Reversing entries are an optional procedure which may be carried out at year-end to simplify the recording of certain routine cash receipts and payments in the following period. As the name suggests, a reversing entry is the exact reverse of an adjusting entry. it contains the same account titles and dollar amounts as the related adjusting entry, but the debits and credits are the reverse of those in the adjusting entry and the date is the first day of the next accounting period.
Let us use an example a small company on a five-day work week which pays its employees each Friday. Assume that the payroll is $600 per day or $3,000 for a five-day week. Throughout the year, a company employee makes a journal entry each Friday as follows:
Next, let us assume that December 31, the last working day of Year 1, falls on Wednesday. All expenses of the year must be recorded before the accounts are closed and financial statements prepared at December 31. Therefore, an adjusting entry must be made to record the salaries expense and the related liability to employees for the three days they have worked since the last payday. The adjusting entry for $1,800 (computed as 3 x $600 daily salary expense) is shown below:
To record salaries expense and the related liability to employees for last three days worked In December.
The closing of the accounts on December 31 will reduce the Salaries Expense account to zero, but the liability account, Salaries Payable will remain open with its $1,800 credit balance at the beginning of the new year. On the next related payday Friday, January 2, a employee can record the $3,000 payroll by a debit of $1,800 to Salaries Payable a debit o $ 1,200 to Salaries Expense, and a credit of $3,000 to Cash. However, splitting the debit side of the entry in this manner ($1,800 to the liability count and $1,200 to expense) requires more understanding and alertness from company personnel than if the entry were identical with the other payroll entries made during the year.
By making a reversing entry as of the first day of the new account period, we can simplify the recording of routine transactions and avoid the need for the company’s accounting staff to refer to prior adjusting entry for guidance. The reversing entry for the $1,800 year-end accrual of salaries would be dated January 1, Year 2, and would probably be made the direction of the accountant responsible for the year-end closing of the accounts and preparation of financial statements. The entry would be as follows:
This reversing entry closes the Salaries Payable account by transferring the $1,800 liability to the credit side of the Salaries Expense account. Thus the Salaries Expense account begins the new year with an abnormal credit balance of $1,800. On Friday, January 2, the normal payroll entry for $3,000 will be made to the same accounts as on every other Friday during the year.
After this January 2 entry has been posted, the ledger account for Salaries Expense will, show a debit balance of $1,200, the result of this $3,000 debit and the $1,800 credit from the reversing entry on January 1. The amount of $1,200 is the correct expense for the two workdays of the new year at $600 a day. The results, of course are exactly the same as if no reversing entry had been used and the company's accounting personnel had split the debit side of the January 2 payroll entry between Salaries Payable and Salaries Expense
The ledger accounts for Salaries Expense and for Salaries Payable illustrate the effects of Posting the adjusting entry and the reversing entry.
Which Adjusting Entries Should Be Reversed?
Even when a company follows a policy of making reversing entries, not all adjusting entries should be reversed. Only those adjustments which create an account receivable or a short-term liability should be reversed. These adjustments will be followed by cash receipts or cash payments within the near future. Reversing these adjusting entries will enable the company’s personnel to record the upcoming cash transactions in a routine manner.
An adjusting entry which apportions an amount recorded in the past should not be reversed. Thus we do not reverse the adjusting entries which apportion recorded costs (such as depreciation) or which record the earning of revenue collected in advance.
In summary, reversing entries may be made for those adjusting entries which record unrecorded expenses or unrecorded revenue. Reversing entries are not made for adjustments which apportion recorded costs or recorded revenue.