Bookkeeping – Closing the Books (Lesson 69)

Lesson 69

All the lessons to date lead into this one long and arduous task with bookkeeping called ‘Closing the Books’.   Closing of the accounting records is performed at the end of interim and fiscal year periods.   The end of the year process is more involved than interim periods; but the procedure is the same.

The closing process is designed to finalize the financial information for that period of time.   It involves correction of errors, posting omissions and confirming balances
of accounts.   Once done, the bookkeeper and management can prepare reports with a high level of confidence with their accuracy.   There is a fundamental tenet of information exchange; it goes like this:

Key Business Principle

Good information (data) into the system maximizes the ability to get good information (reports) out; thus maximizing the ability of users to make good decisions.

Accounting is an essential element if not the primary source of evaluating business performance.   It is the critical step in the business feedback loop of information to make sound business decisions.   The closing procedure validates that the data going in is good.

There are multiple steps in the closing process and include:

Step 1 – Print a trial balance and check for egregious and obvious errors as explained in Lesson 68.
Step 2 – Confirm account balances against third-party documents.
Step 3 – Confirm account balances using internal methods.
Step 4 – Prepare estimated journal entries for long-term financial commitments using tests of reasonableness.
Step 5 – Close all temporary accounts.
Step 6 – Compare and contrast test information against historical activity.
Step 7 – Prepare and print final reports.
Step 8 – Close the accounting period.

The following sections explain each step in more detail.   Be mindful that each step may be different in actual performance based on the respective industry and the actual business methods.   Basically the process deviates somewhat between different companies (think of retail and construction) but is conceptually the same.

Step 1 – Initial Trial Balance

It is best for the bookkeeper to do as much work as possible during the accounting period to reduce the amount of time it takes to close the books at the end of the accounting period.   Often closing processes can take upwards of three days.   Lesson 68 explains the importance of eliminating the obvious accounting errors.

The trial balance acts as the starting point in the closing process.   Each account must be verified for accuracy.   Many accountants will take the initial trial balance and transfer the information to a working trial balance.   This lesson will not go into how the working trial balance is used; however, lessons in the advanced skills section will cover many of the various inner workings in detail.

One of the easiest tools to verify account balances is using third-party source information.

Step 2 – Confirming Account Balances Using Third Party Documents

In a typical small business many of the accounts can be verified for accuracy using third-party source information.   This is all about reconciling the account from another source.   Reconciling means to compare.  The most obvious reconciliation step is with bank accounts.   By using online account information, a bookkeeper can keep bank accounts accurate in real time.

Other third-party documents address many different accounts most notably balance sheet accounts.  These include:

* Prepaid Expenses – Most prepaids are for insurance premiums for future coverage and taxes on real estate or property,  again for future accounting periods.   The bills from the third-party providers clearly state the coverage periods.

* Vendor Statements – Vendors provide monthly statements identifying unpaid invoices and total balance due.   Using the process advocated in Managing Accounts Payable (Lesson 43) the bookkeeper can maintain an accurate balance for this account on an ongoing basis.

* Credit Cards – Just like bank statements, revolving charge accounts have current information online and provide monthly statements.   It is best to maintain these accounts in an ongoing manner eliminating the time commitment to reconcile at month’s end.

* Payroll Liabilities Forms 941, 940 and state unemployment reports act as the reconciling source documents for the liability account of payroll taxes due.   In addition, much of this information is now processed online including state income taxes due and amounts paid.

* Other Taxes Due – Other source documents act as the verification source for balance due including meals and sales tax forms.  Items such as property and revenue taxes are also vouched from their respective schedules.

* Long-Term Debt and Interest – Most lenders send two different forms of balance on account to borrowers.   The first is a monthly statement identifying principle balance due and interest paid to date along with interest owed.   The second form is an annual Form 1099-I (interest) which identifies total interest paid for the year.  A couple of insights are beneficial here.   Both statements and Form 1099-I identify payments received through a date coinciding with the ending prior period (month or year).   This means it may not include recently made payments.   See an Loan Accounting (Lesson 54) and Amortization of Financing Costs for more details.   Secondly, monthly statements will also include escrow balances and amounts paid out from the trust fund for escrow issues of real estate taxes, insurance, replacement reserves and legal compliance items.   These values are usually tied to the balance sheet prepaid items or escrow balances.

