Accruals and Reversals
There are two commonly used methods of accounting - Cash Basis and the Accruals Basis. In cash basis of accounting income is recognized in books when it is received in cash, and expenses are offset when they are actually paid.
Contrary to Cash Basis Accounting, in Accrual Basis Accounting, financial items are accounted when they are earned and deductions are claimed when expenses are incurred, irrespective of the actual cash flow. Accrual accounting method measures the financial performance of a company by recognizing accounting events regardless of when corresponding cash transactions occur. Accrual follows the matching principle in which the revenues are matched (or offset) to expenses in the accounting period in which the transaction occurs rather than when payment is made (or received).
Accrual accounting is considered to be the standard accounting practice for most companies and is the most widely used accounting method in the automated accounting system. This method provides a more accurate picture of the company's current condition, but as all income and expenses need to be recognized based on their occurrence and matching, it is relatively complex when compared to cash accounting, which recognizes transactions only when there is an exchange of cash. The need for this method arose out of the increasing complexity of business transactions and investor demand for more timely and accurate financial information.
To help you understand this concept let’s look at an example. A company has sold merchandise on credit to a customer who is credit worthy and there is absolute certainty that the payment will be received in the future. The company earns a profit of $500 on the total sales price of $2000. The accounting for this transaction will be different in the two methods. The revenue generated by the sale of the merchandise will only be recognized by the cash method when the money is received by the company which might happen next month or next year. However in the Accrual Method the revenue will be recognized in the same period, an “Accounts Receivable” will be created to track future credit payments from the customer.
Based on the above discussion now let’s take a look at some accrual/deferral related concepts:
Accrued revenue is an asset, such as unpaid proceeds from a delivery of goods or services, when such income is earned and a related revenue item is recognized, while cash is to be received in a latter period.
Accrued expense, in contrast, is a liability with an uncertain timing or amount, but where the uncertainty is not significant enough to qualify it as a provision.
As an accounting practice expense and revenue accruals are reversed in the next accounting period to prevent double booking of expenses/revenues when they gets settled in cash.
At the beginning of each accounting period, there is an accounting practice to use reversing entries to cancel out the adjusting/accrual entries that were made to accrue revenues and expenses at the end of the previous accounting period. Use of Reversing Entries makes it easier to record subsequent transactions by eliminating the possibility of duplication.
Reversing entries are made on the first day of an accounting period in order to offset adjusting accrual/provision entries made in the previous accounting period.
Reversing entries are used to avoid the double booking of revenues or expenses when the accruals/provisions are settled in cash.
A reversing entry is linked to the original adjusting entry and is written by reversing the position of debits with credits and vice versa.
Net impact of Original Entry and Reversing Entry on the accounting books is always zero.
In Automated Accounting Systems, it is not possible to delete transactions once the posting has been made. In such systems reversals is the recommended way to correct the erroneous entries. An example is that one interface feed has been posted by mistake twice. This has inflated many income expense accounts. A reversing entry with opposite debit and credit amounts to all the impacted accounts will nullify the impact of the mistake.