Accounting Reversing Entries
Reversing entries are optional accounting journal entries that are made at the beginning of an accounting period, to cancel adjusting entries which were made at the end of the previous accounting period.
The purpose of reversing entries is to simplify the bookkeeping process, and while it is entirely up to the business whether they are used in the accounting cycle or not, it is important to understand that the amounts reported in the financial statements at the end of the accounting period will be the same.
Reversing Entries Example
Suppose, for example, a business pays its employees part way through a month and therefore has to make an adjusting entry at the end of the month for wages earned but not yet paid. If the amount was for 1,500 then the following adjusting entry would have been made.
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.
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.
Lets assume a reversing entry is not made. 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.
To produce this journal in month 2, it has been necessary to separate out the part of the 4,000 payment which related to month 1 (1,500), and the part which related to month 2 (2,500), so that they can be posted to the correct accounts. The amount relating to month 1 is posted to wages payable to remove the liability established at the end of month 1 by the adjusting entry, and the part relating to month 2 has been correctly posted to the wage expense account for month 2.
The alternative to this rather complicated process is to use reversing entries as shown below.
Lets assume now that the business makes reversing entries at the start of month 2.
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).
As before, in month 2, wages of 4,000, which includes the 1,500 from month 1, are paid, and the following journal is made.
In this case, because the reversing entries have already been made, there is no need to separate the payment out into the parts relating to month 1 and month 2. The entire payment of 4,000 is posted to the rent expense account.
Taking into account the 1,500 credit balance the reversing entry has already created, the balance on the wage expense account is now equal to 2,500 (4,000-1,500), which is the amount relating to month 2 as required.
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.
Pros and Cons of Reversing Entries
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.
In general, the following types of adjusting entry should have reversing entries.
- Accrued expenses
- Accrued revenues
- Prepaid expenses initially recorded in an expense account
- Unearned revenues initially recorded in a revenue account
The following adjusting entries should not have reversing entries
- Prepaid expenses initially recorded in an asset account
- Unearned revenues initially recorded in a liability account
While it is a matter of choice whether to post reversing entries or not, it is much simpler to automatically reverse the previous periods adjusting entries than it is to have to analyze journals into component parts relating to different accounting periods.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.