What Is Reversing Entry?
A reversing entry is an optional accounting journal entry made at the beginning of a new accounting period to cancel out a specific adjusting entry from the immediately preceding period. Its primary purpose, within the framework of accrual accounting, is to simplify the recording of routine transactions in the new period and prevent the potential for double-counting. Reversing entries fall under the broad financial category of accounting procedures, designed to streamline the bookkeeping process.
History and Origin
The concept of reversing entries is deeply rooted in the evolution of accrual accounting, which itself stems from the principles of double-entry bookkeeping. Double-entry bookkeeping, a foundational accounting method, is widely credited to have been first systematically described by Italian mathematician Luca Pacioli in his 1494 treatise, Summa de Arithmetica, Geometria, Proportioni et Proportionalita. However, its practical application and development began much earlier, emerging in Italy as early as the 13th century, particularly within banking and merchant communities in cities like Florence and Venice14, 15, 16, 17, 18.
As businesses grew more complex and transactions began to span across accounting periods, the need for accurate financial representation at specific reporting dates became critical. This led to the development of adjusting entries, which allocate revenues and expenditures to the correct periods. Reversing entries evolved as a practical convention to simplify the subsequent accounting for transactions that were initially accrued. By reversing certain adjusting entries, bookkeepers could process subsequent cash receipts or payments as standard transactions, avoiding the need to remember special accounting treatments for previously accrued amounts12, 13. This streamlined approach became especially beneficial in environments where different individuals might handle period-end adjustments and daily bookkeeping, reducing the risk of errors and improving efficiency11.
Key Takeaways
- A reversing entry is an optional accounting entry that cancels out certain prior-period adjusting entries.
- Its main purpose is to simplify subsequent transaction recording in the new accounting period.
- Reversing entries are typically used for accruals, such as accrued expenses and accrued revenues.
- They help prevent double-counting of revenues and expenses in the new period.
- While not mandatory, reversing entries improve efficiency and reduce the likelihood of errors in daily bookkeeping.
Interpreting the Reversing Entry
A reversing entry itself is not interpreted in isolation but rather understood in the context of the adjusting entry it negates. Its function is purely procedural: to clear out temporary balances created by adjusting entries at the end of a previous period so that routine transactions in the new period can be recorded in a straightforward manner. For example, if an expense recognition was accrued at period-end, the reversing entry effectively removes that accrual from the general ledger at the start of the new period. This means that when the actual cash payment for that expense occurs later in the new period, it can be recorded as a simple debit to the expense account and a credit to cash, without having to consider the previous period's accrual10.
The use of reversing entries helps maintain the consistency and clarity of the accounting records, particularly for accounts like accounts payable or accounts receivable that are frequently updated.
Hypothetical Example
Consider a hypothetical company, "GreenThumb Landscaping Inc.," which pays its employees weekly every Friday. The company's accounting period ends on Wednesday, December 31st. Since the last payday was December 26th, employees earned wages for December 29th, 30th, and 31st that will not be paid until the first Friday of January.
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Adjusting Entry (December 31st): To correctly reflect the expenditure for the period, GreenThumb makes an adjusting entry on December 31st. Let's say the accrued wages for these three days are $1,500.
- Debit: Wages Expense $1,500
- Credit: Wages Payable $1,500
This ensures that the December financial statements accurately reflect the wages incurred for that month.
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Reversing Entry (January 1st): On January 1st, the first day of the new accounting period, GreenThumb makes a reversing entry for the exact opposite of the adjusting entry:
- Debit: Wages Payable $1,500
- Credit: Wages Expense $1,500
This reversing entry essentially removes the accrual from the books at the start of the new year.
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Regular Payment Entry (January 3rd): When GreenThumb pays its employees their full weekly wages of, say, $2,500 (covering the $1,500 from the prior year and $1,000 for the first two days of January), the journal entry is simple:
- Debit: Wages Expense $2,500
- Credit: Cash $2,500
Without the reversing entry, the accountant would need to remember to debit Wages Payable for the prior year's accrual and Wages Expense for only the portion earned in the new year. The reversing entry simplifies the daily recording, allowing the entire payment to be debited to Wages Expense, with the reversal effectively netting out the portion related to the prior period in the Wages Expense account.
Practical Applications
Reversing entries are commonly applied in various aspects of accounting, particularly with respect to accruals that represent future cash flows. They are most useful for:
- Accrued Expenses: Expenses incurred but not yet paid or recorded, such as salaries earned by employees but not yet disbursed, or utility services used but for which an invoice has not yet been received. A reversing entry allows the full payment to be recorded as an expense in the subsequent period without complicated adjustments for the portion accrued9.
- Accrued Revenues: Revenues earned but not yet received in cash or formally billed, such as interest earned on investments or services performed for which payment is pending. Reversing these entries simplifies the recording of the eventual cash receipt8.
