Key Takeaways
- Reversing entries are journal entries that are posted at the beginning of a new accounting period to reverse some adjusting entries that were made at the end of the immediately preceding period.
- The preparation of reversing entries is optional and is usually done to simplify the recording process. It also reduces the risk for a data entry personnel who is unaware of the adjusting entries from the previous period to potentially recognize the same income or expense twice.
- Reversing entries only apply to accrued expenses, accrued income, prepaid expenses (expense method), and deferred income (income method)
Overview of the Accounting Cycle
Preparing the reversing entries is the last step in the accounting cycle of the business. The Accounting Cycle refers to the steps that a company takes to prepare its financial statements.
Below are the steps in the accounting cycle, done in the following order:
- Gathering of business source documents
- Analyzing and journalizing business transactions
- Posting journalized transactions to the ledger
- Preparing an unadjusted trial balance
- Journalizing and posting adjusting entries
- Preparing an adjusted trial balance
- Preparing the financial statements
- Journalizing and posting closing entries
- Preparing a post-closing trial balance
- Journalizing and posting reversing entries
Introduction to Reversing Entries
Reversing entries are journal entries that are recorded at the beginning of a new accounting period to reverse certain adjusting entries that were posted at the end of the previous accounting period.
Reversing entries are optional journal entries that you can make to reverse or undo the effects of the following adjusting entries that were posted in the immediately preceding accounting period:
- Accrued expense
- Accrued income
- Prepaid expense (if using the expense method)
- Deferred income (if using the income method)
Reversing entries do not apply to the following adjusting entries:
- Prepaid expense (if using the asset method)
- Deferred income (if using the liability method)
- Depreciation expense
- Bad debts or uncollectible accounts
Purpose of Reversing Entries
The goals of a reversing entry are as follows:
- To simplify the recording of transactions that you expect to occur in the new accounting period.
- To improve the efficiency of data entry when recording routine transactions and avoid possible errors that may result from prior period adjusting entries. An example of this error is the recording of revenues or expenses twice by a data entry staff who is not aware of the adjusting entries that were posted on the previous period.
Reversing entries are prepared and posted to the ledger on the first day of the succeeding accounting period, even though they are the last step in the accounting cycle. They are also optional, which means that you can skip this step and still achieve the same results as when you have used reversing entries, so long as you’re careful with recording transactions that are related to the adjusting entries mentioned above.
If you’ve decided to go the route of using reversing entries to simplify the recording process, you have the option to do it manually where you prepare it yourself and making sure that all necessary reversing entries were posted. Another option is to allow your accounting software to automatically do the preparation of reversing entries for you at the beginning of a new accounting period.
Reversing Accrued Expense
To illustrate reversing entries for accrued expenses, let’s assume that on December 31, 2022 your company accrued $5,000 for salaries to be paid on January 15, 2023. The adjusting entry on December 31, 2022 to accrue salaries would be:
On January 1, 2023, a reversing entry for the accrued expense was made as follows:
Notice that the above reversing entry uses the same ledger accounts and amounts of the same adjusting entry that it aims to reverse. However, this time, salaries payable was debited while salaries expense was credited, effectively reversing the adjusting entry.
Since the $5,000 salaries expense was already closed at the end 2022, the reversing entry on the first day of the next accounting period, i.e. 2023, should result in a salaries expense account having a credit balance of $5,000.
Considering that salaries expense normally has a debit balance, allowing a credit balance will make sense once the actual salaries are paid on January 15, 2023.
Let’s assume that on January 15, 2023, your company pays $12,000 for employee salaries. The entry for this would be:
The net effect of this entry to salaries expense would be a debit balance of $7,000 since the account was first credited for $5,000 on January 1 and debited for $12,000 on January 15. The total payroll of $12,000 consists of $5,000 salaries expense recognized on December 31, 2022 and $7,000 on January 15, 2023.
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 data entry personnel won’t need to worry for the impact made by the adjusting entry on December 31, 2022.
What would happen if no reversing entry was made on January 1, 2023? In this case, the journal entry on January 15 when actual payroll was made would be:
Observe that the above entry still recognized a salaries expense of $7,000 on January 15 which is the same amount of expense recognized when a reversing entry was made. This proves that the same results can be achieved whether or not a reversing entry was made so long as you are aware about the correct amount of salaries expense to be recognized when the actual salaries are paid.
Reversing Accrued Income
To illustrate accrued income and how to reverse it, let’s assume that you rent out apartment spaces for $1,000 per month. On December 1, 2022, one of your tenants promises to pay you at the end of February 2023 the equivalent of 3 months worth of rent covering December 2022 to February 2023.
