Fixing variances in general and subsidiary ledgers – Accounting NOT for Dummies

There can be many causes for a subsidiary ledger to go out of balance with the general ledger.  An invoice could have been posted in an incorrect amount, a general journal entry could have been made to correct the general ledger, or a payment could have been posted using a journal entry rather than using the payables or receivables “modules.”

One example from my world of public accounting involves corrections made by the CPA firm at year end which also affect subsidiary ledgers.  For example, as part of year-end tax closing the CPA firm makes an adjustment to accounts payable to correct the balance to the actual payables at year end, which for whatever reason were misstated.  Let’s say the adjustment is a debit of $1,000 to an A/P account, which brings the balance to the new corrected amount of $9,000.  Prior to the adjustment, the subsidiary ledger shows a balance of $10,000.  In this example, we’ll say that the adjustment relates to only one vendor – ABC Corp. – and that it relates to a mis-posted invoice for COGS.

When the journal entry is posted to the general ledger, here is what happens, using T accounts, where the left side of the “T” is a debit, and the right side a credit:

A/P                                                              COGS                                             ABC Corp A/P sub

$1,0000 |   $10,000                           $10,000 | $1,000                                     | $10,000

Above, you can see that the journal entry has corrected the general ledger, but the subsidiary ledger is now out of balance to the general ledger.

I have developed a procedure, using a “dummy cash account” to fix the problem and bring the accounts back into balance.  First, set up a new cash account and call it “dummy cash” or something similar so that everyone knows it’s not a real account.  Then open vendor payables and select ABC Corp.  Now, make a $1,000 payment to ABC Corp using the dummy cash account, not your real bank account.

Here is what has happened:

A/P                                        COGS                             ABC Corp A/P sub   Dummy Cash

$1,0000 |   $10,000     $10,000| $1,000       $1,000 | $10,000              |$1,000


Now, you can see that Accounts Payable is understated by $1,000 and the dummy cash account has a credit of $1,000.  So, you must make one more journal entry to correct both of these accounts, making a credit to A/P and a debit to dummy cash.

A/P                                         COGS                                ABC Corp A/P sub   Dummy Cash

$1,0000 |   $10,000      $10,000| $1,000     $1,000 | $10,000  $1,000|$1,000

$1,000    |   $1,000


              | $9,000        $9,000|                              |$9,000                   -0-

As you can see, now all is right with the world.  The accounts payable general ledger agrees to the subsidiary ledger, the vendor balance is correctly stated, and COGS has the correct amount of expense.  This same process works in reverse for corrections needed to Accounts Receivable and its subsidiary ledger.

You can use debit memos and credits memos to achieve the same result, as long as you can control where the debit/credit memos post to.  You want them to post right back to the G/L account where you are making the correction.  Some software does not permit you to make entries to accounts payable and accounts receivable in this manner, but here is how that would work, using the above example:

Open up ABC Corp and issue a credit memo to the vendor for $1,000.  Set up the credit memo to post directly to Accounts Payable.  When posted, the credit memo will both debit and credit A/P in the amount of $1,000, so it will have no effect on the A/P balance, and the sub-ledger for ABC Corp. will reflect the $1,000 credit memo, so it will now be in agreement with the general ledger.


What’s the Best Accounting Software?

I hear this question a lot, but it’s kind of like asking:  what’s the best car?  The answer:  it depends on your needs.  So, the first step in evaluating accounting software is to evaluate your needs.  In the old days we called this a “Needs Assessment” and even small companies used to hire CPA firms like ours to perform these needs assessments when they were considering implementing new accounting software systems or upgrading their old software systems.

Today, business owners and non-profit organizations often don’t bother to “waste” time assessing their needs.  We don’t have time for that, do we?  Instead, we prefer to go directly to a solution, not knowing whether that solution has much to do with our needs.  Basic software is so cheap now that we don’t care whether it will work well or not.

