Adjusting Entries and Reversing Entries
Definition
Adjusting entries are the double entries made at the end of each accounting period. Accountants post adjusting entries to correct the trial balance before prepare financial statements. The entries will ensure that the financial statements prepared on an accrual basis in which income and expense are recognized. These transactions aim to correct the income and expense amount that will be included in the Income statement. Another side will impact the balance sheet items.
5 Type of Adjustment
Accrue expense
All expenses must include in the accounting period although they are not yet paid. For example, the accrued expense on payroll, construction contract, and other services. At the end of accounting period, accountants must accrue these transactions base on the occurance.
Accrue revenue
Similar to expense, accountants must record all revenue into financial statements even we not yet receive money or issue invoices to customers. For example, the service company who provide consulting service to client. At year-end, they must estimate the amount of work complete and recognize revenue.
Unearned revenue
In some situations, we receive the cash deposit from our clients, but not yet provide service or goods to them, therefore this balance must be recorded as unearned revenue (Liability). It will be classified to revenue when the service is complete or the goods are delivered.
Prepayment
On the other hand, we may pay cash to our suppliers before using service or receive goods, so these transactions must record into prepayment. It will classify to asset or expense when we receive goods or consume the service.
Non-Cash: depreciation, estimation
Beside of these transactions, we may have some other transaction such as depreciation, amortization, and adjustment of balance sheet items.
Example of Adjusting Entries and Journal Entry
Company A is preparing the annual financial statement for 202X. Accountants have booked all the transactions into their accounting system. However, last month salary is not yet paid, so they prepare adjusting entry for this transaction. Base on prior months, the payroll expense is around $50,000 per month. What should the adjusting entry?
Payroll expense is the operating expense that should record in the month of occurrence. It doesn’t matter whether we pay or not. If we do not record, we will understate operating expenses and liability (amount owed to staff). We can use the best estimation, which is the amount from the prior month if we don’t expect any changes. The variance between accrue and actual expense will adjust to the profit and loss account in next period.
Adjusting Entry for payroll
| Account | Debit | Credit |
|---|---|---|
| Accrue Salary Expense | $ 50,000 | |
| Salary Payable | $ 50,000 |
Example 2
Company B is a consultant company, they usually bill invoices and recognize revenue base on agreement with the client. One month before the year-end, they have started working on one big project amount $ 500,000. On 31 Dec 202X, the project manager estimate that the work done for this project has complete around 20%, however, we can’t bill invoice yet due to the term and condition in agreement. Accountants are looking for the adjusting entries of this transaction.
For accrue basis, both expenses should record in the same accounting period, in this case, the expense mainly the staff salary and admin cost. Revenue mainly from consulting service, it doesn’t correct if we recognize only expense but not revenue. We should record revenue base on work completion 20% which equal to $ 100,000 (20% * $ 500,000).
Adjusting Entries:
| Account | Debit | Credit |
|---|---|---|
| Unbilled Accounts receivable | 100,000 | |
| Accrued Revenue | 100,000 |
Example 3
Company C provides car rental service to customers and they record revenue base on invoice bills on a monthly basis. In Nov 202X, they sign a contract with a customer to rent the car for 2 months from 01 Dec 202X to 31 Jan 202X+1, the fee is $5,000 per month. For some reason, client agrees to pay $10,000 on the signing date. What are the adjusting entries for this transaction on 31 Dec 202X.
First, we can’t recognize the whole amount as revenue because we do not yet provide service to client. It should be recorded as unearned revenue (Liability account). This unearn balance should be reclassed to revenue when we provide service to customer.
Double entries in Nov 202X:
| Account | Debit | Credit |
|---|---|---|
| Cash | $ 10,000 | |
| Unearned Revenue | $ 10,000 |
Second, we need to recognize after the service is completed. However, due to the year-end, we need to split it into two.
Adjust Entries on 31 Dec 202x:
| Account | Debit | Credit |
|---|---|---|
| Unearned Revenue | $ 5,000 | |
| Revenue | $ 5,000 |
Example 4
In order to receive a discount from internet service provider, Company D pays the annual fee of $ 2,000 which covers from 01 June 202X to 31 May 202X+1. The accountant is preparing the adjustment at year-end to correct this balance.