* Payroll Expenses – In Payroll Compliance and Documentation (Lesson 33) I identify the various federal, state and authority derived payroll reports.   These forms act as the reconciliation source document for gross payroll (expense), payroll taxes (expense), payroll liabilities (see above) and payroll benefits paid to date.

In addition to external sources of documentation, internally generated sources are used to confirm balances.

Step 3 – Internally Generated Confirmation Methods

Another resource to confirm account balances are internally generated documents and accounting systems.   The most common method used is visual inspection.   As an example, inventory is physically reviewed and counted for confirmation.   In most cases an inventory count is easy and quickly performed.   Think of dealerships, they simply print a list of VIN or serial numbers, walk the lot and verify existence of the respective units (cars).  Some inventory procedures can get a little complicated as there may literally exist hundreds of items, some located at remote sites.   So counting may be more involved and convoluted.   Instead of conducting an inventory monthly, it is done once a year.  With inventory there are some nuances involved and this is explained in greater detail in the advanced skills section of this website.

Other internally generated documents and methods include:

* Accounts Receivable – As advocated in Lesson 43, accounts receivable is a managed control account.  The bookkeeper is actively involved in the day-to-day monitoring
and collections process.   The values as reported on the balance sheet and for bad debt on the income statement are directly tied to this management process.

* Fixed Assets – Similar to inventory, a visual sighting is used to confirm existence.  Other tools include reviewing titles and property tax documents.  Depreciation schedules act as the basis for the capital expense section’s depreciation expense.  In addition, asset maintenance schedules, especially vehicle reports, confirm expenses in the maintenance expense accounts.

* Other Assets – Tangible assets can simply be verified by visual inspection in a similar manner as fixed assets.   Intangible assets are paper titles and customarily have amortization schedules to expense their respective values over time.

* Warranties – Use allocation schedules to track both remaining values and corresponding expenses.

* Sales – Gross sales are tied to actual invoices generated from a retail software.  For affirmation of sales, each day’s sales is reconciled to deposits, accounts receivable and credit/debit card payments.   In some situations like project or dealership accounting the gross sales are tied to contract worksheets or deal sheets.   Good bookkeepers keep up with this function daily so as not to get overwhelmed at month’s end.

* Expenses – Use internally generated worksheets to tie expenses to some form of reference material.   Great examples include transportation accounts; capital expense accounts of interest and leases, and insurance too.   The best tool includes project accounting for costs or cost accounting used with manufacturing.

* Equity Accounts – Every partner or investor (shareholder, limited liability member or beneficiary) should have a capital account identifying not only basis issues but draws, distributions and dividends.  In addition, tax timing and non deductibles are listed.   These spreadsheets are used to tie the balance sheet equity accounts to corresponding tax timing differences.   Furthermore, tax schedules are explained in more detail in the advanced skillsets section of bookkeeping.

Step 4 – Estimated Journal Entries

The next step in closing the books involves preparation of journal entries, specifically those requiring estimates.   Many of the so-called estimated amounts are very accurate including depreciation, amortization and allocation (prepaid expenses).  Some do require a little work in calculating the amounts including:

A) Income Taxes – Tracking Income Taxes  (Lesson  58)
B) Other Taxes – Other Taxes (Lesson 59)
C) Employee Benefits – Health Insurance, Life Insurance and Dental Benefits
D) Legal Issues – Lawsuits, Accident Claims, Set Asides
E) Asset Valuation Adjustments
F) Reserve for Uncollectible Accounts

Remember to use recurring entries for depreciation, amortization and allocation of prepaid expenses and warranties.

Step 5 – Close Temporary Accounts

Temporary accounts are used to assist the accountant and management in clarifying financial information.   Most often temporary accounts are used in management reports.  So prior to closing temporary accounts, management reports are prepared and printed. These include:

A) Project and Job Costing Reports
B) Production Analysis
C) Financial Schedules for Accounts with Contra Accounts
D) Internal Reports, especially those used as supporting documentation for cash flow reports.
E) Departmental Reports

Temporary accounts include some, not all, contra accounts, internal accounts (explained in advanced bookkeeping), suspense accounts and equity accounts temporarily used with the income statement (for cash flow calculations).   Since most temporary accounts have direct offsets or are transferable via reclassification, it is easy to close them by nulling out their respective values.   This is explained in Closing Temporary Accounts in the advanced skills section of bookkeeping.

