What are reversing journal entries?

2. Example of reversing entries for expenses

Letís see how adjusting and reversing entries work together by looking at an example of accruing and reversing expenses. Suppose Company ABC (fictitious entity) has September month end coming up. The company pays rent amounting to $3,000 on the 10th of each month. The rent period goes from the 11th of the prior month to the 10th of the current month. For example, the company will pay rent on October 10th for the period from September 11th to October 10th.

The company uses accrual basis of accounting.

If the company does not post an adjusting entry at the end of September to record a pro-rated amount of rent, its financial statements will be missing some expense. So, the company records the pro-rated rent (from September 11th to September 30th, or 2/3 of the monthly rent) as an adjusting entry.† On October 10th the company pays the entire monthly rent amount and records it as an expense. So, without reversing entries the company will have rent expense from September 11th to September 30th recorded twice: (1) when the adjusting entry was recorded at the end of September and (2) when the company paid the full monthly rent and recorded it as an expense on October 10th. To eliminate the impact of this double-recording, the company can post a reversing entry on October 1st which will eliminate the impact of September end adjusting entry on October financial statements.

Letís see how this is done with journal entries and how that impacts financial statements.

1) At the end of September the company records an adjusting entry for the pro-rated rent. The amount for the entry is $2,000:

September 11th-30th Rent Expense = $3,000 x (2 ų 3)

Account Titles

Debit

Credit

Rent Expense

$2,000

 

      Accrued Rent Expense

 

$2,000

2) On October 1st the company posts a reversing entry which is opposite to the entry posted at the end of September:

Account Titles

Debit

Credit

Accrued Rent Expense

$2,000

 

      Rent Expense

 

$2,000

3) On October 10th the company pays the monthly rent to the landlord and records the payment as a rent expense:

Account Titles

Debit

Credit

Rent Expense

$3,000

 

      Accounts Payable (or Cash)

 

$3,000

The result of these journal entries for rent related general ledger accounts will be as follows:

 

September

October

Accrued Rent Expense
Balance Sheet Account

$2,000

$0

Rent Expense
Income Statement Account

$2,000

$1,000*

(*) Rent expense for October was calculated as $3,000 paid on October 10th less the $2,000 reversing entry posted on October 1st.

As we can see, the financial statements include the correct amounts of rent expense. For September, the rent period was 20 days or 2/3 of the entire month and the expense was $2,000. For October, the rent period was 10 days or 1/3 of the entire month and the expense was $1,000. This way of recording rent expense is in accordance with the matching principle.

Now, if you think about this example further, on October 31st the company will once again record an adjusting entry for $2,000. So, in total October financial statements will have $3,000 (i.e., $1,000 + $2,000) of rent expense which is what it should be.

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