Businesses have learned to tolerate inefficiencies in the accounting function because they have allocated so few resources to it that they can afford ignore it.  But they often don’t consider the actual costs of using/misusing accounting software.  These costs are hidden in the extra fees you pay at year-end to have your CPA firm unravel the mess you have created in your accounting software (probably using QuickBooks), and in the sometimes critical mistakes you make managing your business because you are relying on inaccurate and misstated financial information.

These costs are also buried in the extra loan documentation hassles and delays that occur when you try to submit your in-house financial statements to your banker.  You might even be paying a higher interest rate than you should because of these financial inaccuracies.

So, back to the accounting software/car analogy:  think about the software in terms of what you need it for, just as you would weigh whether to buy a convertible or an SUV.  The most critical area to assess is the sales cycle:  if your accounting software doesn’t enhance your sales/revenue function, then it almost doesn’t matter what else it can do well. If you sell inventory, then you need a point of sale system that actually works and that integrates with your accounting software.  If you provide services but need to use job costing, then you need enhanced billing features that allow you to track income and expenses by job, including employee time and expenses.

The next most critical area to assess is how the software will be used and accessed by different users simultaneously, and how or whether the software’s internal controls allow for separation of duties.  If you have an accounting clerk processing purchases and recording invoices, you don’t want that person to have the same access to the entire system that your CFO has.  And, please don’t follow the practice of having one logon name and password and handing that out to everyone who will be using the system!  This happens more often than you can believe, and defeats one of the most stellar internal control applications that software can offer:  determining who did what, and when.

After these two areas have been analyzed, you can move on to other functions, but one decision you will need to make is whether or not to go the “cloud computing” route and purchase an on-line accounting software service.  Cloud versions of traditional accounting software systems have, so far, been stripped down versions of the “real” package, so be very careful when choosing.  On the other hand, some strictly cloud-based software services have been around for years and are worth investigating.   If you do go this route, you’ll be improving your productivity, reducing costs, and making life easier for all the users of the system, including the business owner.  But this is where system security, passwords and log on names must be strictly adhered to, since you are also exposing your business to greater risk.

Once you’ve identified the key features you need, you can get a lot of help using the internet and seeing how other businesses rate their experiences with various software systems.  Ask your CPA firm how they view your accounting system’s needs.  If you do take the time to evaluate your own accounting needs, even if you don’t do a formal needs assessment, you are much more likely to find the best accounting software application(s) for your business or non-profit organization.

The IRS, the AICPA, QuickBooks, and You

Earlier this year the IRS announced that it would begin demanding a business’ QuickBooks data file during all future audits conducted by the agency.  In the past, CPAs and their clients would often export the accounting software’s general ledger and other financial information to Excel, and then provide this information to the IRS during an audit, as a way to limit IRS access to non-accounting information.  IRS was satisfied with this until recently when it began to realize the wealth of information that is contained within a company’s software data file – much of which may be unrelated to the year being audited, but may in fact reveal information that could be useful to IRS in evaluating information reported on tax returns.

The IRS has long regarded electronic records as being suspect:  “Electronic records, are, in general, considered less reliable than their paper counterparts due to the ease with which they can be manipulated” according to the recently updated Internal Revenue Manual.  Bingo.  What is so helpful about having the QuickBooks file to audit is the existence within the file of an “audit trail” – a function which cannot be disabled by the users, and which records every keystroke by date, time, and user name.  By studying this audit trail, IRS can determine whether transactions were altered, deleted, or modified, and how often, by whom, and when.

Many CPAs have expressed concern over this new approach because their clients routinely make errors in QuickBooks which have to be corrected after the fact.  They were worried that IRS would regard these errors and corrections as indicative of deceit or fraud, when in fact they are only indicative of incompetence.

