ANALYZE THIS, ANALYZE THAT: A REVERSING ENTRY CASE

ANALYZE THIS, ANALYZE THAT: A REVERSING ENTRY CASE Ting Jie (TJ) Wang, Ph.D. Associate Professor of Accounting College of Business Governors State University Phone: 708-534-4965 / Fax: 708-534-8457 1 University Parkway University Park, Illinois 60484 twang@govst.edu Xinghua Gao, Ph.D. Assistant Professor of Accounting College of Business Governors State University Phone: 708-235-7624 / Fax: 708-534-8457 1 University Parkway University Park, Illinois 60484 Email: xgao@govst.edu Jun Zhan, Ph.D. Assistant Professor of Accounting David Nazarian College of Business and Economics Department of Accounting and Information Systems California State University, Northridge Phone: 818-677-4505 18111 Nordhoff Street Northridge, CA 91330 Email: jun.zhan@csun.edu Corresponding author. 1

ANALYZE THIS, ANALYZE THAT: A REVERSING ENTRY CASE INTRODUCTION Analytical and problem solving skills are essential for not only forensic accountants but also traditional accountants (Davis, Farrel, and Ogilby 2014). The American Institute of Certified Public Accountants (AICPA) will in its tests increase focus on higher-order cognitive skills starting April 1, 2017. Those skills include, but are not limited to, analytical ability, critical thinking, problem solving, and professional skepticism, due to ongoing changes in the business world and impacts on the accounting profession from advancements in technology (AICPA, 2015). It is therefore important and imperative for accounting educators to cultivate an interest in learning among students, and grow their ability in analysis and problem-solving. The AICPA will adopt the modified Bloom s Taxonomy of Educational Objectives in constructing its new tests in 2017. Based on the modified Bloom s Taxonomy, there are four categories of skill levels, namely, Remembering & Understanding, Application, Analysis, and Evaluation. Currently, the AICPA incorporates Remembering & Understanding and Application equally in each of its four sections of the CPA exam auditing and attestation (AUD), business environment and concepts (BEC), financial accounting and reporting (FAR), and regulation (REG). In 2017, the AICPA will include 15~25% of analysis and 5~15% of evaluation in AUD, 20~30% of analysis in BEC, 25~35% of analysis in FAR, and 25~35% of analysis in REG, according to its new blueprints (AICPA, 2015). Based on its new blueprints, the AICPA includes the following key words (or verbs) in the representative task: (1) identify, recognize, understand, explain, define, summarize, and recall (Remembering & Understanding), (2) apply, perform, document, prepare, use, calculate, inquire, test, assist, describe, conduct, measure, determine, and adjust (Application), (3) develop, analyze, compare, detect, interpret, reconcile, investigate, review, and derive (Analysis), and (4) conclude, evaluate, observe, and verify (Evaluation). This paper presents a case that can be used to enhance accounting students analytical and problem solving skills. This case focuses on reversing entries and requires students to identify and define the types/characteristics of year-end adjustments that are applicable and suitable for reversing entries through deductive and inductive reasoning. By going through these two approaches in finding the solution for this case, students will be exposed to fundamental concepts in accounting at a different level, such as accruals and deferrals, year-end adjusting entries, the process of closing, and changes of account balances at different stages of the accounting cycle. Students need to integrate these concepts, understand their relationships, and observe patterns of transactions along the process, in order to arrive at the solution. Students will be going through all four levels of higher-order cognitive skills in this case, namely, Remembering & Understanding, Application, Analysis, and Evaluation. Although reversing entries may be discussed in introductory and/or intermediate accounting courses, this case will be best implemented in senior or graduate/master level of accounting courses subsequent to students mastery of accruals and deferrals involved in year-end adjustments. However, educators are encouraged to apply this case in any way they think may fit. 2

We structure the case into three steps: Step 1-understanding reversing entries (remembering & understanding); Step 2-applying deductive reasoning (remembering & understanding, apply, and analysis); and Step 3-applying inductive reasoning (apply, analysis, and evaluate). In Step 1, we help students understand the process of year-end adjusting entries and closing, and application procedure of reversing entries. In Step 2, we help students understand different types of year-end adjusting entries and applicability of reversing entries by requiring them to apply their understanding of reversing entries acquired from Step 1. In Step 3, we require students to identify and define the types of year-end adjusting entries that are applicable and suitable for reversing entries by deriving patterns of entries based on their observations of the work obtained from Step 2. We strongly urge that educators instruct and guide students through each one of the steps. We compose the case below in such a way so that educators can easily adopt the materials in their classroom. In addition, we share some teaching notes to educators at the end of the paper. STEP 1: UNDERSTANDING REVERSING ENTRIES This case requires students to identify and define the types/characteristics of year-end journal entries which can be used as reversing entries. In order to find the solution for this case, students first need to understand the purpose of a reversing entry and how it works. Therefore, in the first step we help students review the process of year-end adjusting entries and understand the application of reversing entries. We adopt a common textbook example below to demonstrate how a reversing entry works. Educators can add additional materials as needed. Purpose of Reversing Entries The purpose of reversing entries, as indicated in the textbooks, is to ease the process of recording for some of the routinely occurred transactions that are involved in year-end adjusting entries as if these adjusting entries had not taken place or as if the fiscal year-end had not occurred (Kieso, Weygandt, and Warfield 2013; Scott 2013; Walther 2000, and Weygandt, Kimmel and Kieso 2014). Figure 1 illustrates a commonly adopted example from the textbooks, i.e., payroll transaction. In the example, the company processes and records its payroll on the fifteenth of each month. The illustration shows that a routinely occurred monthly payroll transaction involves a debit to Wages and a credit to with a monthly incurred payroll amount (e.g., $10K for the month of May 15 June 14 paid on June 15, $12K for November 15 December 14 paid on December 15, and $11K for December 15 January 14 paid on January 15). Since the fiscal year-end of the company is on December 31, 2014, the company accrues its payroll from December 15 to December 31 in its year-end adjustments by debiting to Wages and crediting to Wages Payable for $5K. The Wages account will be closed out in the closing process at the year-end (i.e., to a zero balance in the account), leaving a credit balance in the amount of $5K in the Wages Payable account before the beginning of the next fiscal year, a new accounting cycle, assuming this is their first year of operations (i.e., there is no prior balance in the account). Without making a reversing entry, the company will have Wages 3

