The end of the financial year has come and gone and it will be Christmas before we know it.
But for accountants and bookkeepers this time of year has a lot to do with reconciling accounts, bank statements and one of those things that seems like such a chore are the end of year, journal entries. But why?
An important task for all accountants and bookkeepers is to be able to give our clients accurate and timely financial information. The importance of this information, which includes reports outlining the profitability and value of our client’s businesses cannot be overstated.
Clients will use this information to review their business performance and to make decisions for their business future. It will be used for finance applications, tax, and strategic reviews amongst other things.
The starting point for preparing these financial reports is the preparation of the End of Year Journals. Without these the reports will not be accurate. But again, why are they seen as such big job?
So, what exactly is an End of Year Journal?
An End of Year Journal a journal entry in the accounting system to record the differences between the business’s financial reporting system and the accountants’ end of year accounts that are used to prepare the Financial Statements and Tax Returns.
The thing is, they need to match so that the reports are accurate. They also need to match so that the accountant, the bookkeeper, and the client are all on the same page. There is no point having one set of accounts provided by the bookkeeper and a different set of accounts provided by the accountant.
The end of year journal entries include several actions to align the records of the bookkeeper and the accountant. The bookkeeper usually performs these entries based on information received from the accountant.
They include addressing things such as:
- Making sure that the end of the last financial year matches the beginning of the new financial year;
- Making sure that the bank account balance in the accounting system matches the bank statements;
- Ensuring that Accounts Receivable and Payable are showing exactly what is due to be received as well as what is owed.
In short, end of year journal entries can be considered as corrective action by the bookkeeper before the final accounts are prepared by the accountant.
But it goes the other way too. The accountant should provide the bookkeeper with the necessary journal entries to reconcile items such as depreciation or income tax.
And when it comes to accounting for income tax and depreciation, it can be particularly complicated. I will explore some of the issues relating to accounting for tax and depreciation.
INCOME TAX
Why is accounting for income tax such a perplexing issue?
One of the complicating factors in determining how to account for income tax is due to the different structures in which clients operate. The four main trading structures of Sole trader, Partnership, Company, and Trust all treat income tax differently.
So how do the structures differ?
SOLE TRADER
A sole trader is the simplest form of business structure; a sole trader is an individual who is legally responsible for all aspects of the business. They own the assets, owe the liabilities and although they may use a trading name different to their legal name, they are the reporting entity.
Unlike other structures below, there is no governing document.
Who pays the tax on profit? – The individual does.
PARTNERSHIP
A partnership is an association of two or more people (or entities) operating a business as partners. The partners may have equal interests in the business or unequal interests. This ownership interest amongst other things is determined by the partnership agreement.
The partnership agreement is the governing document of the partnership.
Who pays the tax on profit? – The Partners do.
The net profit of the partnership is split between the partners based on the details contained in the Partnership agreement. This income is then dealt with in their individual tax returns. Therefore, each individual partner pays their own tax.
COMPANY
For these purposes, let’s consider a Company as being a small Private Company with two Directors and 2 shareholders. Each have equal ownership interest within the company.
A company is a legal entity and it is governed by the Corporations Act 2001. As it is a legal entity, it is separate from its own directors and shareholders. Companies are regulated by ASIC (Australian Securities & Investments Commission).
Each company may have its own set of rules which can be laid out in its constitution.
Who pays the tax on profit? – The Company does.
TRUST
For these purposes, let’s consider a Trust as being a typical Family Trust (Discretionary Trust) that has a Company as its Trustee.
Trusts are, in principle, a very simple concept. A trust is a private legal arrangement where the Trustee holds assets (for example property or cash) in trust for the benefit of the beneficiaries.
For example:
Jackson and Tara are the Trustees of the Charming Family Trust. They hold a rental property in Stockton as well as a share portfolio in trust for the beneficiaries, their children Abel and Thomas.
The trust deed contains the rules within which the trust must operate, it dictates its investment guidelines and describes how benefits will accrue to the beneficiaries under the trust.
Who pays the tax on profit? – The beneficiaries do.
This is because the income of the trust is distributed to the beneficiaries by the Trustee based on the Trust Resolutions that are completed prior to 30 June.
This income is then dealt with in their individual tax returns. Therefore, each individual beneficiary (Abel and Thomas) pays their own tax.
ACCOUNTING FOR INCOME TAX
What do we do with the data file?
Well, for Partnerships and Trusts, it is easy. We don’t have to worry about this. A Partnership or a Trust will not have to pay tax themselves and thus we don’t need to account for it. The profits derived in these structures are split to the partners or allocated to the beneficiaries. They are the ones who will pay tax, not the entities themselves. So, no provision or journal is required.
For Companies and Sole Traders, it is a little more complicated.
Take a small family owned Company for example.
