The following are the only types that can be reversed:
1. Adjusting entry for accrued income,
2. Adjusting entry for accrued expense,
3. Adjusting entry for unearned revenue using the income method, and
4. Adjusting entry for prepaid expense using the expense method.
Adjusting entries for unearned revenue under the liability method and for prepaid expense under the asset method are not reversed. Adjusting entries for depreciation, bad debts and other allowances are also not reversed.
Let us illustrate each of the above.
Reversing Entry for Accrued Income
Example: ABC Company is to receive $3,000 interest income at the end of February 2014. It covers 3 months starting December 1, 2013. At the end of 2013, the accountant properly makes an adjusting entry for one month's worth of accrued income.
At the beginning of 2014, the accountant can prepare this reversing entry:
The adjusting entry is simply reversed. Debit what was credited and credit what was debited.
When the ABC Company receives the interest income at the end of February, the accountant will then prepare this journal entry:
Notice that Interest Income is credited for 3,000. Now you might be asking this: Under the concept of accrual, the interest income to be recognized in 2014 should be $2,000. Then why credit $3,000 Interest Income?
Very good. Well, in the reversing entry at the beginning of the period, Interest Income was already debited for $1,000. So if we combine them ($1,000 debit and 3,000 credit), then we'll end up with $2,000 Interest Income which is the correct amount to be recognized in 2014.
We said that reversing entries are optional. If the accountant did not make a reversing entry at the beginning of the year, the accountant will have this entry upon collection of the income.
Reversing Entry for Accrued Expense
Example: ABC Company will pay rent at the end of January 2014, covering a 3-month period starting November 1, 2013. The entire amount is $6,000.
At the end of December 2013, the accountant properly prepares this adjusting entry for two months worth of rent expense (Nov 1 to Dec 31):
At the beginning of 2014, the accountant can prepare this reversing entry:
Again, notice that the adjusting entry is simply reversed.
When the company pays the entire rent, the accountant will then prepare this journal entry:
In effect, Rent Expense for 2014 is $2,000 even if the accountant debits $6,000 upon payment. This is because of the reversing entry which includes a credit to Rent Expense for $4,000.
If the accountant did not make a reversing entry at the beginning of the year, the accountant will have this entry upon payment of the rent.
Adjusting Entries for Unearned Revenue
Unearned revenue (also known as deferred revenue/income) represents revenue already collected but not yet earned.
Hence, they are also called "advances from customers".
It is to be noted that under the accrual concept, income is recognized when earned regardless of when collected.
And so, unearned revenue should not be included as income; rather, it is recorded as a liability. This liability represents an obligation of the company to render services or deliver goods in the future.
At the end of the period, unearned revenues must be checked and adjusted if necessary. The adjusting entry for unearned revenue depends upon the journal entry made when it was initially recorded.
There are two ways of recording unearned revenue: (1) the liability method, and (2) the income method.
Liability Method of Recording Unearned Revenue
Under the liability method, a liability account is recorded when the amount is collected. The common accounts used are: Unearned Revenue, Deferred Income, Advances from Customers, etc. For this illustration, let us use Unearned Revenue.
Suppose on January 10, 2014, ABC Company made $30,000 advanced collections from its customers. If the liability method is used, the entry would be:
Take note that the amount has not yet been earned, thus it is proper to record it as a liability. Now, what if at the end of the month, 20% of the unearned revenue has been rendered? This will require an adjusting entry.
The adjusting entry will include: (1) recognition of income and (2) decrease in the liability initially recorded (since some of it has already been rendered). The adjusting entry would be:
Actually, we are simply separating the earned part from the unearned portion. Of the $30,000 unearned revenue, $6,000 is recognized as income. In the entry above, we are removing the 6,000 from the 30,000 liability. The balance of unearned revenue is now at $24,000 ($30,000 credit and $6,000 debit).
Income Method of Recording Unearned Revenue
Under the income method, the accountant records the entire collection as income. Using the same transaction above, the initial entry for the collection would be:
If at the end of the year the company earned 20% of the entire $30,000, then the adjusting entry would be:
By debiting Service Income for $24,000, we are decreasing the income initially recorded. The balance of Service Income is now $6,000 ($30,000 - 24,000), which is actually the 20% portion already earned. By crediting Unearned Income, we are recording a liability for $24,000.
Notice that the resulting balances of the accounts under the two methods are the same (Cash: $30,000; Service Income: $6,000; and Unearned Income: $24,000).
If you have noticed, what we are actually doing here is making sure that the earned part is included in income and the unearned part into liability. The adjusting entry will always depend upon the method used when the initial entry was made.
Adjusting Entries for Prepaid Expense
Prepaid expenses represent payments made for expenses which are not yet incurred.
In other words, these are "advance payments" by a company for supplies, rent, utilities and others that are still to be consumed.
Expenses are recognized when they are incurred regardless of when paid. Expenses are considered incurred when they are used, consumed, utilized or has expired.
Because prepayments they are not yet incurred, they are not recorded as expenses. Rather, they are classified as current assets.
Prepaid expenses may need to be adjusted at the end of the accounting period. The adjusting entry for prepaid expense depends upon the journal entry made when it was initially recorded.
There are two ways of recording prepayments: (1) the asset method, and (2) the expense method
Asset Method
Under the asset method, a prepaid expense account (an asset account) is recorded when the amount is paid. Prepaid expense accounts include: Office Supplies, Prepaid Rent, Prepaid Insurance, and others.
Example:
GVG Company acquired a six-month insurance coverage for its properties on September 1, 2014 for a total of $6,000.
Under the asset method, the initial entry would be:
Take note that the amount has not yet been incurred, thus it is proper to record it as an asset.
On December 31, 2014, the end of the accounting period, part of the prepaid insurance already has expired (hence, expense is incurred). The expired part is the insurance from September to December. Thus, we should make the following adjusting entry:
Of the total six-month insurance amounting to $6,000 (or $1,000 per month), the insurance for 4 months has already expired. In the entry above, we are actually transferring $4,000 from the asset to the expense account (i.e., from Prepaid Insurance to Insurance Expense).
Expense Method
Under the expense method, the accountant initially records the entire payment as expense. If the expense method was used, the entry would have been:
In this case, we must decrease Insurance Expense by $2,000 because that part has not yet been incurred (not used/not expired). Insurance Expense shall then have a balance of $4,000. The amount removed from the expense shall be transferred to Prepaid Insurance. The adjusting entry would be:
What we are actually doing here is making sure that the incurred (used/expired) portion is included in expense and the unused part into asset. The adjusting entry will always depend upon the method used when the initial entry was made.