First, we can’t recognize the whole amount as expense cost we not yet consume the service yet, so we should record as prepayment (Asset account).
Entries in June:
| Account | Debit | Credit |
|---|---|---|
| Prepayment | $ 2,000 | |
| Cash | $ 2,000 |
Second, prepayment will be reclassed to internet expenses after the service is consumed. We assume the accountant not yet reclass this prepayment at all. We reclass prepayment to expenses from Jun-Dec 202X ($ 2,000/12 * 7 months)
Adjusting entries on 31 Dec 202X:
| Account | Debit | Credit |
|---|---|---|
| Internet Expense | $ 1,166 | |
| Prepayment | $ 1,166 |
Note: in real practice, we can reclass the prepayment to expense on a monthly basis ($ 2,000 /12 = $ 166 per month) which will be more accurate for monthly reports.
Example 5
Base on the calculation, the depreciation expense for company E:
| Class of fixed asset | Amount |
|---|---|
| Deprecation of Computer equipment | 3,000 |
| Depreciation of Machinery | 8,000 |
| Depreciation of Building | 5,000 |
What should be the adjusting entries for deprecation?
Adjusting entries of Depreciation:
| Account | Debit | Credit |
|---|---|---|
| Depreciation expense_Computer Equipment | $ 3,000 | |
| Depreciation expense_Machinery | $ 8,000 | |
| Depreciation expense_Building | $ 5,000 | |
| Accumulated Depreciation_Computer Equipment | $ 3,000 | |
| Accumulated Depreciation_Machinery | $ 8,000 | |
| Accumulated Depreciation_Building | $ 5,000 |
Risk of Adjusting Entries
Most of the bookkeeping software such as QuickBooks have a module to record revenue, expense and other routine transaction. However, the adjusting entries require accountants to manually selected chart accounts before posting into the system. If accountants do not understand the nature of transactions, it is highly likely to select the wrong accounts and it will impact financial statements.
Therefore, all the adjusting entries must be reviewed by the management teams such as accounting manager or finance manager. The person who approves these kinds of transaction must know the impact and know what he is doing.
Adjusting Entries and Reversing Entries
Reversing entries are the entries post at the beginning of the accounting period which aims to eliminate the accrue adjusting entries which we made at the end of prior accounting period. Without reversing entries, the accountant is highly likely to make a double posting for the same transaction.
At the beginning of new accounting period, accountant reverses all adjusting entries which record at the end of previous period. And subsequently, they just record transactions normally, it prevents any confusion regarding double booking.
However, reverse entries are not compulsory. If accountant does not reverse the transactions, he must be aware of the accrue amount and nature of the transaction. And when the transaction actually happens, he records only the different amount.
Example fo Reversing Entries
Company ABC is using a consulting service from one accounting firm which starts during December and expects to finish in early February next year.
On 31 December, the company needs to prepare a financial statement, they decide to accrue $ 5,000 for a professional service. They record below adjust entries:
| Account | Debit | Credit |
|---|---|---|
| Consulting Service Expense | $ 5,000 | |
| Accounts Payable | $ 5,000 |
On 01 February, the supplier issue an invoice of $ 6,000, which is higher than our estimation.
Use Reversing Entries
If accountants using reversing entry, they should record two transactions.
- Reversing entries on 01 January
| Account | Debit | Credit |
|---|---|---|
| Accounts Payable | $ 5,000 | |
| Consulting Service | $ 5,000 |
- Journal Entry for the whole amount on 01 February
| Account | Debit | Credit |
|---|---|---|
| Consulting Service | 6,000 | |
| Accounts Payable | 6,000 |
Without using Reversing Entries
The accountant will not record the reverse entry. They just wait for the final invoice from the supplier and record the different amounts only.
| Account | Debit | Credit |
|---|---|---|
| Consulting Service | 1,000 | |
| Accounts Payable | 1,000 |
Accountants must record only $ 1,000 as they already accrue $ 5,000 in the prior year. If they record the full amount, the total expense will be double.