Enter the AICPA.  Earlier this year, the AICPA sent a memo to IRS asking for their clarification on their position regarding providing “an exact copy of the original electronic data file…and not an altered version” to IRS auditors.  The AICPA wanted to know whether such a file could be condensed so as not to provide prior year data, but only the data for the year under audit, and whether CPAs are being exposed to potential malpractice claims by inadvertently turning over unrelated data contained within a client’s QuickBooks file.  Some CPAs have gone ahead and either condensed the QuickBooks file or had a software company perform a “redaction” of the file, to remove prior year information.  Anecdotal evidence indicates that this is okay with the IRS, however, it has yet to officially comment on the AICPA’s questions.

So far, the IRS is only training its auditors on the use of QuickBooks and Peachtree during an audit, but it may expand its training to other software packages if it sees a need.  Since QuickBooks has the market share, with a reported 85% of the total, IRS was smart to choose QuickBooks as its first software package to use in its new approach to auditing electronic records.

Now you can count the IRS as yet one more reason not to use QuickBooks.  But, if you are already using QuickBooks or Peachtree and you are about to be audited, but sure to contact your CPA so that they can help you in providing only the information that IRS is entitled to receive during the audit, and nothing more.  And, since QuickBooks is kind enough to provide you with an audit trail, make good use of it by strictly adhering to user log-ins and passwords for each unique user of the system.

How Gross Are Your Gross Wages?

It is amazing just how much difficulty business owners and bookkeepers have in understanding how to post payroll entries.  A common misconception is that somehow a business’ gross wage expense is altered by decisions that the employees make as to how to spend their salaries.  Part of the cause is the way in which businesses must assume responsibility for some of these decisions, such as turning over 401k contributions, Section 125 cafeteria plan deferrals and the like.  Another part of the cause is that accounting software makes bad bookkeepers out of good business owners.

But here is the accounting, legal and tax reality of employee wages:  the salaries recorded on your books must always be the amount which your employee has earned for the period in question.  This must always be the “gross” amount, not reduced by ANY deferrals made by the employee.  What the employee decides to do cannot impact the expense that you as an employer incur when you pay your employees the wages they have earned.

The next challenge is trying to create a journal entry from the payroll reports you receive from the payroll service bureau.   I follow the practice of using a “payroll clearing account” which is an account in your general ledger meant to always end up having a zero balance at month end.  Using a clearing account makes it easier to post payroll entries, especially if you use direct deposit for your employees’ paychecks.  Here is an example of how this works.

A direct deposit comes out of your business checking account to pay your employees, usually accompanied by a report called a “check register” which should be familiar sounding.  The check register shows each direct deposit amount, with a total amount debited from your business account usually a day or two before payday.  Let’s say this amount is $25,000.  Remember, this is your employee’s net pay.  Then, your bank account gets hit for another sum, which includes employer payroll taxes and employee withholdings.  We’ll say this amount is $10,000.  And, you also need to turn over employee retirement plan contributions and Section 125 plan contributions to a 3rd party administrator, in the amounts of $3,000 and $1,000 respectively.  You will also receive reports that indicate how these amounts have been determined.  Usually, the payroll journal and the cash requirements report are the most helpful in generating the format for the journal entry.

Using a payroll clearing account allows you to post the bank debits in lump sums without needing to know at the time how these amounts are to be spread and “grossed up” to employees’ wages and employer payroll taxes.  Here’s how this looks, using “T-accounts”:

Clearing account                                Cash                 

Dr          |          Cr                                Dr          |    Cr       

25,000                                                                  25,000

10,000                                                                  10,000

As you can see, we’ve just dumped the entries into the clearing account, but now we can reconcile cash easily at month end because the totals entered will match the bank statement.

At month end or before, we need to “clear” the clearing account with a journal entry.  We can look at the payroll journal and find the amounts for gross wages for the month,  and total employer payroll taxes.  Here’s what the entry looks like:

                                    Dr                                    Cr                                       Type of account

Gross wages                $34,000                                                                       expense          

Employer taxes               5,000                                                                      expense

Payroll clearing                                     $35,000                                          clearing          

Retirement plan payable                        3,000                                            liability

Section 125 plan payable                        1,000                                           liability

I realize this seems too easy, but there’s really nothing more complicated to it.  When the checks were written to pay the retirement plan and 125 funds to 3rd party administrators, you posted those to the same liability accounts noted above.  At the end of the month, those account balances would be zero, since no further funds are owed.  The clearing account is now zero.  And, gross wages are really, really gross.

