Accounting is the study of your business’s financial past. And, as we’ve seen in many Hollywood films, bad things happen when you try to mess with the past.
That’s why it’s an accounting faux pas to delete transactions in your accounting software. Business owners should familiarize themselves with reversing entries, which can clear previously recorded transactions without erasing any financial data.
Overview: What are reversing entries?
Business owners use reversing entries to neutralize journal entries prepared in the previous accounting period. Reversing entries are used in accrual accounting, where revenue and expenses are recorded when earned and incurred and not only when cash is involved.
Accrual-basis businesses, guided by the matching principle, prepare adjusting entries so that revenues and expenses are recognized in the proper period. On the first day of the next accounting period, they may prepare reversing entries that clear the adjusting entries.
Preparing reversing entries is an optional, intermediate step between recording revenue or expenses and having cash enter or leave your business. Many business owners implement reversing entries to reduce the likelihood of double-counting revenue and expenses.
The most common reversing entry is for payroll. First, you record an adjusting entry at the end of the month for wages owed but not yet paid. You record a reversing entry on the first of the new month, clearing the way for the payroll journal entry on payday.
Without the reversing entry, you risk accidentally recording payroll expenses twice — once at the end of the first month and again on payday.
Businesses also use reversing entries to delete erroneously recorded transactions. You can make transposition errors and other mistakes go away with a reversing entry. Reversing entries are a type of journal entry, which is how businesses record transactions.
3 benefits of using reversing entries
Reversing entries are optional, but I’d highly recommend them. Here’s why you should implement reversing entries in your small business accounting system.
1. They reduce the likelihood of accounting errors
Reversing entries, which are generally recorded on the first day of an accounting period, delete adjusting entries from the previous period. They reduce the likelihood of duplicating revenues and expenses and committing other errors.
Say you’re a consultant using the accrual method. You’re waiting on a bill from your independent contractor that you expect to be around $10,000, but you haven’t gotten it in the mail yet. Rather than waiting for the bill, you record a $10,000 expense at the end of the month.
To keep your accounting records clean, you record a reversing entry on the first of the next month that turns your liability back to $0. Then, when the bill comes in for $9,500, you record a new journal entry for $9,500 in consultant fees and accounts payable.
Without a reversing entry, you’d have a $10,000 expense on your books until the bill comes in. You’d then have to do some accounting and arithmetic gymnastics to record the $9,500 invoice accurately.
Imagine how easy it would be to forget that you recorded the $10,000 last month. Absent a reversing entry, you’d wind up showing a $19,500 expense for the contractor’s work, a mistake that’s sometimes hard to catch.
2. They make it easier for multiple bookkeepers
If you have more than one person working with your accounting software, reversing entries can help you avoid errors due to miscommunication.
Reversing entries negate revenue and expense accruals, making it easy to record transactions without having to look back at what someone else has already recorded.
Say you and your spouse share bookkeeping responsibilities. On March 31, you recorded a $2,000 revenue journal entry for a client whose work you completed but haven’t yet billed. You recorded it late at night and didn’t immediately tell your spouse because you have a rule about not talking about work past 6 p.m.
When your spouse sends out invoices on April 3, the accounting software automatically records another $2,000 in accounts receivable for the same client. Without her knowing about it, your company’s revenue is inflated by $2,000.
If your business used reversing entries, you’d have accurate financial statements and one less pain point with your spouse.
3. They create an audit trail for errors
It’s best practice not to delete journal entries, even if there’s a mistake. The best way to correct your accounting records is to record a reversing entry and create a fresh and correct journal entry.
Accounting software automatically numbers all journal entries so that auditors can easily track deletions. Auditors will question accounting records with missing journal entries since they could be a sign of financial malfeasance.
While you might have been well-intentioned in deleting incorrect journal entries, it’s better to lay your cards out to auditors by showing them your erroneous and corrective journal entries.
An example of reversing entries
Timothy owns Tim’s Antiques, a curio shop in Boston. He has two employees who are paid every Monday for the previous week’s work. An accountant in another life, Timothy uses the accrual basis of accounting.
The last day in September falls on a Wednesday. On Sept. 30, Timothy records a payroll accrual to reflect wages owed but not paid for Monday, Tuesday, and Wednesday. Each employee earns $250 per workday.
The adjusting journal entry goes as follows. (For simplicity, I’m ignoring payroll taxes, but you want to include all payroll liabilities here.)
The payroll accrual is $1,500, which accounts for three days of wages for two employees ($250 per workday x 2 employees x 3 days).
On Oct. 1, Timothy records a reversing entry, which flip-flops the debited and credited accounts. The journal entry neutralizes the Sept. 30 journal entry, making it as if it never happened, and Timothy’s salaries payable account goes back to $0.
When payday rolls around on Oct. 5, Timothy records a payroll journal entry for the entire amount he owes his employees, which is $2,500 ($250 per workday x 2 employees x 5 working days).
The Sept. 30 accrual reflected three days of wages, but now he owes the employees for working five days. Since he reversed the accrued wages, the payroll journal entry is for the entire amount paid to employees.
Don’t forget to record reversing entries
Reversing entries can help you manage your accounting records more efficiently. One downside is how easy it is to forget about reversing entries at the beginning of the month. Tie a ribbon around your finger or put a note on your calendar to remind yourself to record reversing entries.
View more information: https://www.fool.com/the-blueprint/reversing-entries/