Payable and Wages accounts overstated in the system after they process and record their payroll on January 15 until the year end in 2015 when they prepare and record year-end adjusting entries, if they record the payroll transaction in the same way as in 2014. The company needs to take into account the overstatements in these two accounts and the accrued payroll from December 15 to December 31, instead of just the latter, when they make year-end adjustments in the second year in 2015. The company may make an adjustment to the recording of the payroll on January 15, 2015, if they are able to, instead of just following their routine payroll entries, to offset the overstatements in Wages Payable and Wages accounts. For example, they can debit Wages for $6K and Wages Payable for $5K, and credit for $11K. This way, the overstatements in Wages Payable and Wages are offset in the recurring transaction, and the ending adjusting entry for the second year will follow the same routine; that is, to accrue for the payroll from December 15 to December 31, 2015. It will be more efficient and effective for the company to adopt the reversing entry process right after they close the book and begin another new accounting cycle, especially when the recording of payroll entries and year-end adjustments are performed by two different departments/employees (i.e., making an adjustment to the payroll entry on January 15, 2015 is not realistic). When the reversing entry procedure is followed, the overstatement in Wages Payable will be offset and a reduction in Wages equal to the amount that was accrued in the year-end adjustment previously will be entered into the book at the beginning of a new cycle. The Wages account will end up with a correct amount equal to the wages accrued from January 1 to January 14 when the payroll transaction is recorded as usual on January 15, 2015 (Figure 1). In addition, in the year-end adjustments of the second year, the company only needs to accrue for the payroll that is accrued between their last payroll transaction and the end of the fiscal year as they have done in 2014. They do not need to deal with any overstatements from the beginning of the year in their year-end adjustments as indicated previously. As a result, it is efficient and effective when we follow the procedure of recording reversing entries depicted in this example. Based on the illustration in Figure 1, we can help students recognize two necessary conditions when reversing entries are applicable and suitable: (1) the recording of the repeating/recurring entry stays the same way as previously, and (2) the recording of the fiscal year-end adjusting entry in the subsequent year stays the same way as previously as well. Both conditions are required if a reversing entry is to be applicable. STEP 2: APPLYING DEDUCTIVE REASONING (ANALYZE THIS) Only year-end adjusting entries are subject to reversing entries, but not all of them are applicable and suitable for reversing entries. In order to identify and define types/characteristics of these year-end adjusting entries that are applicable for reversing entries, students need to understand all types of year-end adjusting entries to begin with. Thus, in this step we require students to get familiar with all types of year-end adjusting entries by following a deductive reasoning approach. That is, we work from a general rule (applicability of reversing entries from 4

Step 1) to a more specific knowledge/situation (several year-end adjusting entries, e.g., supplies, A/R, etc.). We will help students review the year-end adjusting entries first. Types of Year-End Adjusting Entries Basically, there are seven possible types of year-end adjusting entries as follows: 1) Accrued (recognition before cash flows): In a simple form, it means that revenue is recognized before cash is received. s such as interests, rental, etc. are examples of accounts that will be accrued in the yearend adjustments. 2) Accrued (recognition before cash flows): In a simple form, it means that expense is recognized before cash is paid. s such as interests, rental, utilities, payroll, etc. are examples of accounts that will be accrued in the year-end adjustments. 3) Deferred (recognition after cash flows): In a simple form, it means that cash for a revenue account is received before the company performs and completes the revenue event (e.g., delivering the products or providing the services). Deposits/advances from customers or tenants are examples of revenues that will be deferred in the year-end adjustments. 4) Deferred (recognition after cash flows): In a simple form, it means that cash for an expense is paid before the company uses it. Deposits or prepayments made by the company to utility/insurance companies or landlords are examples of expenses that will be deferred in the year-end adjustments. 5) Changes in Estimates/ Valuation Adjustments/Expirations: There are estimates used for fixed and other assets (e.g., number of useful years, salvage value, etc.). The company may change estimates on the recording of depreciation, amortization, and depletion, as well as accounts receivable/bad debt. There are also asset valuation adjustments (Baskerville 2011) made to reflect values of assets according to GAAP (e.g., supplies, accounts receivable, inventory, fair value reporting). In addition, there are expirations on certain assets and liabilities (FinanceReading.com), such as expirations on unearned revenues, prepaid insurance/rent, depreciation on assets, etc. All the changes/adjustments/expirations will result in year-end adjustments. These definitions may be overlapping and are not mutually exclusive. 6) Changes in Principle: The company may want to change its way of recording inventory (e.g., average cost to LIFO) and/or revenues from long-term contracts (e.g., completed-contract to percentage-of-completion). Thus the company needs to make an adjusting entry at the year-end. 7) Corrections of Errors The company also needs to correct any errors in reporting in its year-end adjustments. 5

Table I shows a sample list of adjusting entries that accounting students learned from intermediate accounting courses. Along with each account (column A), recurring entry (column B), and year-end adjustment (column C), Table I also provides rationale (column D), type of adjustments (column E), and applicability of a reversing entry (column F). Students will first apply their general understanding of reversing entries to these year-end adjusting entries by filling out columns B-F. Table I contains suggested answers from the authors. Educators will need to decide on how much to reveal to students. Students need to come up with the recurring entries, year-end adjusting entries, rationale for year-end adjustments, type of each year-end adjusting entry, and applicability of reversing entries. Students should be encouraged to create work as shown in Figure 1 for each year-end adjustment. STEP 3: APPLYING INDUCTIVE REASONING (ANALYZE THAT) As of the end of Step 2, students should have a comprehensive understanding of the concepts such as accruals and deferrals, types of adjusting entries, the processes of year-end adjusting entries and closing, and application of reversing entries. However, students may not be able to come up with the types/characteristics of year-end adjusting entries for reversing entries yet, i.e., the solution of the case, even though they have recognized some entries that are applicable and others that are not applicable in Table I from Step 2. Therefore, students will work from specific observations to a broader generalization and theory in this step, that is, apply inductive reasoning. We will ask students to apply definitions of reversing entries from the textbooks to their work in Table I. Table II provides a list of definitions for reversing entries from the textbooks. Educators should remind students that definitions from textbooks may not be completely applicable, and that they need to know the reasons why these definitions are and are not applicable. We will then require students to come up with their own definition for the application of reversing entry by summarizing their observations of the patterns of transactions from sample transactions in Table I. Students may detect and derive patterns such as the frequency and type of recurring entry, the basis of its recurring, the frequency of recurring, types of year-end adjusting entries, whether cash flow is involved, etc., along with the applicability of reversing entry. Appendix H shows an example of patterns in which observations can be gathered together based on (1) if reversing entry is applicable and (2) type of adjusting entry. Students may point out different patterns/categories and gather things differently, which is perfectly alright. Students need to find a solution for the case. They should be motivated to create a list of conditions/findings based on their analysis from Steps 2 and 3. They should also be encouraged to discuss and debate with others about their findings. Educators can use the list of findings that we provide here to guide students. 6

CONCLUDING REMARKS The accounting profession has called for more high-order cognitive skills on its workforces due to ongoing changes in the business world and advancements in technology. As a result, the AICPA will be incorporating more questions requiring high-order skills in it examination in 2017. This case focuses more on advanced tasks involving high-order skills such as application, analysis, and evaluation. It will help students develop high-order skills and give them an opportunity to integrate their knowledge of the accounting cycle. Recording reversing entries is an optional procedure in the accounting cycle. Yet we believe this procedure has non-trivial educational values to accounting students due to its close relationship with year-end adjusting entries. By going through two different analyses, i.e., deductive and inductive reasoning, in order to identify and define the types/characteristics of year-end adjusting entries for reversing entries, students will get a chance to improve their analytical and problem-solving skills along with the opportunity to integrate their understanding of the concepts of accruals and deferrals, types of adjusting entries, the processes of year-end adjusting entries and closing, and application of reversing entries. The optimal timing for covering the case will be at the topic of accounting changes and errors in an intermediate accounting course or at a master-level financial accounting course. A team project will also be ideal because it provides a cooperative learning environment to students. We took a survey from a small group of graduate accounting students after administering the case and found that 39 percent of the correspondents regard this case easy to follow, 61 percent indicate they enjoy doing this exercise, and 93 percent believe this exercise strengthens their understanding of accounting concepts. We share our experience and provide tasks and objectives of each step in the Teaching Notes below. 7

TEACHING NOTES The following are some suggestions for implementing this case in the classroom. We will go over them step by step and then provide suggested solution for the case. STEP 1: Understanding Reversing Entries Higher-Order Skills Involved Remembering & Understand Recall Recognize Understanding In this step, students will understand the purpose of reversing entries and how it is applicable. Students should realize that two conditions must exist when revering entries are applicable and suitable, such as (1) the recording of the repeating/recurring entry stays the same way as previously recorded and (2) the recording of the fiscal year-end adjusting entry in the subsequent year stays the same way as previously recorded as well. The objective for this step is: to help students remember and understand how reversing entries work in the wages example (Figure 1), which involves with the following: 1. recalling and understanding how a payroll transaction is recorded, 2. recalling and understanding how the year-end adjusting entry works for the wages example, 3. recalling and understanding how the year-end closing works for the wages example, and 4. recognizing the two conditions determining whether reversing entries are applicable or not in the wages example. STEP 2: Applying Deductive Reasoning (Analyze This) Higher-Order Skills Involved Evaluation Verify Analysis Detect Determine Application Apply Perform Remembering and Understanding Understand Recall Recognize In this step, students will enhance their understanding of reversing entries by applying their knowledge of reversing entries obtained from Step 1 to several year-end adjusting entries which they have acquired from previous courses. Instructors can provide a few initial/recurring entries to students in order to help them start the project. Instructors can demonstrate that there may be different ways to record initial/recurring entries, e.g., capitalize versus expense, and different estimation methods for the year-end adjustments, e.g., Income Statement versus Balance Sheet. As a result, students may come up with different year-end adjusting entries, rationales, types of adjustment, and/or applicability of reversing entry. Students may or may not remember what/how year-end adjustments should be made, but instructors may provide hints or reveal more examples. In order to enhance their understanding of the concepts of accruals and deferrals, students need to be reminded to follow the classifications of types of year-end adjusting entries, i.e., Accrued, 8

Accrued, Deferred, Deferred, etc. Students may need to be aware of possible overlapping classifications. Students do not have to create diagrams exactly like those shown in the figures in this case. They should be encouraged to create their own diagrams or tables. They should be required to demonstrate/document on how they come up with their decisions, i.e. their reasoning. The objective of this step is to provide students an opportunity to apply their understanding of the applicability of reversing entries acquired previously to several other accounts, which involves with the following: 1. understanding different types of year-end adjusting entries, such as accruals and deferrals, etc. 2. recalling a recurring entry for each account, and its related year-end adjusting entry (Table I), 3. recognizing its rationale for the adjustment and type of year-end adjustment made previously (Table I), 4. performing and documenting their work as shown in the figures in the paper for each account, 5. detecting and determining if a reversing entry is applicable or not under each account, and 6. verifying their work in terms of the decision they made in the previous task above in 4. STEP 3: Applying Inductive Reasoning (Analyze That) Higher-Order Skills Involved Evaluation Observe Evaluate Conclude Analysis Develop Analyze Compare Application Apply In this step, students will have an opportunity to enhance their high-order skills, such as application, analysis and evaluation. Students will first apply definitions of reversing entries from textbooks (and may need to reconcile for the differences), and then develop a way for comparison and evaluation of their work before they can make a conclusion. The objective of this step is to give students an opportunity to first integrate their understanding of reversing entry within the accounting cycle and then develop high-order skills, which involves the following: 1. applying and reconciling the definitions of reversing entry from the textbooks to their work in Table I, 2. observing the patterns of their work from diagrams and Table I and developing a way to organize them for comparison below, 3. comparing and analyzing the patterns from the above, and 4. concluding the findings based on their work above. Suggested Solution-Applicability of Reversing Entry Based on their observations from Step 3, students may conclude that reversing entries are applicable when the year-end adjustments are accrued revenues and accrued expenses, i.e., Type 1 and Type 2 adjustments (Notes Receivable, Notes Payable, Utilities, and Wages). Students may also conclude that reversing entries under certain circumstances will be applicable for deferred revenues and deferred expenses, i.e., Type 3 and Type 4 adjustments, especially when the recurring entries of the related yearend adjustments involve revenue/expense account (Unearned, Supplies, and Prepayment). 9

Students should be encouraged to look into the reasons and circumstances of the applicability of reversing entries. In sum, reversing entries will be applicable and suitable for those year-end adjustments which interrupt the recognition cycle of the revenue or expense recorded at recurring entries. If the company records, in recurring entries before the fiscal year-end, revenue after its earning process (i.e., earned) when they received cash or expense after its consumption when they paid, applying reversing entries will undo the interruption on the recognition cycle from the year-end adjustments, such as accrued revenues and accrued expenses. If the company records, in recurring entries before the fiscal year-end, revenue before the completion of its earning process or expense before it fully uses up the service/resource, applying reversing entries will also undo the interruption on the recognition cycle from the year-end adjustments such as deferred revenue and deferred expense. However, if the company records asset/liability in the recurring entry, i.e., capitalization method, for deferred revenues or deferred expenses, the year-end adjustments will complete the recognition cycle for the revenue or expense. As a result, reversing entries are not applicable because applying reversing entries in these cases will undo the recognition cycle of revenues and expenses from the previous period. 10

FIGURE 1. An Illustration of the Purpose of Reversing Entries 6/15/14** 12/15/14** $5K 12/31/14 $6K 1/15/15** 12/15/15** $4K 12/31/15 Wages Exp. $10K $10K Year-End Adjusting Entry Wages Exp. $12K $12K Wages Exp. $5K Wages Pay. $5K With Reversing Entry Wages Pay. $5K (-0-) Wages Exp. $5K (Cr $5K) Wages Exp. $11K (Dr $6K) $11K Wages Exp. $4K Wages Pay. $4K (Cr $4K) Without Reversing Entry OR Wages Exp. $6K (Dr $6K) Wages Pay. 5K (-0-) $11K Wages Exp. $11K (Dr $11K) $11K Wages Exp. $4K Wages Pay. $4K (Cr $4K) Wages Pay. $1K (Cr $4K) Wages Exp. $1K Notes: Accrued, a Type 2 adjustment. **Recurring event is likely to occur more than once a year with debiting to Wages and crediting to. Year-end adjusting entry accrues wages expense/payable from the very last payroll date in that year, i.e., 12/15. Parentheses following the account indicate the net balance of the account after the recording of the transaction. 11

(A) Account Supplies Accounts Receivable Notes Receivable Prepayment PPE Liabilities Interests on Bonds Issued Notes Payable Utilities Wages (B) Recurring Entry Supplies (Capitalize) Supplies () A/R Sales A/R Sales Interest Prepaid Rent/Ins (Capitalize) Rent/Ins () Fixed Unearned Sales Interest (Bond Discount/Premium) Interest Utilities Wage Table I. Applicability of Reversing Entries with Sample Transactions (C) Year-End Adjustment Supplies Supplies Supplies Supplies Bad Debt (I/S Approach) Allow. for Doubtful Accts Bad Debt Allow. for Doubtful Accts (B/S) Interest Receivable Interest Rent/Insurance Prepaid Rent/Insurance Prepaid Rent/Insurance Rent/Insurance Depreciation Accumulated Depreciation Unearned Sales Unearned Interest (Bond Discount/Premium) Interest Payable Interest Interest Payable Utilities Utilities Payable Wages Wages Payable 12 (D) Rationale for YE Adjustments Recognized used supplies & adjusted for unused supplies Recognized bad debt & adjusted for Net A/R Recognized interest receivable & revenue Recognized expired/used & adjusted for unexpired/unused prepayment Recognized estimated depreciation on asset Recognized earned & adjusted for unearned revenue Recognized interest expense Recognized interest expense Recognized usage of utilities Recognized wages expense (E) Type of Adjustment (4) Deferred (4) Deferred (5) Changes In Estimates/ Value Adjustment (1) Accrue (4) Deferred or (5) Expirations (4) Deferred or (5) Expirations (F) Applicability No (App. B.I) Yes (App. B.II) No (App. C.I) Yes (App. C.II) Yes (App. D) No (App. E.I) Yes (App. E.II) (5) Expirations No (3) Deferred or (5) Expirations (3) Deferred or (5) Expirations (2) Accrued (2) Accrued (2) Accrued (2) Accrued No (App. F.I) Yes (App. F.II) Yes (App. G) Yes ( See Figure 1) Yes (See Figure 1) Yes (Figure 1)

Table II. Purpose and Definition of Reversing Entries from Textbooks Authors Purpose of Reversing Entries Definition of Reversing Entries To simplify the recording of transactions in the next accounting period. Kieso, Weygandt, and Warfield, 2013 (Page 126) Scott, 2013 (Page 627) Walther (Chapter 4) Weygandt, Kimmel, and Kieso, 2014 (Page 192) To record routine transactions in the usual manner. To simplify the accounting process. To simplify subsequent transaction related to an adjusting entry. All accruals should be reversed. All deferrals (initial entry to revenues/expenses) should be reversed. Adjusting entries like depreciation and bad debt are NOT reversed. If an adjusting entry is to be reversed, it must meet both of the following qualifications: 1. The adjusting entry increases an asset or liability account. 2. The asset or liability account did not have a previous balance. Ordinarily be appropriate for adjusting entries involving the recording of accrued revenues and expenses. Involve future cash flows. Applied to accrued expenses. Applied to accrued revenues. 13

REFERENCES American Institute of Certified Public Accountants. 2015. Exposure Draft: Maintaining the Relevance of the Uniform CPA Examination Baskerville, Peter. http://www.saylor.org/site/wp-content/uploads/2011/12/bus103- ENDOFPERIODADJUSTMENTS.pdf Davis, Charles, Ramona Farrell, and Suzanne Ogilby. 2009. Characteristic and Skills of the Forensic Accountant. American Institute of Certified Public Accountants. Financereading.com, http://financereading.com/types_of_accounting_adjustments.htm. Kieso, Donald E., Jerry J. Weygandt, and Terry D. Warfield. 2013. Intermediate Accounting, 15 th edition, Wiley. Scott, Cathy J. 2013. College Accounting: A Career Approach, 12 th edition, Cengage Learning. Walther, Larry M. 2010. Financial Accounting: Principles of Accounting.com, CreateSpace Independent Publishing Platform. Weygandt, Jerry J., Paul D. Kimmel, and Donald E. Kieso. 2014. Financial Accounting, 9 th edition, Wiley. 14

APPENDIX A Supplement of Sample Year-End Adjusting Entries Supplies (see Appendix B) Appendix B shows two illustrations involving supplies. There are two ways to record supplies, i.e., Capitalization or method. In Appendix B.I, we can see that the original entry is a debit to an asset, i.e., Supplies, following the capitalizing method, and in Appendix B.II a debit to an expense, i.e., Supplies, following the expensing method. Both are Type 4 year-end adjustment Deferred because cash is paid for an expense before the company uses it. In the example, there are $8K of supplies used in 2014 and $2K of supplies left at the end of 12/31/14, and $9K of supplies used in 2015 and $3K left at the end of 12/31/15. Under the capitalization method as shown in Appendix B.I, we will record (1) the purchase of supplies by debiting Supplies and crediting with the amount purchased, and (2) the total use of supplies (i.e., $8K) in 2014 by debiting Supplies and crediting Supplies in the yearend adjustment on 12/31/2014. The Supplies account will be closed in the closing process, leaving $2K of supplies in the Supplies account after the closing. If reversing entries will be applicable and suitable, these two conditions must be met. Otherwise, reversing entries will not be applicable. The diagram in Appendix B.I, i.e., the capitalization method, shows that these two conditions are not met with a reversing entry but they are met without a reversing entry. Although the recording stays the same for the purchase on 5/20/15 as on 6/15/14 with a reversing entry, but the recording for the year-end adjustment on 12/31/15 differs than the one on 12/31/14 since it needs to count for the usage in 2014, the previous year. As a result, reversing entries are not applicable in this case. However, these two conditions are met with a reversing entry when we follow the expense method, as shown in Appendix B.II. Accounts Receivable (see Appendix C) When we record a sale with Accounts Receivable, we accrue the revenue. As collections for these receivables are made, we offset the accrual of revenues. We will then estimate uncollectible in the year-end adjustments. For the purpose of this article, the estimate for the uncollectible will be classified as adjustments to asset value, i.e., a Type 5 adjustment Valuation Adjustment. There are two ways to estimate the uncollectible, i.e., the Income Statement and Balance Sheet method. As shown in Appendix C.I, i.e., the Income Statement approach, we don t need a reversing entry because the two conditions (same recording for the recurring and year-end adjustment) are not met. If we record a reversing entry, it will require an additional calculation for the amount of bad debt expense (i.e., adding the estimates from the previous years). However, we will benefit from the reversing entry procedure when we adopt the Balance Sheet method as shown in Appendix B.II. After we record the reversing entry, i.e., debiting Allowance for Doubtful Account and crediting Bad Debt, we can just record the same year-end adjusting entry for the Allowance with the estimate from the Accounts Receivable on both 12/31/14 and 12/31/15 in the example (assuming the estimate is $3K at the end of 2015), as well as the recurring entry on 5/20/2015. If we don t make a reversing entry, we will need to perform an additional calculation for the Allowance account, i.e., subtract the previous balance in the Allowance account from the current estimate. Notes Receivable (see Appendix D) The adjustment for accruing interests on notes receivable is a Type 1 adjustment Accrued, as shown in Appendix D. The diagram shows that the two conditions are met with a revering entry. We will ease the recording for the interest on notes receivable when we follow the reversing entry procedure. We can record the same entries for the receipt of cash, i.e., the recurring entry, as well as the year-end adjustment, i.e., accruing the interest for the period from the last receipt of payment to the end of the year. However, we will need to make an adjustment to the 15

recurring entry (to Interest Receivable and Interest accounts) when we receive the interest payment if we do not make the reversing entry. Prepayment (see Appendix E) The adjustment for prepayment is a Type 4 adjustment Deferred, as shown in Appendix E. The illustrations show that reversing entries will not be applicable under the Capitalization method but will be applicable under the method. The illustration in Appendix E.I, the Capitalization method, shows that we will need to recognize and adjust for the amount of expired insurance, i.e., Insurance and Prepaid Insurance, in the year-end adjustment regardless of whether we will adopt the reversing entry procedure or not later on. However, in the subsequent year the calculation of the amount of expired insurance will need to go back to the original amount of the prepayment from the previous period if we adopt the reversing entry procedure (i.e., $12K + $12K - $5K in the example). As a result, following a reversing entry in this case will not achieve the two conditions. On the other hand, the illustration in Appendix E.II, i.e., method, shows that we will meet the two conditions when we adopt a reversing entry. In this case, we need to recognize and adjust for the amount of unused insurance, i.e., Prepaid Insurance and Insurance, in the year-end adjustment. By following a reversing entry, we will be recording the recurring entry and year-end adjusting entry the same way for all years. Liabilities (see Appendix F) The adjustment for unearned revenue is a Type 3 adjustment Deferral. There are two ways to record this unearned revenue. We can record the receipt of cash as unearned revenue and then adjust for the amount earned in the year-end adjustment (Appendix F.I) or we can record the receipt of cash as revenue to begin with and then adjust for the amount of unearned in the year-end adjustment (Appendix F.II). The illustrations show that reversing entry will not be applicable when we record the receipt of cash as unearned revenue but will be applicable when we record the receipt of cash as revenue in the recurring entry. Interests on Bonds Issued (see Appendix G) The adjustment for interest expense for bonds is a Type 2 adjustment Accrued. We will be meeting the two conditions when we follow a reversing entry. With a reversing entry, we will record the same entries when we make interest payments on the interest dates and the same entries when we record year-end adjustments. If we do not follow with a reversing entry, however, we will make an adjustment to the entry when we pay the interest on the interest dates. 16

I. Capitalize 6/15/14 $8K Used APPENDIX B An Illustration of Supplies 12/31/14 $9K Used 5/20/15** 12/31/15 Supplies $10K $10K Year-End Adjusting Entry $2K Left $3K Left Supplies Exp. $8K Supplies $8K With Reversing Entry Supplies $8K (Dr $10K) Supplies Exp. $8K (Cr $8K) Supplies $10K (Dr $20K) $10K Supplies Exp. $17K (Dr $9K) Supplies $17K (Dr $3K) II. Without Reversing Entry Supplies $10K (Dr $12K) $10K Supplies Exp. $9K Supplies $9K (Dr $3K) 6/15/14 $8K Used 12/31/14 $9K Used 5/20/15** 12/31/15 Supplies Exp. $10K $10K Year-End Adjusting Entry $2K Left $3K Left Supplies $2K Supplies Exp. $2K With Reversing Entry Supplies Exp. $2K (Dr $2K) Supplies $2K (-0-) Supplies Exp. $10K (Dr $12K) $10K Supplies $3K (Dr $3K) Supplies Exp. $3K (Dr $9K) Notes: Without Reversing Entry Supplies Exp. $10K (Dr $10K) $10K Supplies $1K (Dr $3K) Supplies $1K (Dr $9K) Deferred, a Type 4 adjustment. **Recurring event may or may not occur more than once a year with debiting to Supplies/Supplies and crediting to depending on the method followed. Year-end adjusting entry adjusts Supplies account and reflects the ending balance of the account. Parentheses following the account indicate the related net balance of the account after the recording of the transaction. 17

I. I/S Approach 6/15/14** APPENDIX C An Illustration of Uncollectible of Accounts Receivable 12/31/14 5/20/15** 12/31/15 $2K Estimated $3K Estimated A/R $10K Sales $10K Year-End Adjusting Entry Bad Debt * $2K Allow. For Doubtful Account $2K With Reversing Entries Allow. For Doubtful Account $2K (-0-) Bad Debt $2K (Cr $2K) A/R $10K Sales $10K Bad Debt $5K (Dr $3K) Allow. For Doubtful Account $5K (Cr $5K) Without Reversing Entries A/R $10K Sales $10K Bad Debt $3K (Dr $3K) Allow. For Doubtful Account $3K (Cr $5K) II. B/S Approach *assuming the first year Year-End Adjusting Entry Bad Debt Exp. $2K Allow. For Doubtful Account* $2K With Reversing Entries Allow. For Doubt. Account $2K (-0-) Bad Debt $2K (Cr $2K) A/R $10K Sales $10K Bad Debt $3K (Dr $1K) Allow. For Doubt. Account $3K* (Cr $3K) Notes: Without Reversing Entries A/R $10K Sales $10K Bad Debt $1K (Dr $1K) Allow. For Doubtful Account $1K (Cr $3K) Value Adjustment, a Type 5 adjustment. **Recurring event occurs more than once a year. The ending estimated balance is based on Bad Debt account under I/S Approach and based on Allowance account under B/S Approach. Year-end adjusting entry adjusts Bad Debt and Allowance accounts based on the method followed. Parentheses following the account indicate the related net balance of the account after the recording of the transaction. 18

APPENDIX D 7/01/14 An Illustration of Notes Receivable $1K Earned 12/31/14 7/01/15** $1K Earned 12/31/15 N/R $100K Sales $100K Year-End Adjusting Entry Interest Receivable $1K Interest $1K With Reversing Entry Interest $1K (Dr $1K) Interest Receivable $1K (-0-) $2K Interest $2K (Cr $1K) Interest Receivable $1K (Dr $1K) Interest $1K (Cr $2K) Without Reversing Entry $2K Interest Receivable $1K Interest 1K Interest Receivable $1K Interest $1K Notes: Accrued, a Type 1 adjustment. **Recurring event may or may not occur more than once a year with debiting to and crediting to Interest. Year-end adjusting entry accrues interest receivable/revenue from the very last interest payment date in that year, i.e., 7/01. Parentheses following the account indicate the related net balance of the account after the recording of the transaction. 19

I. Capitalization 8/01/14 APPENDIX E An Illustration of Prepayment $5K Used 12/31/14 $7K used 8/01/15** $5K Used 12/31/15 Prepaid Insurance $12K $12K Year-End Adjusting Entry With Reversing Entries Insurance $5K Prepaid Insurance $5K Prepaid Insurance $5K (Dr $12K) Insurance $5K (Cr $5K) Without Reversing Entries Prepaid Insurance $12K (Dr $24K) $12K Prepaid Insurance $12K (Dr $19K) $12K Insurance $17K (Dr $12K) Prepaid Insurance $17K (Dr $7K) Insurance $12K Prepaid Insurance $12K (Dr $7K) II. 8/01/14 $5K Used 12/31/14 $7K used 8/01/15** $5K Used 12/31/15 $7K Left $7K Left Insurance $12K $12K Year-End Adjusting Entry With Reversing Entries Prepaid Insurance $7K Insurance $7K Insurance $7K (Dr $7K) Prepaid Insurance $7K (-0-) Insurance $12K (Dr $19K) $12K Prepaid Insurance $7K (Dr $7K) Insurance $7K (Dr $12K) Notes: Without Reversing Entries Insurance $12K (Dr $12K) $12K Deferred, a Type 4 adjustment. **Recurring event may or may not occur more than once a year with debiting to Prepayment and crediting to. Year-end adjusting entry adjusts Prepayment account and reflects the ending balance of the account. Parentheses following the account indicate the related net balance of the account after the recording of the transaction. Prepaid Insurance $0K Insurance $0K (Dr $12K) 20