Your adjusting entry at the end of December 2022 will be:
At the beginning of January 1, 2023, the entry to reverse the above adjusting entry should be:
Since the rent income that you accrued on December 2022 was already closed to equity, the rent income account at the beginning of January 2023 should show a debit balance of $1,000 after posting the above reversing entry. Having a rent income account with a debit balance may seem odd at first, considering that income accounts normally have credit balances, but this would make sense once you’ve made the entry to collect the rent.
As promised, your tenant paid you $3,000 on February 28, 2023. The entry to record this will be:
After posting the entry, your rent income account should now show a credit balance of $2,000 which is the net effect of debiting it for $1,000 and then crediting it for $3,000. You have recognized a total of $3,000 for this transaction, with $1,000 recorded on 2022 while the remaining $2,000 being recorded in 2023 upon collection.
If you didn’t record a reversing entry at the beginning of January 2023, then your entry on February 28, 2023 would be:
This entry still has the same result as in the case where you posted a reversing entry since it still recognizes $2,000 rent income for 2023. Using a reversing entry would simplify the work of the data entry personnel who doesn’t need to consider the impact of any previously-posted adjusting entry.
Reversing Prepaid Expense
The need to prepare reversing entries for prepaid expenses depend on which method you use in recording prepayments. The two methods are the expense method and the asset method.
To illustrate, let’s assume that on July 1, 2023 you purchased a 12-month insurance coverage plan starting July 1 and paid an upfront fee of $60,000. Below we’ll discuss how to record reversing entries and which method it could be applied.
Expense method
Under the expense method, the advance cash payment for the insurance will immediately be debited to the expense account, Insurance Expense. Therefore, the entry on July 1, 2023 will be:
Since this entry immediately expensed the full amount of the insurance even if the expense has not yet been incurred, an adjusting entry to transfer the unexpired portion of the insurance to an asset account on December 31, 2023 should be made as follows:
After this adjusting entry, both the prepaid insurance account and the insurance expense accounts should have debit balances of $30,000 each. At the start of the succeeding accounting period on January 1, 2024, the above adjusting entry should be reversed as follows:
This reversing entry should decrease the prepaid insurance account by $30,000, resulting to a zero balance again, effectively reversing the adjusting entry. At the same time, the insurance expense account would be debited for $30,000 which corresponds to the unexpired portion.
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.
If the reversing entry was not made at the beginning of 2024, then you still need to make sure to prepare an adjusting entry to recognize insurance expense for the expired portion on June 30, 2024.
Asset method
Using the asset method, the prepaid insurance account is debited for the advanced cash payment instead of the insurance expense account. The entry on July 1, 2023 will be:
At the close of the accounting year on December 31, 2023, the adjusting entry for the expired portion of the insurance will be:
However, at the beginning of the following accounting period on January 1, 2024, the above adjusting entry does not need to be reversed anymore since on that date, the prepaid insurance account already shows the correct balance. Upon full expiration of the insurance on June 30, 2024, the entry will simply be as follows:
After recording this entry, the prepaid insurance should already show a zero balance since the whole insurance plan has already expired.
Reversing Deferred Income
Similar to prepaid expenses, there are also two methods for recording deferred income, also called unearned income. These are the income method and the liability method.
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.
Income method
When using the income method for recording customer advances, the customer’s payment will immediately be recorded as service revenue. The entry to record this on October 1, 2023 will be:
On December 31, 2023, the unearned portion of the amount received should be transferred to the Unearned Revenue liability account as follows:
The above adjusting entry should be reversed by posting the following entry on January 1, 2024, the start of the new accounting period:
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 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.
Liability method
Under the liability method, the unearned revenue account will be credited to record the advance payment by the customer instead of recording it directly to service revenue. The entry on October 1, 2023 will be:
On December 31, 2023, the adjusting entry to record earned revenue of $3,600 would be:
The adjusting entry reduces the unearned revenue liability by $3,600 resulting to a credit balance of $2,400. Since the unearned revenue account already reflects the correct balance on January 1, 2024, there is no need to reverse the above adjusting entry anymore.
Below should be the entry to record the earned revenue on February 29, 2024. This will reduce unearned revenue to zero for this cash advance transaction since services were already fully rendered at this time.
Review Questions
- How can reversing entries help with the accounting process?
- What are the types of adjusting entries that don’t need to be reversed?
- How can reversing entries help prevent the recognition of income or expense twice?
- What would be the effect if you skip recording reversing entries?
- When are reversing entries prepared?
