Accuracy in Accounting & Bookkeeping: The Practical Consequences to Small Businesses

 In Accounting & Bookkeeping Tips, Michigan Accountant, Taxation

If you’re an Accountant, you should be practical and also do not harm-a Hippocratic Oath for Accountants.  Accountants should be driven with a desire to help their Client’s understand the benefit(s) of instituting processes and methods to ensure good record keeping.  As an Accountant or Bookkeeper, you’re in a great position to gain your Client’s trust to help them develop workflows and procedures to mitigate or eliminate issues before they become real problems involving extensive digital file “clean-up.”  We all get busy and lose focus, but if businesses get complacent with keeping accurate records then, there is a very real possibility that it will impact more than just a paper statement.  Poor or non-existent records can carry significant costs in the form of increased tax liability or an inability to obtain credit, as just two examples.

So, given this foundation.  I’d like to present some clear examples of how this COULD occur and why it needs to be avoided.

Most of the Online (Web-based) Accounting Platforms have similar workflow procedures, so these examples that could happen, pertain to many of the Platforms that are currently available.

Invoicing, Payments and Deposits

This is the procedure that if not used in the way, intended by the software provider is probably the most problematic in terms of identifying and correcting errors.  Left uncorrected, these errors will likely have real consequences for potential increased tax liability.

Scenario 1:  A business invoices a customer, and receives payment but doesn’t use the receive payment function or bank deposit feature in the online platform.  Instead the business inputs the deposit directly in their bank account register (a manual entry) which functions just like a checkbook.  They use “Income” as the account to input this deposit.  Now, income has been duplicated…it was “counted” once when the invoice was created and again, when the payment was recorded in the register.  Let’s assume that the amount of income received was $10,000.  In this situation, income and assets (Accounts Receivable) are overstated by $10,000.

Scenario 2:  A business invoices a customer, and uses both the receive payment and bank deposit function in the platform, correctly.  However, the Owner/Shareholder goes to the bank and makes a deposit for less than the amount they received…he needed cash for some expenses on the way back to the office and no transaction for the amount of cash that was taken from the deposit is made.  A day or so later, the bank feed for this transaction appears in the bank review tab, but because it cannot be matched to the bank deposit transaction in the accounting platform, the Owner/Shareholder simply adds the feed to the bank register and again chooses “Income” as the offset Account.  Again, Assets are overstated (the bank balance in the register is overstated and Undeposited Funds is also overstated because less was deposited than received) and Income is overstated…let’s assume by the same amount as in #1:  $10,000.

Now, let’s also assume that this is an Accrual-Basis S-Corporation with a single Shareholder/Employee.  If this Shareholder has a (personal) 35% marginal rate, with no deductions associated with this additional $10,000, this equates to an additional $3,500 in tax liability for this transaction, alone.

These scenarios are just two examples of problems that frequently occur and there are many other variations on the same theme.  The Shareholder in this case is taxed on all Accrual Net Earnings, and because there were no additional deductions, this additional $10,000 flowed through the S-Corp to the Shareholder’s 1040 Return by way of the Shareholder’s K-1.  If it’s not caught and fixed, this Shareholder is on the hook for an additional $3,500 based on one transaction, alone.  Now multiply this one occurrence by the probability that errors of this type or others are duplicated considering the several hundred or perhaps thousands of transactions that occur in the company’s fiscal year.  See my point?

This is the connection that Small Business Owners need to understand between accuracy and tax liability.  When it’s explained in very real terms, like paying more (in taxes) than you’re legally obligated to, because of errors, they “get it.”

Expenses vs. Bills

Expenses are different than Payables or Bills.  Focusing on purchases (excluding non-cash entries like depreciation or amortization), expenses are created when you pay cash for something, now.  Bills or payables are created when you pay your supplier or vendor, later.

Scenario:  A business creates a bill for an obligation that they intend to pay over time, but they create expenses (in error) for payments that they believe reduce the amount outstanding on the bill.  Note:  Paying down an obligation is not an expense.  This has the effect of overstating expenses and liabilities.  Overstated expenses do not mean that the tax liability has not been reduced, the tax liability is simply understated because of the Accounting/Bookkeeping error.  Liabilities (Accounts Payable) on the company’s books are overstated in this example, and this has the effect of distorting the Balance Sheet, reducing Equity or the Net Asset Value of the Company.  Banks and other Creditors extend credit based not only on earnings but on the Financial strength of a would-be Debtor.  Overstated Liabilities can spell the difference between getting credit or getting shot down.

So What? 

Yes, examples like these, in and of themselves are not too difficult to grasp and correct.  The battle is created when you multiply the probability that errors are replicated given the hundreds (or thousands) of transactions over the course of weeks, months or even years.  With that many transactions, it will not be possible or practical to correct each error.  It will require adjustments to Retained Earnings/Owners Capital Accounts and the associated Asset or Liability Accounts.  And yes, tax returns will also need to be amended.

An oil filter manufacturer made a TV commercial years ago with the tagline, “You can pay me now, or pay me later.”  That phrase has meaning here.  The cost of “unwinding” these types of errors to determine a potential tax benefit or a re-statement of Assets and Liabilities could exceed the benefit itself!  Understanding these types of errors can help determine which accounts are overstated or understated.  Using this, a good Accountant can isolate various problems that affect permanent Accounts (Accounts which carry over from year to year) to help quantify the magnitude of the error.  However, lacking source documents or other records, it will, at best, be an estimate.

In most challenges, games or sports, we keep score to measure how well we did against predefined rules. Accountants keep score to help clients understand the strength and operational effectiveness of their businesses.  Without accurate, consistent Accounting we can’t guide our clients toward their future if we can’t determine where they’ve been.

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