Teller Morrow Pty Limited operates an automotive repair shop;
In the 2017 financial year, it is expected to have net profit of $50,000.00;
There have been no Income Tax Instalments paid in advance;
The Company Tax Rate is 28.5% and thus the projected tax will be $14,250.00
We account for this by the following end of year journal entries:
Debit Income Tax Expense $14,250.00
Credit Income Tax Payable $14,250.00
When the tax is paid to the ATO, we do the following:
Debit Income Tax Payable $14,250.00
Credit Bank Account $14,250.00
If income tax instalments of say $15,000.00 have been paid in advance we account for the expected refund by doing the following journal:
Debit Income Tax Expense $14,250.00
Credit Income Tax Payable $14,250.00
When the refund is paid to the company, we do the following:
Debit Income Tax Payable $14,250.00
Debit Bank Account $750.00
Credit Provision for Income Tax $15,000.00
Now let’s look at a Sole Trader / Individual’s treatment.
Bobby Munson operates a small Ice Cream Shop called Samcro Sweets;
In the 2017 financial year, it is expected to have net profit of $50,000.00;
Bobby also has a rental property that has made a $10,000.00 loss;
He made $6,000.00 in interest on his bank accounts;
He has a share portfolio that generated franked dividends totalling $3,000.00;
He worked part time for his friend Nero and made a salary of $15,000.00 and had PAYG tax withheld of $2,000.00
How do we account for this? Well as a sole trader, Bobby needs to include all these elements in his personal tax return. A sole trader’s income tax is calculated based on the lot, not just the business.
Sure, we know that his business made a profit of $50,000.00 but as a sole trader, what about the impact of everything else?
The short answer is that it is not common practice for accountants to provide an end of year journal for the income tax reconciliation for sole traders because the income tax generated by the business and the sole trader’s other activities are one in the same.
However, it can be done.
Sole Trader clients will occasionally request that their tax liability be dissected to show the impact each different component (interest, dividends, rental property) has. As a result, a journal entry can be provided to show the tax position on the sole trader’s business.
DEPRECIATION
The accounting for depreciation requires an ongoing series of entries to account for the allocation of an assets usage to depreciation (an expense) and eventually to reduce that assets value to Nil. These entries are designed to reflect the ongoing usage of fixed assets in the business over time.
Depreciation is the gradual allocation to expense of an asset’s cost over its expected useful life. The reason for using depreciation to gradually reduce the recorded cost of a fixed asset is to recognise a portion of the asset’s expense at the same time that the company records the revenue that was generated by the fixed asset.
So, if an asset will last the business 10 years, there will be amounts allocated as an expense for each of the 10 years the business uses the asset.
The journal entry for depreciation can be a simple entry designed to account for all types of fixed assets, or it may be completely separately for each asset.
The basic journal entry for depreciation is to debit the Depreciation Expense account (which appears in the Profit and Loss Statement) and credit the Accumulated Depreciation account (which appears in the Balance Sheet as a contra account that reduces the amount of fixed assets).
Over time, the accumulated depreciation balance will continue to increase as more depreciation is added to it, until it equals the original cost of the asset. At that time, you stop recording any depreciation expense, since the cost of the asset has now been reduced to zero.
For example, Teller Morrow calculates that it should have $25,000 of depreciation expense in the current year. The entry is:
Debit Depreciation expense $25,000
Credit Accumulated depreciation $25,000
Teller Morrow could also have shown a higher level of detail, and instead elects to allocate the $25,000 of depreciation among different expense accounts, so that each class of asset has a separate depreciation allocation. The entry is:
Debit Depreciation expense – Automobiles $4,000
Depreciation expense – Computer equipment $8,000
Depreciation expense – Furniture & fixtures $6,000
Depreciation expense – Office equipment $7,000
Credit Accumulated Depreciation $25,000
Finally, depreciation is not intended to reduce the cost of a fixed asset to its market value. Market value may be substantially different, and may even increase over time. Instead, depreciation is merely intended to gradually charge the cost of a fixed asset to expense over its useful life.
So, who should do the journal entries for depreciation? The bookkeeper or the accountant? Well, I think this is a discussion that needs to be had with the accountant, bookkeeper, and client to determine who is going to do which aspect of the job. There are numerous methods to account for depreciation and according to the Australian Taxation Office, there are different periods over which each conceivable asset can be depreciated. So it is essential that all members of the team are on the same page.
This eliminates confusion, double handling and ensures that consistency is maintained with the client’s file.
COLLABORATE…
At PTAM we believe in having an honest conversation with our clients. We tell it like it is and we don’t sugar coat it.
Just as accountants expect the information that is provided by the bookkeeper to be accurate, in turn the bookkeeper needs the adjustments from the accountant so they can adjust their records too.
We all work on the same team. That team is the client’s business so it is important that the flow of information goes both ways.
I suggest having a conversation with the client, bookkeeper, and the accountant to determine the best strategy for preparing the end of year process.
Work out the requirements in an action plan and ensure all parties (client, bookkeeper and accountant stick to it).
This sounds like simple advice but it really will ensure that our clients are getting the best value from their financial reports.