Why Do You Use Reversing Entries?
To understand the use of reversing entries, you need to understand the accrual method of accounting and adjusting entries. In accrual accounting, adjusting entries are used to record revenues (such as accounts receivable) when they are earned, rather than when the cash is received, and record expenses (expense payable) when they happen rather than when paid. When the revenue is received or expense paid, the reversing entry removes the adjusting receivable or payable entry and records the actual revenue or expense.
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Purpose
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By correctly allocating an expense, adjusting entries ensure the financial statements are correct. Reversing entries are a way to "undo" an adjusting entry, and they tend to simplify record-keeping.
Example
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As an example, assume a company pays employees every two weeks, and one week of the pay cycle falls in January and the other week in February. Because the company's financial statements must show the payroll expense for January, at the end of that month, the company records an adjusting entry with a debit of $10,000 to Payroll Expense and a credit of $10,000 to Payroll Payable. If the payroll for the second week of the pay cycle is $8,000, when the company pays employees the $18,000, the company makes a reversing entry with a debit of $10,000 to Payroll Payable and a credit of $18,000 to Payroll Expense.
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Optional
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The use of reversing entries is optional. The company could record a $10,000 Payroll Expense at the end of January and another $8,000 Payroll Expense when employees are paid. However, this approach can become confusing because someone must track and remember how much of the payroll has already been paid and how much still needs to be paid.
Considerations
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Technically, a reversing entry is a special type of adjusting entry and has two parts: the original adjusting entry and the reverse entry. If a company wants to reduce the number of adjusting and reversing journal entries, expenses need to be paid in the period in which they occur.
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