Every January we promise ourselves we’ll do things better this year. If you own a business, you might resolve to stay on top of your records all year so you don’t have to panic at tax time. But what if, despite your best intentions, tax season is looming and your records are a total mess?
I sat down with our in-house bookkeeper, Abbas Ali, and Joey Cowan, our customer success champion, for tips on tackling year end like a boss. They shared four key steps to follow, along with some great insight on using this exercise as an opportunity to better understand your business.
“Doing your accounting isn’t about being compliant so you don’t get in trouble. It’s about taking control of your business so you have the power to influence its growth.” —Joey Cowan
Step 1: Catch up on your bookkeeping
The first thing you need to do to get ready for tax time is get your bookkeeping in order. You’ll need to gather up all your receipts and bills from purchases you’ve made during the tax year, as well as your customer invoices and bank account statements.
Update your expense records
First, pay off any outstanding bills right away. Make note of any expenses that you’ve used, but haven’t been charged for yet, like phone, gas and electricity bills, and also any expenses you’ve pre-paid but haven’t yet used, like insurance, rent, and some kinds of equipment. We’ll cover these a bit later.
Don’t forget to include any personal expenses that you also use for your business. For example, if you work from home your rent, insurance, utilities, and repairs would count, as would your car if you use it for your business. Divide the total cost based on business and personal use.
Update your income records
Check for billable sales or services that you haven’t invoiced for yet and send those out. Follow up on any outstanding invoices and send final reminders to late customers—start calling if you need to.
Make note of any customer deposits you’ve received for work you haven’t done yet, as well as work that you’ve started but can’t invoice for just yet. We’ll cover these in a bit.
If you’re using an accounting software, make sure you’ve properly categorized and verified all your income and expenses, and that taxes are accounted for within each transaction.
Reconcile your accounts
Make sure all of the transactions in your bank statements appear in your accounting records, and that there aren’t any duplicates.
Run your final payroll
Complete your payroll and remind your employees to submit any expense reimbursement before the period ends. Make sure your payroll is reflected in your transactions pages, and create any necessary journal transactions.
Don’t make these common mistakes:
- Don’t record your assets as expenses. Your capital assets and equipment purchases are adding value to your business, so they’re not considered expenses.
- Make sure you’re consistent with how you record your inventory purchases. Goods and materials for resale are considered inventory, and there are two ways to record them. The easiest way is as a cost of goods sold (COGS) expense, with periodic adjustments to reflect inventory fluctuations. