Understanding Reversal Entries Kalaithasan Kuppusamy Reversal entries, which are done on the first day of a new accounting period, are the complete opposite of adjustments entries done at the end of a preceding accounting period. For example, if an adjustment done on a balance-day, 31 December 2012, requires a debit in the rent expense account and a credit in the rent payable account, then the reversal entry would be a debit in the rent payable account and a credit in the rent expense account done on 1 January 2013, the first day of a new accounting period. This transactional entries can be illustrated as below: Adjustment entry done on 31 December 2012: Dr. Rent expense 800 Cr. Rent payable 800 Reversal entry done on 1 January 2013: Dr. Rent payable 800 Cr. Rent expense 800 Most students do not have any problems with the reversal entries as they are opposite to adjustment entries. If one knows how to do adjustments, then they would be able to do the reversal. Nevertheless, it is important for students to understand the origin of reversal entries, when it is done (certain approaches to prepayment recording preclude the need for it) and learn the benefits associated with the recording activity. Origination of reversal entry In the early 70s, students are not exposed to the reversal entries because the computerised accounting system is not that widespread. Adjustment is done within the same expense or revenue account, that is, without using a separate accrual or prepayment account. For example, in a case where rent expense for an accounting period is RM10,000 and the entity has only paid RM9,200 during the accounting period, the RM800 owing will be shown as an accrual adjustment on the balance-day. Without a separate account for adjustment, the record is done as below: Rent Expense Year 1 Cash 9,200 Year 1 Income summary 10,000 Balance c/d 800 10,000 10,000 Year 2 Balance b/d 800 Kalaithasan Kuppusamy 1
Thus, a credit opening balance in an expense account signifies an accrual status (a liability) as opposed to a separate liability account. To journalise this adjustment, a debit and credit with the same amount is done in the same account. This does not make sense as it cancels off automatically. However, the addition of c/d and b/d rationalises the journal entry. In a computerised system, rationalising with c/d and b/d is not acceptable as the account names are created in the chart of accounts initially without these add-ons. Unless, special instructions are built-in into the systems, the system would not allow such kind of entries. In order to solve this problem, a separate accrual or prepayment account is created to record the adjustment. This solves the problem in a computerised system for the purpose of adjustments. On the other hand, an attempt to solve one problem have led to other problems. Hence, the introduction of reversal entry to tackle the other problems caused by a separate accrual or prepayment account used in the adjustment process. Reversal entry the problem solver Continuing with the example on rent expense from the earlier section, the adjustment for rent expense would have entailed the opening of a separate accrual account called rent payable (or with any other relevant account name). The rent payable account is a liability account and would be balanced off at the end of an accounting period whereby, its balance will be carried down to the following period. When payment for rent is made in the new accounting period, the amount has to be split between the amount owing in the rent payable account and the balance to be recorded in the rent expense account of the new period. Assuming that RM2,000 is paid for rent expense, without the reversal entry, the journal entry has to be: Dr. Rent payable 800 Rent expense 1,200 Cr. Cash 2,000 When a reversal entry is done, this kind of splitting the amount paid for recording is not necessary. With the reversal entry, the rent payable account balance would be transferred to the rent expense account. When the amount is paid in the new period, it just need to be recorded in the rent expense account. By doing so, it offsets the amount owing from the last accounting period (rent payable amount transferred by reversal) and the remaining amount for the current period. This can be illustrated as below: Kalaithasan Kuppusamy 2
Rent Payable Year 2 Rent expense 800 Year 2 Balance b/d 800 (reversal entry) Rent Expense Year 2 Cash 2,000 Year 2 Rent payable 800 (reversal entry) Therefore, the journal entry for the payment done would be (no splitting of the amount paid): Dr. Rent expense 2,000 Cr. Cash 2,000 In this case, the reversal entry has managed to simplify the process of recording by avoiding the need for splitting the amount paid. Thus, one of the advantages of doing a reversal entry is said to be the simplification of the recording process. Next, take a case of rent prepaid. For example, the rent for an accounting period is RM10,000 and the amount paid during the period is RM10,800. It means that RM800 is considered as prepaid and requires adjustment to indicate the prepayment. It can be illustrated as follows: Rent Expense Year 1 Cash 10,800 Year 1 Rent prepaid 800 Income summary 10,000 10,800 10,800 Rent Prepaid Year 1 Rent expense 800 Year 1 Balance c/d 800 Year 2 Balance b/d 800 Kalaithasan Kuppusamy 3
For the new accounting period, you have paid the amount for one-year rent, that is, RM9,200 after taking into account the prepaid amount. Say that this amount is recorded in the rent expense account, what are the options we have in order to close the expense account to income summary? Option 1: Closing rent expense and rent prepaid account to income summary separately. Cr. Rent expense 9,200 Rent prepaid 800 Option 2: Closing rent prepaid to rent expense first (similar to reversing), then closing the rent expense account to income summary. Dr. Rent expense 800 Cr. Rent prepaid 800 Cr. Rent expense 10,000 Alternatively, you might want to solve this problem by recording the payment straight into the rent prepaid account. If you do this, you just have to close the rent prepaid account to income summary. Thus, there will be times where payments will be recorded in the rent expense account and there will be situations where the payments will be recorded in the rent prepaid account. If this is the case, we can conclude that our recording process is not standardized and obviously, unsystematic. With the introduction of the reversal entry, this problem can be solved and our recording process will be much standardized and systematic. It means the accounting recording process starts off with the reversal in the beginning of the year, the recording of the payments in the expense account during the year, the adjustment and the closing from the expense account at the end of the year. This process is repeated annually. This is what we call as a standardized and systematic process and the reversal entry plays a part in achieving this objective. Returning to the rent payable and splitting of the payment in the new accounting year, there could be possibilities where the preparer failed to split the amount and record the whole amount in the rent expense account. The rent payable account may be left unattended and the balance is carried until the end of the year. Assuming that the amount paid in the new year was RM10,800, inclusive of the amount owing for the last accounting period, oblivious about the existence of the rent payable account, it would prompt for an adjustment for rent prepaid at the end of the year or RM10,800 is taken as the rent expense for the period. If RM10,800 is taken as the rent expense for the period, it would have resulted in overstating the rent expense by RM800. This amount has been taken as amount owing in the previous period and counted as part of the rent expense and in the current period, it being accounted for again. This is what Kalaithasan Kuppusamy 4
has been termed as double counting. If the preparer makes an adjustment for prepaid, it would have resulted in a rent payable balance and a rent prepaid balance presented in the balance sheet. Though it cancels off, the information provided is not accurate. The rent payable is counted again when it should be zero and the rent prepaid is accounted for when it is non-existent. Hence, with reversal entry, errors of such nature are avoided. This is another one of the advantages of reversal entry whereby it helps to avoid errors of double counting. In summary, the reversal entry is a solution to a solution to a same account adjustment problem. The solution of using a separate accrual or prepayment account for adjustment, though seems perfect in certain respect, it has its weaknesses, namely, unnecessary additional recording (splitting of amount), non-standardized and unsystematic recording process and errors of double counting. With the use of reversal entries, these weaknesses can be overcome. Recording approaches and reversal entry In business practice, it is common to pay certain expenses in advance and some other expenses in arrears. For instance, rent and insurance are usually paid in advance, where as, salaries and rates are paid in arrears. Likewise, revenues too follows the same practice as one s expenses can be the other s revenue. When expenses are paid in advance, accounting practices allow the preparer to record the payment based on two approaches, the asset approach or the expense approach. For example, when rent is paid in advance of RM10,800, it can be recorded as: Using the asset approach: Dr. Rent prepaid 10,800 Cr. Cash 10,800 Note: It is called an asset approach because the payment is recorded in an asset account. Rent prepaid is an asset account. Using the expense approach: Dr. Rent expense 10,800 Cr. Cash 10,800 When you use the asset approach to record the payment, the need for reversal entry does not arise. This is because it is your standard practice to record payment to an asset account and make adjustment from the asset account. There would not be a situation where the rent prepaid account will be left unattended and the next payment is recorded in an expense account. Hence, in an asset approach, the standardized procedure is to record payment in an asset account, such as rent prepaid, and do the adjustment from the asset account. Here is an illustrative example: Kalaithasan Kuppusamy 5
Example: Rent expense for an accounting period is RM10,000. Rent is always paid in advance and it is the policy of the business entity to record rent payment in an asset account. During year 1, the rent paid was RM10,800. In year 2, the amount paid was RM11,000. Show the relevant journal entries for these two years. Year 1: Recording the payment using the asset approach Dr. Prepaid rent 10,800 Cr. Cash 10,800 Dr. Rent expense 10,000 Cr. Prepaid rent 10,000 Cr. Rent expense 10,000 Note: Rent expense is closed and the Prepaid rent account balance is carried forward to the next accounting period. Reversal entry is not needed as the standard procedure as per the business entity policy is to record payment in the asset account (Prepaid rent) and make adjustment from that account. Year 2 (same procedures applies): Recording the payment using the asset approach Dr. Prepaid rent 11,000 Cr. Cash 11,000 Dr. Rent expense 10,000 Cr. Prepaid rent 10,000 Cr. Rent expense 10,000 Note: The balance in the Prepaid rent account at the end of Year 2 will RM1,800 that will be shown as a current asset in the Balance Sheet. Kalaithasan Kuppusamy 6
Using the same illustrative example, assuming that the business entity uses the expense approach to record, the journal entries will be as follows: Year 1: Recording the payment using the expense approach Dr. Rent expense 10,800 Cr. Cash 10,800 Dr. Prepaid rent 800 Cr. Rent expense 800 Cr. Rent expense 10,000 Note: Rent expense is closed and the Prepaid rent account balance is carried forward to the next accounting period. Reversal entry is required to avoid all the problems that have been discussed in the earlier section. Year 2: Recording of the reversal entry on the first day of Year 2 Dr. Rent expense 800 Cr. Prepaid rent 800 Recording the payment using the asset approach Dr. Rent expense 11,000 Cr. Cash 11,000 Dr. Rent expense 1,800 Cr. Prepaid rent 1,800 Cr. Rent expense 10,000 Note: The balance in the Prepaid rent account at the end of Year 2 will RM1,800 that will be shown as a current asset in the Balance Sheet. On the first day of Year 3, this amount will be transferred to the Rent expense account through the reversal entry. Kalaithasan Kuppusamy 7
For revenues received in advance, the business entity has an option to record receipts using the liability approach or the revenue approach. The liability approach does not require a reversal entry but the revenue approach requires one. Using the same illustrative example, let us capture the records done for the receipt of rent and the rent income by the landlord according to the liability and revenue approach.. Year 1: Recording the receipt using the liability approach Dr. Cash 10,800 Cr. Rent received in advance 10,800 Dr. Rent received in advance 10,000 Cr. Rent income 10,000 Dr. Rent income 10,000 Cr. Income summary 10,000 Note: Rent income is closed and the Rent received in advance account balance is carried forward to the next accounting period. Reversal entry is not needed as the standard procedure as per the business entity policy is to record received in the liability account (Rent received in advance) and make adjustment from that account. Year 2 (same procedures applies): Recording the payment using the asset approach Dr. Cash 11,000 Cr. Rent received in advance 11,000 Dr. Rent received in advance 10,000 Cr. Rent income 10,000 Dr. Rent income 10,000 Cr. Income summary 10,000 Note: The balance in the Rent received in advance account at the end of Year 2 will RM1,800 that will be shown as a current liability in the Balance Sheet. Kalaithasan Kuppusamy 8
Now, using the revenue approach to record, the journal entries will be as follows: Year 1: Recording the received using the revenue approach Dr. Cash 10,800 Cr. Rent income 10,800 Dr. Rent income 800 Cr. Rent received in advance 800 Dr. Rent income 10,000 Cr. Income summary 10,000 Note: Rent income is closed and the Rent received in advance account balance is carried forward to the next accounting period. Reversal entry is required to avoid all the problems that have been discussed in the earlier section. Year 2: Recording of the reversal entry on the first day of Year 2 Dr. Rent received in advance 800 Cr. Rent income 800 Recording the received using the revenue approach Dr. Cash 11,000 Cr. Rent income 11,000 Dr. Rent income 1,800 Cr. Rent received in advance 1,800 Dr. Rent income 10,000 Cr. Income summary 10,000 Note: The balance in the Rent received in advance account at the end of Year 2 will be RM1,800 that will be shown as a current liability in the Balance Sheet. On the first day of Year 3, this amount will be transferred to the Rent income account through the reversal entry.. Kalaithasan Kuppusamy 9
For all expense and revenue approaches, whether it is an accrual or prepayment, reversal entries are required. For all asset and liability approaches, generally used for prepayment only, there is no need for reversal entry. You should be able to justify the reasons for this reversal entry requirement based on the explanation given in the earlier section. How do you know whether a business entity is using the asset or expense approach from the unadjusted Trial Balance? Since all the payment is recorded in an asset account as per the asset approach, only the asset account is presented in the unadjusted Trial Balance. The expense account appears only after the adjustment, that is, in the adjusted Trial Balance. Thus, in the case of rent expense, an unadjusted Trial Balance will only show the Prepaid rent account when asset approach is used. After the adjustment, the Prepaid rent and the rent expense account appear in the adjusted Trial Balance. When the expense approach is used, rent expense account is shown in the unadjusted Trial Balance, and both accounts appear in the adjusted Trial Balance. The same applies for revenue. Conclusion It must be noted that accounting is dynamic. It changes to accommodate the dynamism in the business environment, and at the same time, improves to enhance its effectiveness and efficiency in the recording and reporting processes. Reversal entry evolved from these very reasons whereby it facilitated in improving the recording process. However, the objective of this article is to enable students to understand and appreciate the practicality of reversal entry with the hope that, to a certain degree, it mitigates rote learning prevailing among majority of our students. Kalaithasan Kuppusamy 10