The 10 Minute Bank Reconciliation

Yes, there are times when I can do a bank reconciliation in 10 minutes, even for clients with hundreds of transactions per month.  Over the years, I have developed a number of techniques to help me quickly identify bank reconciliation errors and potential causes. But before I get to the “how” of performing bank reconciliations, what are they and why should you do them?

The purpose of a bank reconciliation is to allow you to determine the accuracy of cash balances on a specific period-end date (usually monthly) as recorded in your general ledger.  You should always perform your bank reconciliation as of the last day of the accounting period, not mid-month, because that’s not the date that you are closing the accounting period.  So, get the bank to give you statements with a month-end cut off.  The bank statement tells you which transactions have cleared the bank, regardless of whether such transactions are known to you.  Your books have the complete record of all of your known transactions, but items can appear on your bank statement that you don’t know about.  These are, generally:  NSF checks, interest earned, bank fees, other automatic debits, and deposit errors.  Likewise, items that you know about may not be known to the bank, such as outstanding checks and deposits in transit.  So, the bank reconciliation ties together these two separate sets of records, with your own books trumping everything, because that’s what will be reflected in the general ledger.

Bank reconciliations before the existence of accounting software were often performed in a “4 column” format, with the following column headings:  Beginning Balance, Deposits, Checks, Ending Balance.  This format allowed the accountant or bookkeeper to quickly identify reconciliation issues because each column would then be totaled to agree to the bank’s totals.  This would mean that you could tell if your error was in the checks or in the deposits section of your bank reconciliation.  With accounting software, even though the process is the same, your ability to identify errors is reduced.  A lot of software packages will try to give you hints, but sometimes the hints add to the confusion.  In addition, with accounting software, you can fail to mark items that have cleared and still appear to have correctly performed a bank reconciliation.  This occurs when you or your CPA make journal entries to correct errors, but the journal entries and the errors themselves never get marked as cleared.  I have seen bank reconciliations with un-cleared transactions going back 5 years!  Obviously, this cannot be even factually true, and it means that whoever is performing the bank reconciliations does not understand their function very well.

Aside from ensuring the accuracy of your general ledger cash balances, timely and accurate bank reconciliations are one of the most important elements of your internal control system.  Stale items or unusual outstanding items at period end can indicate financial fraud.  Cash accounts are involved in 93% of all frauds, which is why auditors are trained to search for and identify unusual transactions when reviewing bank reconciliations.  Management review of bank reconciliations is a critical function, but often managers don’t actually know what to look for.  If this describes you, contact your CPA and ask them to show you how to perform this kind of review and what to document, and I’ll offer a few tips below.

Now, back to the 10 minutes I have allotted for the bank reconciliation:  open up your reconciliation tab in your accounting software and enter the period end date and the bank statement balance where indicated.  Make sure that you have the software set up NOT to show transactions for periods after this date.  Mark all of the transactions as cleared.  Now, working backwards, take your bank statement and identify the last check which cleared, and breaks in the check sequences and unmark those checks which haven’t cleared.  Then, enter any automatic debits that you haven’t yet recorded in your books, but which are shown on your bank statement.  Check the last deposit in your books to see if it has cleared the bank.  If not, unmark deposits that have not cleared.  Enter your interest earned and any bank charges shown on the bank statement.  Not in balance yet?  Scan the bank statement for any surprises, such as NSF checks and deposit errors.  Most of the time, the bank reconciliation has now been balanced and is ready to be printed (yes, always print or pdf it because certain software may not allow you to do this later, and your CPA wants it and so does the IRS if you are ever audited).

If you are still out of balance at this point, it is now time to check each item from the books to the bank, one by one.  Again, I usually start backwards because it is generally the month-end transactions that are the culprit.  Remember that your books trump all, so you use your book transactions as your source and compare that to what has cleared the bank, not vice versa.

