On both old and new business, companies can also avoid premium notes by entering into agreements involving deposits of a portion of the premium with…

When a company receives a deposit for a premium, it has received cash for a service (insurance coverage) it has not yet provided. According to the revenue recognition principle, income cannot be recognized until it is earned. The receipt of cash creates an obligation for the company to either provide future coverage or return the funds. This obligation is recorded on the balance sheet as a liability. The deposit is only credited to income (as earned premium) when it is applied to pay for the premium and the corresponding coverage period begins.

A. A liability: This is partially correct as the deposit is a liability, but it is an incomplete answer. Option C provides a more comprehensive explanation of the accounting treatment, including the impact on income recognition.

B. Unearned revenue and not credited to income until the deposit is used to pay the premium: "Unearned revenue" is a specific type of liability. While technically correct, "liability" is the broader and more fundamental accounting classification for this obligation, making option C a better and more precise choice.

D. Asset and not credited to income until the deposit is used to pay the premium: This is incorrect. While the cash received is an asset, the accounting entry for the deposit itself establishes a liability, representing the company's obligation to the policyholder.

1. NAIC Accounting Practices and Procedures Manual

Statement of Statutory Accounting Principles (SSAP) No. 53

Property and Casualty Contracts—Premiums:

Reference: Paragraph 9 states

"Premiums received by an insurer prior to the effective date of the policy shall be recorded as a liability (advance premiums)." This directly supports that the deposit is treated as a liability.

Reference: Paragraph 4 states

"Premiums are earned ratably over the term of the policy." This supports the principle that the amount is not credited to income until it is earned over the policy period after being applied.

2. Harrison

W. T.

Horngren

C. T.

Thomas

C. W.

& Tietz

W. M. (2020). Financial Accounting (12th ed.). Pearson Education.

Reference: Chapter 3

"Accrual Accounting & the Financial Statements

" discusses unearned revenue. It defines unearned revenue as a liability created when a company receives cash from a customer before providing the service. The text explains

"Upon receipt of the cash

the company increases Cash (an asset) and increases Unearned Revenue (a liability)... The company will record the revenue when it has earned it." This general accounting principle is directly applicable.

3. University of Wisconsin-Madison

School of Business

Course Material for AIS 620: Financial Reporting.

Reference: Course modules on "Revenue Recognition" and "Liabilities" consistently teach that payments received in advance of delivering goods or services are recorded as a liability (often titled "Unearned Revenue" or "Deferred Revenue") and are only recognized as revenue in the income statement as they are earned. This aligns with the treatment of premium deposits in the insurance industry.