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What are reversing entries and why are they used?

Reversing entries are made on the first day of an accounting period in order to remove certain adjusting entries that were made in the previous accounting period. Two benefits of reversing entries are:

  • the chance of double-counting revenues and/or expenses will be greatly reduced, and
  • the processing of subsequent documents will be more efficient

Reversing entries are most often used with accrual type adjusting entries.

To illustrate reversing entries, let's assume that a retailer uses a temporary help service from December 15 - 31. The temp agency will bill the retailer on January 10 and the retailer agrees to pay the invoice by January 15. If the retailer's accounting year ends on December 31, the retailer will make an accrual-type adjusting entry 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 and balance sheet as of December 31 will include the temp service expense and the retailer's 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. This results in the account Temp Service Expense beginning January with a zero balance.

On January 1, the retailer should enter the following reversing entry: debit Accrued Expenses Payable for $18,000 and credit Temp Service Expense for $18,000. This will result in Accrued Expenses Payable now having a zero balance and the account Temp Service Expense will have an unusual credit balance of $18,000. When the actual invoice arrives from the temp agency on January 11, the retailer can simply debit the invoice amount to Temp Service Expense. If the invoice is $18,000 the balance in Temp Service Expense will move from the credit balance of $18,000 to a balance of $0. (The $18,000 credit from the reversing entry on January 1 and the debit of $18,000 from the invoice entry on January 11.) Thanks to the reversing entry, the retailer did not have to stop and consider whether the invoice amount pertained to December or January.

If the invoice amount on January 11 had been $18,180 the entire amount would still be debited to Temp Service Expense and the resulting debit balance of $180 will be reported as a January expense. This insignificant amount is acceptable since the adjusting entry amount was an estimate.