- Prepaid Expenses (using the expense method): If initial prepaid expenses (like insurance or rent) are recorded directly as an expense, the adjusting entry converts the unexpired portion to an asset. A reversing entry can then reset this, allowing subsequent full expensing when the next payment is made7.
- Unearned Revenue (using the income method): If unearned revenue (cash received for services not yet rendered) is initially recorded as revenue, the adjusting entry defers the unearned portion to a liability. A reversing entry can then reverse this deferral.
These applications help streamline the accounting cycle and support the accuracy of financial reporting. Accurate financial reporting is paramount for businesses to make informed strategic decisions and maintain stakeholder trust. Companies are required by law to prepare accurate financial statements in accordance with accounting principles, and non-compliance can lead to penalties and damage to reputation5, 6.
Limitations and Criticisms
While useful for simplifying bookkeeping, reversing entries are not without their nuances and potential pitfalls. One significant limitation is that they are optional, leading to inconsistencies across organizations that may or may not employ them. Furthermore, not all adjusting entries should be reversed. For instance, adjusting entries for depreciation, bad debts, or those related to prepaid expenses or unearned revenue recorded initially as assets or liabilities, respectively, are generally not reversed, as reversing them would lead to incorrect account balances4.
Incorrectly applying a reversing entry or making errors in general journal entry processes can lead to significant accounting errors. Common errors include reversed entries (where debits and credits are improperly switched) or duplicated entries, which, while not always throwing off a trial balance, can still misstate accounts3. Such errors undermine company credibility, waste resources, and hamper the reliability of information needed for business decision-making2. Auditors pay close attention to journal entries, especially those made at period-end, to detect potential fraud or material misstatements, highlighting the importance of meticulous record-keeping even with simplifying procedures like reversing entries1.
Reversing Entry vs. Adjusting Entry
A reversing entry and an adjusting entry are both integral to accrual basis accounting, but they serve distinct purposes and are performed at different times in the accounting cycle.
| Feature | Reversing Entry | Adjusting Entry |
|---|---|---|
| Purpose | To simplify future recording of routine transactions by canceling out prior period accruals. | To allocate revenues and expenses to the correct accounting period. |
| Timing | First day of a new accounting period. | End of an accounting period, before financial statements are prepared. |
| Requirement | Optional. | Mandatory under accrual accounting to ensure accurate financial statements. |
| Effect | Undoes the effect of a previous adjusting entry. | Ensures revenues and expenses are recognized in the period they occur, regardless of cash flow. |
| Accounts | Typically affects accrued income and accrued expenses. | Affects various income statement and balance sheet accounts (e.g., revenue recognition, expense, prepaid, unearned). |
The confusion between the two often arises because a reversing entry directly counteracts an adjusting entry. However, adjusting entries are crucial for adhering to the matching principle and revenue recognition principle, ensuring that a company's financial position is accurately reflected at the end of a period. Reversing entries are merely a bookkeeping convention to make the subsequent daily accounting process more efficient.
FAQs
Why are reversing entries optional?
Reversing entries are optional because they are a matter of accounting efficiency rather than a requirement for accurate financial reporting under GAAP. The same end result in the general ledger and financial statements can be achieved without them, but it would require more complex recording of subsequent cash transactions in the new period.
What types of adjusting entries are typically reversed?
Generally, only adjusting entries that create an accrual (accrued expenses or accrued revenues) are candidates for reversing entries. These are adjustments where cash has not yet changed hands, but the revenue has been earned or the expense incurred. Adjusting entries for deferrals, like prepaid expenses or unearned revenue (when initially recorded as an asset or liability, respectively), or for non-cash items like depreciation, are typically not reversed.
How does a reversing entry prevent double-counting?
Consider an accrued expense. The adjusting entry debits the expense and credits a payable at period-end. Without a reversing entry, when the cash is paid in the new period, the accountant would need to debit the payable for the accrued portion and the expense for the new period's portion. By using a reversing entry, the payable is debited and the expense is credited at the start of the new period, effectively zeroing out the accrued expense. This allows the full subsequent cash payment to be debited entirely to the expense account, streamlining the process and avoiding accidental double-counting of the expense when the actual payment is recorded.
Do reversing entries appear on financial statements?
No, reversing entries are internal accounting procedures and do not directly appear on external financial statements like the income statement or balance sheet. Their purpose is to simplify the bookkeeping process, and any temporary effects they create on income or expense accounts at the very beginning of a period are nullified by subsequent transactions during that period, leading to correct period-end balances.
Can reversing entries correct errors?
While reversing entries are primarily used for their intended purpose of simplifying accrual accounting, they can also be used to correct a prior journal entry that was posted in error. This application is distinct from their routine use with accruals but demonstrates their flexibility as a bookkeeping tool.