Part I: Debits and Credits
Let’s start with the basics: debits and credits.
Debits and credits have the following effects on the five major account types:
In my experience, few staff within the 1-3 year stage of their careers have truly committed these fundamental rules to memory.
To be successful in public accounting, you must have your debits and credits memorized.
I’m nothing special, and struggled at first myself. Once I began working through journal entries manually, the relationships between the debit and credit normal accounts crystallized in my mind.
Even as a novice tax preparer, you can reason your way through the majority of the tax preparation issues you’ll face if you understand debits and credits. You can apply this principal to all sorts of tax-related transactions, from simple interest income to the sale of amortized bonds, and beyond.
The Problem with QuickBooks
At small to mid-size firms, you’ll spend a fair amount of time using QuickBooks. This is due to the program’s wide availability and thus frequency of use by small business clients.
As an inexperienced staff, the drawback of using QuickBooks is the same feature that makes it so popular; the program handles the complexity of double-entry accounting behind the scenes.
Record an entry in the checkbook register to expense office supplies and what happens? QuickBooks debits Office Expense and credits Cash. However, you don’t see that happen, you see the net effect; Cash decreases, expenses increase and Net Income goes down.
Without working through entries by hand, you’ll miss out on learning the fundamentals. And without practicing these fundamentals, you’ll build your real-world experience on an unstable foundation.
Using a Manual Trial Balance Tool
A manual trial balance is a set of Excel worksheets that allow a preparer to adjust financial statements through manual journal entries. It consists of a Trial Balance and an set of Adjusting Journal Entries, or “AJEs”.
Manual trial balances have two benefits. The first is that by design, all adjustments are clearly laid out, allowing more transparency during review. You record adjustments one at a time, documenting each account affected. The second benefit is that you’ll learn very quickly how varying accounts interact with one another. Through repetition, you must recall whether each account is debit or credit normal, and how one account interacts with its related counterpart. There is no pop up window or error message that lets you know you’re out of balance. It’s up to you to keep track of each change and stay in balance.
Step 1: Input Unadjusted and Prior-Year Data
To start working with your manual trial balance, you’ll need to do the following:
- Download your free Tax Grappler template using this link.
- Input your prior year adjusted financials and current-year unadjusted financials in the applicable columns, beginning on the left.
- In the template, “XX” refers to the prior year-end, and “XY” to the current year-end.
- If you opt to copy and paste your financials, make sure your summation formulas are copied as well. Overriding summations with hardcoded totals is a bad habit to get into.
- Once you have input the financial statements, confirm that you are in balance.
- For efficiency, I generally pass on inputting the prior-year Income Statement and instead simply hardcode adjusted Net Income in the Equity section.
- A formula below the Total Liabilities and Equity line item will let you know if you’re out of balance and if so, by how much.
- Many items have already been linked and formulas input, such as subtotals. Don’t start inputting data until you’re sure the cell is an input field.
- Only input the minimum items necessary. Let the worksheet handle summations. This minimizes the possibility of errors and retains the workbook and spreadsheets’ integrity, allowing future revisions.
- Input your adjusting journal entries (“AJEs”) on the AJE tab, but link your adjustment in the Trial Balance to your adjusting journal entry input. That way, if you need to revise your AJE, you only need to make the correction once, reducing the potential for transposition errors.
- STAY IN BALANCE. I cannot stress this enough. Prepare your unadjusted financials, confirm you balance. Post an AJE, confirm you balance. Repeat. Nothing can blow budgets and derail you faster than slipping out of balance. An ounce of prevention is worth a pound of cure.
Step 2: Adjusting the Book Financials
Once you’re in balance, the next step is to make your book adjustments. In book adjustments, you are making corrections to the client’s financials. These adjustments are not merely for presentation, but rather to correct specific transactions prepared by the client on their books. Some common book adjustments include:
- Reconciling Retained Earnings
- Capitalizing fixed assets and expensing items unnecessarily capitalized by the client
- Reclassifying transactions recorded to the wrong accounts
- Recording year-end adjustments like depreciation and amortization expense
- Accruing tax-related transactions like pension contributions
Step 3: Adjusting the Tax Financials
Once all of the book entries have been made, you’ll move on to your tax entries. These generally focus on reclassifications for presentation purposes, and do not need to be posted by the client.
Note: AJEs that affect a Balance Sheet and Income Statement account will need to be posted by the client because it will affect Retained Earnings. For this reason, AJEs that only affect Income Statement accounts do not necessarily need to be posted on the client’s books.
For instance, the client may have included multiple types of insurance within the Insurance expense account (e.g. Health Insurance and Auto Insurance). You may want to separately state the Health Insurance in order to reconcile your Income Statement to the tax return, line by line. A reclassifying tax entry will separately state the expense. Since this adjustment doesn’t affect the Net Income for book purposes, the client doesn’t need to record the AJE.
Step 4: Reconciling to the Tax Return
The final step is grouping the adjusted tax accounts to illustrate the link between the financials and presentation on the tax return.
Every client is different, and depending on the accounts being used, there will be a few remaining summations and adjustments required to match the balances on the financials with those on the tax return.
These could include combining various meal expense accounts into a single item, or grouping Repairs and Maintenance found near the bottom of the Income Statement with the Repairs and Maintenance the client has included as a sub account of Auto Expense. There are endless combinations and adjustments, and the client’s prior reporting and your partner’s preference will dictate the manner and degree to which the accounts are presented and combined.
Book-to-Tax Adjustments (“M-1’s”)
“M-1” refers to the schedule on business tax returns used to reconcile the tax return back to net book income, and is located just after the Balance Sheet or “Schedule L”. M-1’s are outside of the scope of this discussion, but for reference, there are four general categories of book-to-tax (“M-1”) adjustments:
- Increases to income from book to tax
- Income on tax return, not on books
- Expenses on book, not deductible for tax
- Decreases from income from book to tax
- Income on books, not on tax return
- Expenses on tax return, not on books
In the manual trial balance, the book-to-tax reconciliation is located at the bottom of the Income Statement portion of the Trial Balance.
Step 5: Referencing
Frankly, you should be referencing as you go. In practical application, at any point in time, your workpapers should be referenced. They may not be finished because of pending information, but you should strive for a work product that anyone could take over and pick up exactly exactly where you left off.
Maintaining a complete work product concurrently is far more efficient in the long run. It prevents re-work and minimizes time when restarting a project that has been on hold.
There should never be a question as to where your figure came from. I generally reference only when its not immediately clear, and always when you need to refer to another page in the workpapers for the source of the amount.
The most important rule is that your referencing matches the language and conventions understood by your firm. Follow last year for reference.
That covers the basics of the manual trial balance. In part two of the fundamentals of business tax series, we’ll go through some examples to illustrate the uses and value of the manual trial balance tool.