Step 6 – Compare and Contrast Current to Historical Information

One of the fundamentals of financial accounting is that it is rare for a company to have either significant growth or sudden losses without management knowing beforehand. Often significant financial change is identified with sudden increases or decreases in sales volume, material purchases or fluctuations in the labor force.   Absent this, financial changes will be reasonable or unnoticeable, specifically per account from one period to the next.   They will also be reasonable in change when comparing the same period one year apart.

So each account is compared with a side by side alignment to both the prior (if interim, the prior month or quarter) period and in a separate report, the same period in a prior year.   This allows the bookkeeper to compare results for the period and contrast any significant differences.   Here is an example of ACME’s month to month comparison for its income statement.

.                                   ACME HAULING
.                      Comparative Income Statement
For the Two Months Ending May 31, 2016 and June 30, 2016

.                                                May 31, 2016         June 30, 2016
Sales                                           $342,719                 $383,741

Allowances                                    (21,605)                  (18,297)
Net Sales                                       321,114                   365,444

Costs of Transportation:
Fuel                                                 85,610                     93,404

Labor                                               49,657                     56,491
Repairs & Maintenance                   33,915                     37,006
Compliance                                       4,632                       4,882
Depreciation                                    19,410                     19,410
Taxes                                                  9,809                     11,078
Gross Profit                                    118,081                   143,173
Overhead:
Management                                   21,305                     23,744

Facilities                                           6,790                       6,849
Insurance                                        14,272                      14,799
Office Operation                               3,017                        2,933
Taxes and Licenses                         10,044                      12,757
Other                                                  2,113                       1,681
Capital                                              18,961                     19,403
Operational Profit                           $41,579                   $61,007

Does anything look abnormal?

The novice reader will note that sales increased by more than 10% in one month.   That indeed is unreasonable; but now reconsider thinking about this industry.   As hauling goes into summer months, it really isn’t unreasonable to have sales increase by more than 10%.   A decrease is definitely an alarm unless production was hampered by a lot of foul weather.

A simple financial trick is to compare costs to net sales as a percentage.  In May fuel is 26.6%.   In June fuel costs as a percentage of net sales is 25.5%.   This appears comparatively normal especially if fuel prices remained stable during both months.

Now let’s compare ACME’s prior year June financial data to the current year.

.                                            ACME HAULING
.                                 Comparative Income Statement
.           For the 30 Days Ending June 30, 2015 and June 30, 2016

.                                           June 30, 2015      June 30, 2016
Sales                                        $357,925             $383,741

Allowances                                 (19,111)              (18,297)
Net Sales                                   338,814               365,444
Costs of Transportation:
Fuel                                              96,758                 93,404
Labor                                            49,473                 56,491
Repairs & Maintenance                31,817                 37,006
Compliance                                    4,449                   4,882
Depreciation                                 16,201                 19,410
Taxes                                               8,838                 11,078
Gross Profit                                 131,278               143,173
Overhead:
Management                                18,710                 23,744
Facilities                                         6,669                   6,849
Insurance                                      19,592                 14,799
Office Operations                           2,714                   2,933
Taxes and Licenses                        10,800                12,757
Other                                              2,520                    1,681
Capital                                           17,262                 19,403
Operational Profit                        $53,011               $61,007 

As a comparative point, operational profit as a percentage of net sales is 15.65% in June of 2015 and 16.69% in June of 2016.  This is a 6.6% difference between the two years.   They appear to be reasonable, but is there any one or two line items that stand out?

If you said  ‘insurance’, you are correct.   Why was insurance so high in 2015?   The bookkeeper looks at the details for both years and the only contrast is the cost of the deductible paid in June of 2015 for $5,000 for an accident.   Without that $5,000 additional expense in 2015 the profit would have been $58,011 and as a percentage of net sales, 17.12%, slightly higher than June of 2016.

Based on the comparison of two periods and two years the only contrast was in insurance.  So it would appear that data entry in the books qualifies as a job well done.   Do the same for the balance sheet.