Once in balance, the bank reconciliation is now ready for management review.  The business owner or manager should confirm that only current transactions are listed in the outstanding checks.  Checks older than 6 months are considered stale.  Usually, these are errors or duplicates that have not been corrected, but if not, Oregon businesses are required to turn over any unclaimed payments to the State Department of Lands.  If you see any unusual outstanding checks, or any “corrections” entered immediately after month end, this could indicate fraud.  Likewise, outstanding deposits or transfers among accounts that are from a prior period or are immediately reversed after month end could also indicate fraud. Scan through all the transactions listed and make sure that the totals appear reasonable in comparison to your typical monthly volume and dollar amounts of transactions, and that check sequences make sense.  Scan check payees to make sure you recognize the vendors.  Review the payroll entries and trace them back to the payroll reports provided by your service bureau.  And, even though most bank reconciliations are performed by the same person who recorded the transactions (your bookkeeper), make sure that this person IS NOT a check signer.

The internal control function of the bank reconciliation is where you should spend your time.  The routine part involving doing the reconciliation itself should not be a hassle, and if it is – get in touch with your accountant for their advice on how to make the process more efficient.

Spousal bookkeeping: why I recommend divorce

Okay, so I don’t really recommend divorce.  But, with a spouse as bookkeeper, you as a business owner have some unique challenges to face. 

First of all, you can’t fire your spouse if they are incompetent.  And, they are quite likely to be incompetent.  No offense meant to your spouse.  In fact, most bookkeepers today are incompetent.  This is in large part due to the advent of accounting software, and more specifically to the dominance of QuickBooks in the accounting software market.

Before accounting software, there were bookkeepers, and there were spouses doing bookkeeping.  These spouses would have taken accounting and/or bookkeeping classes at a local college or university, or even self study classes.  They took these classes so that they would become competent bookkeepers and accountants.    Suppliers, bankers, creditors, and regulators all relied on accurate accounting information from their small business clients.  And, before on-line banking, the only way to know what was happening in the company bank accounts was to keep up to date records and to timely reconcile the bank accounts each month. So, the bookkeeper’s role and competence were critical to the success of the company.

Businesses today have the same stakeholders that they did 50 years ago:  lenders, creditors, suppliers, regulators, taxing authorities, owners, family members, etc.  They may even have a few more stakeholders:  the neighborhood, the community, employees, and the environment, if they choose to recognize these stakeholders.

So, why do we give these stakeholders far less accurate financial information today than we did 50 years ago?  It’s a question that has troubled me for the last decade or so as I have seen the quality of in-house financial information of small businesses decline substantially.  On-line banking is a partial contributor to this decline:  we think that by checking the bank accounts every day we “know” what is going on.  But the other main culprit is the dominance of QuickBooks in the accounting software market.

QuickBooks is marketed as the end-all/be-all accounting system that anyone with half a brain can set up and use, and that can do all the accounting work for you so that you don’t do much of anything.  This makes it possible for an untrained person to think that not only is QuickBooks a piece of cake to use; accounting itself is not something that requires any knowledge, skill, or advance study.  Heck, maybe you only even need a quarter of a brain to do it. 

As anyone who has taken accounting classes will tell you, nothing could be further from the truth.  And, as anyone who works with any kind of software will tell you:  learning any software package requires time, skill, knowledge, patience, study, and problem-solving abilities.  In our fast paced world, it’s easy to buy into the idea that “the software can do it” so we don’t have to. 

So, here’s what I recommend for those businesses with a “spousal bookkeeper”:  invest in college or university classes or other form of training for your spouse.  Talk with your CPA about problems with the current accounting system and ask them for their frank assessment of your personnel and recommendations for improvements.  Ask your bookkeeper for their frank assessment as well.  Most people don’t choose to be incompetent, but they sometimes need prompting to address a problem.  This way, maybe you can avoid divorce after all, and  have timely, accurate and reliable financial statements as well.