I. 8/01/14 APPENDIX F An Illustration of Unearned $5K Earned 12/31/14 $19K Earned 3/31/15** $15K Earned 12/31/15 $24K Unearned $24K Year-End Adjusting Entry Unearned $5K $5K With Reversing Entries $5K (Dr $5K) Unearned $5K (Cr $24K) $20K Unearned $20K (Cr $44K) Unearned $39K (Cr $5K) $39K (Cr $34K) Without Reversing Entries $20K Unearned $20K (Cr $39K) Unearned $34K (Cr $5K) $34K II. 8/01/14 $5K Earned 12/31/14 $19K Earned 3/31/15** $15K Earned 12/31/15 $24K $24K Year-End Adjusting Entry $19K Unearned $19K Unearned $19K $5K Unearned With Reversing Entries Unearned $19K (-0-) $19K (Cr $19K) $20K $20K (Cr $39K) $5K (Cr $34K) Unearned $5K (Cr $5K) Without Reversing Entries $20K $20K (Cr $20K) Unearned $14K (Cr $5K) $14K (Cr $34K) Notes: Deferred, a Type 3 adjustment. **Recurring event may or may not occur more than once a year with debiting to and crediting to Unearned accounts. Year-end adjusting entry adjusts Unearned account and reflects the ending balance of the account. Parentheses following the account indicate the related net balance of the account after the recording of the transaction. 21

APPENDIX G An Illustration of Bond Interests 7/01/14 10/31/14 $80 12/31/14 10/31/15** $80 12/31/15 $24K (Bond Disc/Prem) Bonds Payable $24K Interest $160 (Bond Disc/Prem) $160 Year-End Adjusting Entry Interest $80 (Bond Disc/Prem) Interest Payable $80 With Reversing Entries Interest Payable $80 (Bond Disc/Prem) Interest $80 (Cr $80) Interest $480 (Dr $400) (Bond Disc/Prem) $480 Interest $80 (Dr $480) (Bond Disc/Prem) Interest Payable $80 Without Reversing Entries Interest $400 Interest Payable 80 (Bond Disc/Prem) $480 Interest Payable $80 (Bond Disc/Prem) Interest $80 Notes: Accrued, a Type 2 adjustment. **Recurring event may or may not occur more than once a year with debiting to Interest and crediting to accounts. Year-end adjusting entry accrues interest expense/payable from the very last interest payment date in that year, i.e., 10/31. Parentheses following the account indicate the related net balance of the account after the recording of the transaction. 22

APPENDIX H Patterns of Entries That Are or Are Not Applicable to a Reversing Entry Applicability Type Account Observations on Recurring Entries Recurring YE Adj. Reversing Is Applicable Reversing Is Not Applicable (1) Accrued (2) Accrued (3) Deferred (4) Deferred (5) Valuation Adjustment (3) Deferred (4) Deferred (5) Valuation Adjustment Notes Receivable (App. D) Utilities, Wages (Fig. 1) Notes Payable, Bond Interests (App. G) Unearned (App. F.II) Supplies, Prepayment (-App. B.II & E.II) Accounts Receivable (B/S-App. C.II) Unearned (App. F.I) Supplies, Prepayment (Capitalize-App. B.I & E.I) Accounts Receivable (I/S-App. C.I) PPE Liability (Warranty) 1. Reoccurs on time basis, may or may not reoccur before the end of next fiscal year 2. inflow in the recurring transaction 1. Reoccurs on time basis, likely to reoccur before the end of next fiscal year 2. outflow in the recurring transaction 1. Reoccurs on need basis, may or may not reoccur before the end of next fiscal year 2. outflow in the recurring transaction 1. Reoccurs on time/effort basis, may or may not reoccur before the end of next fiscal year 2. inflow in the recurring transaction 1. Reoccurs on need/usage basis, may or may not reoccur before the end of next fiscal year 2. outflow in the recurring transaction 1. Reoccurs on customer demand basis, likely to reoccur before the end of next fiscal year 2. inflow in the recurring transaction 1. Reoccurs on time/effort basis, may or may not reoccur before the end of next fiscal year 2. inflow in the recurring transaction 1. Reoccurs on need/usage basis, may or may not reoccur before the end of next fiscal year 2. outflow in the recurring transaction 1. Reoccurs on customer demand basis, likely to reoccur before the end of next fiscal year 2. inflow in the recurring transaction 1. Reoccurs on need basis, may or may not reoccur before the end of next fiscal year 2. outflow in the recurring transaction 1. Reoccurs on customer demand basis, likely to reoccur before the end of next fiscal year 2. outflow in the recurring transaction Liability Liability Liability Liability Liability 23