Now that there is a high level of confidence in the accuracy of information, it is time to print and prepare reports.

Step 7 – Print and Prepare Reports

Steps one through six comprise the more arduous tasks of closing the books.   The printing and preparation of reports is actually one of the more enjoyable tasks as a bookkeeper.  Now that the values in the respective accounts on the trial balance are accurate; the reporting step is merely a formatting process.

As a bookkeeper you must understand that there are a lot of different kinds of reports.  Most are highly defined for a single purpose like management or cost accounting reports.  I have not covered these in this bookkeeping series.   Those are for a different series.  Nor have I explained project or class accounting.   Project and class accounting are covered in future lessons as a part of the advanced skills for bookkeepers.   The reports for printing and presentation in regards to the end of the period are broader in scope and are referred to as financial statements.   They include the following:

1) Balance Sheet
2) Income Statement
3) Statement of Retained Earnings
4) Cash Flows Statement
5) Notes to Financial Statements

In small business the balance sheet and income statement are the two most commonly desired reports.   The other three are a little more sophisticated and require more knowledge to actually prepare.   They go beyond the scope of basic bookkeeping.   However, this series serves as the core lessons to understand and prepare these advanced reports.  Once you complete the advanced series section,  you will be able to understand and prepare the other three reports.   For now, let’s focus on the balance sheet and income statement (profit and loss statement).

Balance Sheet Reports

The balance sheet is a snapshot of a moment in time along a historical financial timeline.   The most common report date is December 31 of each year at 11:59 PM.   Most novice bookkeepers fail to remember that it is designed this way as it reports lifetime cumulative earnings to that moment in time.   Retained earnings include all earnings up through the prior year at 11:59 PM plus a line for current earnings for the current year.   At 12:01 AM on January 1, the current earnings line is collapsed into retained earnings and current earnings starts anew at zero dollars for the new year.

In small business balance sheets are also prepared at interim intervals, usually every month.  It is uncommon and not recommended to prepare or print balance sheets for partial periods as they tend to be misleading.   So please do not prepare a balance sheet during the middle of a month or quarter.

The closing process eliminates unneccessary contra accounts, zeros out suspense accounts and sets the proper values for temporary and internal accounts.   Once the period reports are prepared, these temporary, internal and contra accounts are reopened for use during the next interim period.

The balance sheet has two primary formats in presentation.   The first is a summarized format whereby any sub-groups like cash, fixed assets and intangibles, all with multiple accounts, are collapsed as one value.  I explained this in Lesson 68 in regards to how the trial balance is presented.  The summary format is best for outside presentation especially to third-party lenders.   Third party lenders have no real interest in how the cash is divided among the various cash accounts or how fixed assets are categorized into equipment groups and so on.

The detailed presentation format is designed for the management team as it allows for them to ask appropriate questions and get a clearer picture of the financial breakout of the company.

So when preparing financial reports, always include a summary set and a detailed set.  The balance sheet serves as the cover report for financial statements.

In addition to the current period report, many accountants like to prepare comparative time frame reports.   The two comparatives include the prior period so a reader can identify changes between two consecutive periods and the same period of time from the prior year.   This comparative report allows a reader to evaluate change in the current year by comparing different assets, liabilities and equity changes over one year.

So the basic balance sheet reports are as follows:

.       Summary Set                                Detailed Set
.    Current Period Only                      Current Period Only

.    Prior Period Comparative              Prior Period Comparative
.    Prior Year Comparative                 Prior Year Comparative

I’m sure anyone reading this wants to know how to read the financial report.   This is an involved and protracted explanation and is covered in many other articles on this site.   For the purpose of this lesson, look at the equity section.   In general, if the equity increases between two periods or from one year to the next this means the business is profitable.   However, decreases may not mean the company is losing money, the reader must evaluate change including the draws, distributions or dividends paid out during this time period.   Sometimes the draws, distributions or dividends exceed earnings thus reducing overall equity.   The company can still be performing well and equity decreases during this period.   To determine profitability, look to the income statement for results.

