Do Accrued Expenses Reverse Year-End Closing?
One purpose of the year-end closing is to empty all of the temporary accounts --that is, income and expenses -- into the permanent balance sheet account, retained earnings. Under generally accepted accounting principles, or GAAP, you must recognize income and expenses in the period they occur, not when money changes hands. Reversal entries at the start of a new year help ensure that you record accruals in the proper periods without double counting. The accrued expenses account is used to reverse the year-end closing of incurred but unpaid expenses.
During the current accounting period, your business might incur unpaid expenses and income. For example, you might use $1,000 of electricity in December but won’t receive the invoice from the utility company until January. If you didn't use reversal accounting, you would simply book a debit to the electricity expense account and a credit to accounts payable of $1,000 in December, However, you might be concerned that you’ll mistakenly book the same transaction in January when you receive the bill, thereby double-counting the expense. Reversal entries eliminate this potential problem.
If you use reversing entries, one of the first steps in closing out the year is to record unpaid expenses to a special liability account called accrued expenses. Unlike expense accounts, the accrued expenses liability account doesn't sweep into retained earnings at the close. You can therefore consider accrued expenses as a permanent account, because its balance carries through to the next year. For example, at year-end closing, you book your December $1,000 electricity expense as a debit to the electricity expense account and as a credit to the accrued expenses account. This recognizes the expense in the period you incurred it.
By entering an expense before closing the books for the period, you ensure that you record the expense in the proper period and report the expense in the period’s income statement, as per GAAP requirements. For example, you’ll report the unpaid December electricity expense as an operating expense on the year-end income statement. Once reported, you credit the $1,000 balance in the electricity expense account and debit this amount to retained earnings. Some companies employ a two-step process, first using an income summary account to empty out all of the temporary accounts and then transferring the income summary balance to the retained earnings account. In either case, the expense account has a zero balance going into the new year.
At the start of the new year, you book entries to reverse the transaction that recorded the original debit to the expense account and credit to the accrued expenses account. For example, on Jan. 1 you enter $1,000 as a debit to the accrued expenses account and as a credit to the electricity expense account. This removes the balance from the accrued expenses account and creates a negative $1,000 balance in the electricity expense account. When you receive your bill, you enter a $1,000 debit to the electricity expense account, thereby driving its balance to zero, and enter a $1,000 credit to accounts payable. In this way, you won’t report the expense in the new year’s income statement. Accounting systems provide automatic booking of reversing entries so that you don’t have to remember to enter them.