk of recording a gain related to a payment that is never received. Alternatively, record the gain as soon as the payment is probable and the amount can be determined, but this constitutes accrued revenue, so is discouraged unless there is a high degree of certainty regarding the payment.
A gain from insurance proceeds should be recorded in a separate account if the amount is material, clearly labelling the gain as non-operational. For example, the title of such an account could be "Gain from Insurance Claims". Although a gain is recorded, the likely total outcome of an insurance claim is a net loss, as the amount of the claim is offset against the actual loss incurred, net of an insurance deductible. It may be necessary to disclose in the financial statement footnotes the nature of the events resulting in insurance proceeds, the amount of the proceeds, and the income statement line item in which the resulting gain is recorded.
Insurance derivatives are financial instruments that derive their value from an underlying insurance index or the characteristics of an event related to insurance. They are useful for insurance companies that want to hedge their exposure to catastrophic losses due to exceptional events, such as earthquakes or hurricanes. Insurance derivatives are fundamentally different from traditional insurance. Derivatives afford project owners access to the risk-sharing of financial markets, and this kind of diversification can be better than that of geographical distribution. The settlement process is also typically quicker and less onerous than for traditional insurance.
Residual value insurance contracts between a lessor and an insurance carrier are accounted for as either purchased insurance contracts or derivatives under ASC 815, depending on the contract’s characteristics. When payment under the residual value insurance contract is not based on the value of a specific non-financial asset, but on an index, the contract would be accounted for as a derivative. However, settlement based on using the appraisal value or the sales proceeds of the specified asset owned by the party would meet the scope exception in ASC 815-10-15-59 and the contract would be accounted for as purchased insurance.
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Bookkeeping entries for insurance claims
Let's consider a scenario where your rental property has sustained damage during a flood, specifically to an HVAC unit. The original unit cost $10,000, and while it's been depreciated over the last five years, it still has a remaining book value of $8,181.80. In this case, the insurance payout cannot be counted as profit. You would need to remove the asset from your service and account books. This involves creating a new account in your chart of accounts. If your Asset Disposal account has a profit, create a new revenue account called "Gain from Insurance Claim." If there's a loss, create a new expense account, "Loss from Insurance Claim." To zero out the Asset Disposal account, create a manual journal transaction, crediting the Gain from Insurance Claim account and debiting the Asset Disposal account.
Now, consider a claim related to general damages. Suppose water entered your rental property during a storm, causing $15,000 worth of damage. If your insurance company sends you a check for $10,000, the bookkeeping entry is straightforward. You would debit the Cash/Bank (asset account) and credit Other Income (income account).
For personal insurance proceeds deposited into a business bank account, the journal entry is similar: Debit: Cash/Bank (asset account), Credit: Capital (equity account). If you then need to withdraw those funds for personal use, the entry becomes Debit: Drawings (asset account), Credit: Cash/Bank (asset account).
In the case of a business suffering a loss covered by insurance, it's generally recommended to wait until the insurance proceeds are received to record the gain. However, if the payment is highly probable and the amount can be determined, you can record the gain early, though this is considered accrued revenue.
When dealing with damaged inventory, the process involves three stages: writing off the damaged inventory to the impairment of inventory account, setting up accounts receivable from the insurance company once the claim is agreed upon, and finally receiving the cash.
A basic insurance journal entry for a small business is Dr Insurance Expense Cr Bank. Additionally, when a business puts in an insurance claim, the journal entry is Debit: Cash/Bank (asset account), Credit: Other Income (income account).
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Accounting for insurance proceeds as purchased insurance
Insurance proceeds refer to the cash payment received by an insured party from its insurer in response to a claim made. When accounting for insurance proceeds, the general rule is to remove the value of the damaged assets from your books and record the proceeds. However, the specific accounting procedures depend on the nature of the insurance contract, the type of loss, and whether the insurance company reimbursed the loss.
For example, if an insurance company covers the entire loss, the first entry is a debit to fire damage for the full amount of the loss, followed by a credit to inventory to remove the lost inventory from your accounting books. The second entry is a debit to cash-fire damage reimbursement, and a credit to fire damage for the full amount of the insurance proceeds. This procedure zeroes out the amount of the fire damage loss on the company's books.
In the case of a residual value insurance contract, the accounting treatment depends on whether the settlement is based on the value of a specific non-financial asset or an index. If the settlement is based on the higher of specific asset appraisal, actual proceeds from a sale, or an asset valuation guide, it may be considered to have multiple underlyings. In this case, the contract is subject to ASC 815 if all the underlyings are highly correlated with any of the underlyings that do not qualify for the scope exception.
It is important to note that insurance proceeds are typically tax-free, but there may be exceptions. Additionally, the gain from insurance proceeds should be recorded separately if the amount is material, clearly indicating that the gain is non-operational. Furthermore, it is recommended to wait until the insurance proceeds are received before recording them to avoid the risk of recognising a gain related to a payment that is never received.
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Frequently asked questions
Insurance proceeds are benefit proceeds paid out by any type of insurance policy as a result of a claim.
The most reasonable approach to recording these proceeds is to wait until they have been received by the company. An alternative is to record the gain as soon as the payment is probable and the amount can be determined, but this is discouraged unless there is a high degree of certainty regarding the payment.
If your Asset Disposal account has a profit, create a new revenue account called "Gain from Insurance Claim". If your Asset Disposal account has a loss, create a new expense account called "Loss from Insurance Claim".
Record the repair expenses as you normally would. Once you deposit the insurance check, credit the repair expense account instead of an income account.
