The purpose of reversing entries is always to simplify the bookkeeping process, for that reason not all adjusting entries should be reversed. For example, it serves no useful purpose to reverse the depreciation adjusting entry from the previous period, only to reinstate it at the end of the current period. It should be noted that whichever method is used, the financial statements for each month will be the same. In each case at the end of month 2, the balance on the wages expense account is 2,500, and the balance on the wages payable liability account is nil.
Why are Reversal Entries Used?
It might be helpful to look at the accounting for both situations to see how difficult bookkeeping can be without recording the reversing entries. Let’s look at let’s go back to your accounting cycle example of Paul’s Guitar Shop. If you were unable to make the reversing entry, then you need still need to prepare an adjusting entry to recognize the earned portion on February 29. Frequently, reversing entries are passed to fix input errors made during the passage of any journal entry. However, reverse entries add to the workload of the individual performing the entries. In month 2 wages of 4,000, which includes the 1,500 from month 1, are paid, and the following journal has to be made.
If you were to forget to reverse the expense in the second example, the accounting records would show a $20,000 expense in January and another $20,000 expense in February, where the February amount is erroneous. The key indicator of this problem will be an accrued liability of $20,000 that the accounting staff should locate if it is periodically examining the contents of the company’s liability accounts. In the next accounting period the business now has two options, either leave the adjusting entry as it is, or to make a reversing entry. The wages earned but not yet paid of 1,500 has been included in the wages expense account, and a liability (wages payable) has been established. If the accountant did not make a reversing entry at the beginning of the year, the accountant will have this entry upon collection of the income. Adjusting entries for unearned revenue under the liability method and prepaid expense under the asset method do not make sense to reverse.
They reduce the likelihood of duplicating revenues and expenses and committing other errors. Preparing reversing entries is an optional, intermediate step between recording revenue or expenses and having cash enter or leave your business. Many business owners implement reversing entries to reduce the likelihood of double-counting revenue and expenses. Reversing entries are usually made to simplify bookkeeping in the new year. For example, if an accrued expense was recorded in the previous year, the bookkeeper or accountant can reverse this entry and account for the expense in the new year when it is paid. The reversing entry erases the prior year’s accrual and the bookkeeper doesn’t have to worry about it.
The alternative to this rather complicated process is to use reversing entries as shown below. While you might have been well-intentioned in deleting incorrect journal entries, it’s better to lay your cards out to auditors by showing them your erroneous and corrective journal entries. For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online.
If Paul does not reverse last year’s accrual, he must keep track of the adjusting journal entry when it comes time to make his payments. Since half of the wages were expensed in December, Paul should only expense half of them in January. On January 7th, Paul pays his employee $500 for the two week pay period. Paul can then record the payment by debiting the wages expense account for $500 and crediting the cash account for the same amount.
To illustrate the process of reversing deferred income, let’s assume that on October 1, 2023, a customer paid you in advance amounting to $6,000 for services to be rendered for the next 5 months. Below are separate approaches for recording this transaction using the two methods. When the remaining $30,000 insurance expires on June 30, 2024, no adjusting entry is necessary since the amount was already recognized as expense when we recorded we posted the reversing entry on January 1, 2024.
- The reversing entry simplified the recording process by allowing the recording of the entire $12,000 salaries paid as expense when the actual payroll was made.
- The key indicator of this problem will be an accrued account receivable of $10,000 that the accounting staff should eventually spot if it is regularly examining the contents of its asset accounts.
- When the temp agency’s invoice dated January 6 arrives, the retailer can simply debit the invoice amount to Temp Service Expense and credit Accounts Payable (the normal routine procedure).
- Business owners should familiarize themselves with reversing entries, which can clear previously recorded transactions without erasing any financial data.
Pros and Cons of Reversing Entries
Assuming the retailer’s accounting year ends on December 31, the retailer will make an accrual adjusting entry on December 31 for the estimated amount. If the estimated amount is $18,000 the retailer will debit Temp Service Expense for $18,000 and will credit Accrued Expenses Payable for $18,000. This adjusting entry assures that the retailer’s income statement for the period ended December 31 will report the $18,000 expense and its balance sheet as of December 31 will report the $18,000 liability. A journal entry made on the first day of a new accounting period to undo the accrual type adjusting entries made prior to the preparation of the financial statements dated one day earlier. Reversing entries allow for an effortless way to avoid double-counting revenues or expenses that were accrued at the end of an accounting period.
Trial Balance
Reversing entries negate revenue and expense accruals, making it easy to record transactions without having to look back at what someone else has already recorded. You’re waiting on a bill from your independent contractor that you expect to be around $10,000, but you haven’t gotten it in the mail yet. Rather than waiting for the bill, you record a $10,000 expense at the end of turbo tax and form 8606 the month.
The original adjusting entry is simply reversed at the start of month 2. The wages payable account now has a zero balance (1,500-1,500), and as expense accounts are temporary and are zeroed at the start of each month, the wages expense account now has a credit balance of 1,500 (0-1,500). To illustrate reversing entries, let’s assume that a retailer uses a temporary employment agency service to provide workers from December 15 to December 29. The temp agency will bill the retailer on January 6 and the retailer is required to pay the invoice by January 10.
The resulting debit balance of $250 in Temp Service Expense will be reported as a January expense. Since the $250 is insignificant difference from an estimated amount, it is acceptable to report the $250 as a January expense instead of a December expense. After the January 1 reversing entry, the account Accrued Expenses Payable will have a zero balance, and the account Temp Service Expense will have an unusual credit balance of $18,000.
Definition of Reversing Entries
Auditors will question accounting records with missing journal entries since they could be a sign of financial malfeasance. That’s why it’s an accounting faux pas to delete transactions in your accounting software. Business owners should familiarize themselves with reversing entries, which can clear previously recorded transactions without erasing any financial data. Since you’re expecting to fully earn the unearned portion of $2,400 from the customer’s advance payment on February 29, 2024, the reversing entry has already transferred this amount to service revenue. When the full amount becomes earned by February 29, there’s no need for you to record it anymore.
If the accountant did not make a reversing entry at the beginning of the year, the accountant will have this entry upon payment of the rent. If your business used reversing entries, you’d have accurate financial statements debits and credits and one less pain point with your spouse. On March 31, you recorded a $2,000 revenue journal entry for a client whose work you completed but haven’t yet billed.
In effect, Rent Expense for 2021 is $2,000 even if the accountant debits $6,000 upon payment. This is because of the reversing entry which includes a credit to Rent Expense for $4,000. If you have more than one person working with your accounting software, reversing entries can help you avoid errors due to miscommunication. Imagine how easy it would be to forget that you recorded the $10,000 last month. Absent a reversing entry, you’d wind up showing a $19,500 expense for the contractor’s work, a mistake that’s sometimes hard to catch. Without a reversing entry, you’d have a $10,000 expense on your books until the bill comes in.
