Understanding Reversing Entries: When and Why to Use Them in Accounting

Reversing entries are a key component of accrual accounting that help streamline the financial reporting process across accounting periods. By cancelling or reversing specific entries made at the end of a period, these entries simplify the bookkeeping process in the new period. This article explores what reversing entries are, when to use them, and the benefits they provide.

What are Reversing Entries?

Reversing entries are accounting journal entries made at the start of a new accounting period to cancel out or reverse certain adjusting entries that were made at the end of the previous period. This approach helps eliminate the need to remember which adjustments need to be made again in the current period, streamlining the bookkeeping process.

When to Use Reversing Entries

Accruals

Reversing entries are commonly used for accrued revenues and expenses. For example, if an expense was accrued at the end of the period, such as wages payable, a reversing entry is made at the start of the new period to negate that accrued entry. This ensures that the actual payment can be recorded simply in the new period without duplicating the expense. An equivalent example would be when you estimate a monthly phone bill and do not receive the detailed bill until the following month. You can post a reversing journal entry in the current month and then in the following month, based on the detailed bill, you can post the actual amounts.

Deferred Revenues

Reversing entries are also used to reverse revenue recognition when a company has received payment for a service not yet performed. For instance, if a company receives payment for a service in advance, the revenue would be deferred until the service is actually performed. At the start of the new period, a reversing entry can be made to cancel out the deferred revenue recognition when the service is provided.

Benefits of Reversing Entries

Simplification

One of the primary benefits of reversing entries is that they help streamline the accounting process in the new period. By reversing certain entries at the start of the new period, accountants can focus on recording new transactions without having to constantly adjust for previous entries.

Accuracy

Reversing entries reduce the risk of errors in recording transactions. By eliminating the need to constantly adjust for previous entries, the accuracy of financial records is improved. This ensures that the financial statements are more reliable and provide a clearer picture of the company's financial performance.

Clarity

Reversing entries make it easier to track current transactions without the confusion of previous adjustments. This clarity helps in better understanding the financial performance of the company during the current period, as the previous adjustments are removed from the account balances, giving a clear snapshot of the financial status.

Example of Reversing Entries

For example, if a company accrued 1,000 in wages at the end of December, a reversing entry would be made on January 1 to cancel that accrued wage expense. When the actual payroll is processed in January, the company would record the wage expense without worrying about the previous accrual. Similarly, in the case of the estimated phone bill, a reversing entry can be posted in the current month and then in the following month, based on the detailed bill, two postings can be made to AP, showing one in each month for clarity and accuracy.

In summary, reversing entries are a valuable tool in accrual accounting that help manage and simplify financial reporting across accounting periods. By understanding when and why to use them, accountants can ensure accurate, streamlined, and clear financial records.