Income Statement Reports

Unlike balance sheets, income statement (profit and loss statement) reports span a time period, usually one accounting period (month, quarter or year).   Any interim period will also include a second column for year to date information.   Also income statements include comparative reports.   This includes prior period, current period and year to date; and prior year comparative period, prior year to date, current period and current year to date.   In effect comparative reports are either a three column (successive periods in interim reporting) and four columns with prior year period comparative reports.   Look at the following table and two examples of the header sections.

.       Summary Format            Detailed Format     # of Columns
.      Current Period & YTD   Current Period & YTD              2

.      Comparative Successive Periods & Year to Date             3
.      Comparative Prior Year & YTD Comparative                  4

YTD is an acronym for ‘Year to Date’.

.                       ACME CARPET CLEANING
.                  Comparative Income Statement
For the Two Months Ending May 31, 2016 and June 30, 2016

.                                                                                    Year to Date
.                                         5/31/16         06/30/16           06/30/16
Sales                            $ZZZ,ZZZ      $ZZZ,ZZZ     $Z,ZZZ,ZZZ

… 

.                        ACME CARPET CLEANING
.                      Comparative Income Statement
.       For the Month Ending June 30, 2015 & June 30, 2016

.                                             Year to Date                               Year to Date
.                        05/31/16         05/31/16             06/30/16            06/30/16
Sales             $ZZZ,ZZZ      $ZZZ,ZZZ          $ZZZ,ZZZ     $Z,ZZZ,ZZZ

The goal of preparing these reports is to provide clarity to a reader of any trends.  Hopefully a continuous improvement especially with bottom line performance is trending. The proper package layout is as follows for both the summary and detailed sets.   Remember summary reports are designed for presentation to third-party users such as banks,  insurance providers and vendors.

Balance Sheet – Single period only
Income Statement – Standard two column current period and year to date
Balance Sheet – Two successive periods (comparative)
Income Statement – Three column two successive periods and year to date information
Balance Sheet – Two successive years (comparative)
Income Statement – Two comparative same month periods and year to date, four columns

This presentation format allows management to review and analyze the information in a more organized pattern.   Trends and deviations are easy to identify and evaluate.

Once reports are printed, scan in both sets as two separate files to the financial reports directory for that particular period.   Now that reports are ready, it is time to close the accounting period.

Step 8 – Close the Accounting Period

One of the biggest drawbacks to technology is the ability of an accountant to mistakenly record an entry to a prior period or year.   Simply enter the wrong year with the journal entry and post.   Now the financials are incorrect for prior periods.   With paper based books (the old fashion way) it is easy to spot the fact that you were entering an economic transaction to the wrong year; prior year books were locked up or stored on a separate shelf for audit purposes.

Modern day technology requires the bookkeeper to manually ‘lock’  the prior periods and assign a password to enter prior period journal entries.   Sage (maker of Quantum, formerly Peachtree) requires the user to close the period by backing up the data file and compressing (purging) actual raw entries thus leaving the final balances as reported with a trial balance.

No matter what method is required, closing the books is merely a mental note to the bookkeeper to avoid making entries in prior periods.  If one is required it should be done in cooperation with the CPA and the owner’s authorization.

Summary

At the end of every interim and fiscal accounting period the bookkeeper must close the books.   The closing process is essential to ensure account values as reported on the trial balance are accurate.   Multiple steps are used to close out the books.  They include:

1) Eliminating obvious errors in a trial balance.
2) Confirming account balances against third-party source documents.
3) Using internally generated documents, schedules and calculations to accurately state other account balances.
4) Enter estimated amounts such as depreciation, amortization and taxes.
5) Close all temporary accounts.
6) Test data by comparing and contrasting against historical information and patterns.
7) Prepare and print final reports.
8) Close the books by securing historical data.

Once done, the bookkeeper can now forward the data files to the Certified Public Accountant for any annual requirements including audits and tax preparation services.   Act on Knowledge.

If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org.  I would love to hear from you. If interested in my services as an accountant/consultant; click on My Services‘ in the footer of this article. 

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About David J Hoare 427 Articles
I spent 12 Years as a Certified Public Accountant, Over 20 Years of Practice in Accounting and Consulting, Controller in Management of Closely Held Operations, Masters of Science in Accounting, Prepared over 1,000 Business Tax Returns and Hundreds of Individual Returns