What are reversing entries and why are they used?

Definition of Reversing Entries

Reversing entries are made on the first day of an accounting period to remove accrual adjusting entries that were made at the end of the previous accounting period. Two benefits of using reversing entries are:

  • It greatly reduces the chance of double-counting revenues and/or expenses, and
  • It allows for more efficient processing of the actual invoices that will be processed in the new
    accounting period

Example of Reversing Entries

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. 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.

After the financial statements are prepared, the closing entries will transfer the balance in the account Temp Service Expense to an owner's/stockholders' equity account. As a result, the account Temp Service Expense will begin January with a zero balance.

When a reversing entry is recorded as of January 1, it simply removes the estimated amounts contained in the December 31 accrual adjusting entry. In other words, the January 1 reversing entry will:

  • Debit Accrued Expenses Payable for $18,000, and
  • Credit Temp Service Expense for $18,000

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.

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). If the actual invoice is $18,000 the balance in Temp Service Expense will change from a credit balance of $18,000 to a balance of $0. (Zero is the correct expense for the new accounting period, since the $18,000 had been reported as an expense in the previous accounting period.) Thanks to the reversing entry, the person paying the retailer's bills can do what is done for any other vendor invoice.

If the invoice amount on January 6 had been $18,250 the entire amount would be debited to Temp Service Expense and credited to Accounts Payable. 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.

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