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Reversing Entries

Introduction

Reversing entries are made at the beginning of the new accounting period to enable a smoother accounting process. This step is optional and is especially useful to companies that use the cash basis method.

In a Nutshell

The purpose of reversing entries is to cancel out certain adjusting entries that were recorded in the previous accounting period.

Reversing entries are optional. Bookkeepers make them to simplify the records in the new accounting period, especially if they use a "cash basis" system.

Only the following adjusting entries may be reversed: 1) accrued income, 2) accrued expense, 3) unearned revenue using income method, and 4) prepaid expense using expense method.

Preparing Reversing Entries

In this step, the adjusting entries made at the end of the previous accounting period are simply reversed, hence the term "reversing entries".

However, not all adjusting entries qualify for this step.

The only types of adjusting entries that may be reversed are those that are prepared for the following:

  1. accrued income,
  2. accrued expense,
  3. unearned revenue using the income method, and
  4. prepaid expense using the expense method.

Adjusting entries for unearned revenue under the liability method and prepaid expense under the asset method do not make sense to reverse. Adjusting entries for depreciation, bad debts and other allowances also are not reversed.

Reversing Entry for Accrued Income

Example: ABC Company is to receive $3,000 interest income at the end of February 2021. It covers 3 months starting December 1, 2020. At the end of 2020, the accountant properly made an adjusting entry for one month's worth of accrued income.

Date
2020
Particulars Debit Credit
Dec 31 Interest Receivable 1,000.00  
    Interest Income   1,000.00

At the beginning of 2021, the accountant can prepare this reversing entry:

Date
2021
Particulars Debit Credit
Jan 1 Interest Income 1,000.00  
    Interest Receivable   1,000.00

The adjusting entry is simply reversed. What was debited is now credited and what was credited is now debited.

When the ABC Company receives the interest income at the end of February, the accountant will then prepare this journal entry:

Feb 28 Cash 3,000.00  
    Interest Income   3,000.00

Notice that Interest Income is credited for 3,000. Now you might be asking this: Under the concept of accrual, the interest income to be recognized in 2021 should be $2,000. Then why credit $3,000 Interest Income?

Notice also that in the reversing entry at the beginning of the period, Interest Income was already debited for $1,000. So if we combine them ($1,000 debit and 3,000 credit), then we'll end up with $2,000 Interest Income which is the correct amount to be recognized in 2021.

We already said that reversing entries are optional. If the accountant did not make a reversing entry at the beginning of the year, the accountant will have this entry upon collection of the income.

Feb 28 Cash 3,000.00  
    Interest Receivable   1,000.00
    Interest Income   2,000.00

Note: Actually, if you combine the reversing entry and journal entry for collection earlier, you'll come up with that journal entry.

Reversing Entry for Accrued Expense

Example: Suppose that ABC Company and its lessor agrees that ABC will pay rent at the end of January 2021, covering a 3-month period starting November 1, 2020. The entire amount is $6,000.

At the end of December 2020, the accountant properly prepared this adjusting entry for two months worth of rent expense (Nov 1 to Dec 31):

Date
2020
Particulars Debit Credit
Dec 31 Rent Expense 4,000.00  
    Rent Payable   4,000.00

At the beginning of 2021, the accountant can prepare this reversing entry:

Date
2021
Particulars Debit Credit
Jan 1 Rent Payable 4,000.00  
    Rent Expense   4,000.00

Again, notice that the adjusting entry is simply reversed.

When the company pays the entire rent, the accountant will then prepare this journal entry:

Jan 31 Rent Expense 6,000.00  
    Cash   6,000.00

In effect, Rent Expense for 2020 is $2,000 even if the accountant debits $6,000 upon payment. This is because of the reversing entry which includes a credit to Rent Expense for $4,000.

If the accountant did not make a reversing entry at the beginning of the year, the accountant will have this entry upon payment of the rent.

Jan 31 Rent Payable 4,000.00  
    Rent Expense 2,000.00  
    Cash   6,000.00

There you have the first two types of adjusting entries that can be reversed. If you are having trouble understanding the process, don't worry. It requires some time and a little effort for the concepts to sink in. In part 2, we'll take a look at the other two types.

Part 2: Reversing Entries for Unearned Income and Prepaid Expense

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