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Reversing entries are crucial adjustments that companies make in every fiscal period. Therefore, it is critical to understand what they are and how they impact accounting.
What are Reversing Entries?
Reversing entries in accounting are adjustments made at the beginning of a new accounting period to counteract the impact of adjusting entries made at the end of the previous period. These adjusting entries, which handle accruals and deferrals, ensure that revenues and expenses get recognized in the correct period. Reversing entries simplify the accounting process by nullifying the effects of these adjustments.
The primary advantage of reversing entries is their ability to streamline accounting procedures. By removing the effects of specific adjusting entries from the prior period, accountants can focus on the new period’s transactions without the complication of considering adjustments made in the previous period. While not all adjusting entries require reversing entries, they are a practical tool to enhance efficiency and accuracy in financial reporting.
How do Reversing Entries work?
Reversing entries operate by simplifying the accounting process and facilitating a smoother transition from one accounting period to the next. Their functionality is grounded in reversing specific adjusting entries made in the previous period. Reversing entries apply to two cases: accruals and deferrals.
In the case of accruals, if the prior period recognized revenue or expenses that were earned or incurred but not yet recorded, a reversing entry is made at the beginning of the new period. This entry effectively cancels out the impact of the accrual, making it easier to record the actual transaction in the next period when it occurs. For instance, if services were rendered but not yet billed, the reversing entry ensures a clean slate for billing and revenue recognition in the current period.
For deferrals, if the previous period involved deferring the recognition of revenue or expenses to a future period, a reversing entry is employed. This entry removes the deferral, allowing the recognition of income or expenses in the new period when they occur. For example, if prepaid expenses were deferred in the prior period, the reversing entry ensures that these expenses are recognized in the current period, aligning with the actual occurrence.
Why do companies need Reversing Entries?
Reversing entries meet the fundamental need to simplify and enhance the accuracy of the accounting process during the transition between accounting periods. Adjusting entries is crucial for correctly recognizing revenues and expenses, but they can create complications when dealing with routine transactions in the new period.
Reversing entries address this by erasing the impact of specific adjustments, providing a clean slate for recording actual transactions in the fresh period. This simplification not only streamlines the accounting workflow but also reduces the risk of errors and misinterpretations that arise from the complexities of adjusting entries from the previous period and new transactions in the current period.
What is an example of a Reversing Entry?
A company, Red Co., estimates its utility expense to be $10,000 for an accounting period. However, the company did not receive a bill for it until after the period. Under accounting principles, Red Co. still records the expense using the following entry.
| Dr | Utility expense | $10,000 |
| Cr | Accrued expenses | $10,000 |
In the next period, Red Co. receives the bill, which is $11,000. Therefore, the company reverses the one recorded in the previous period first using the following entry.
| Dr | Accrued expenses | $10,000 |
| Cr | Utility expense | $10,000 |
Once reversed, Red Co. records the actual expense as follows.
| Dr | Utility expense | $11,000 |
| Cr | Accrued expenses | $11,000 |
Conclusion
Reversing entries are adjustments made in every accounting period to remove the impact of adjusting entries made in the previous one. These entries usually apply in two cases: accruals and deferrals. Companies need reversing entries to comply with the requirements under accounting principles and to maintain accurate financial records.
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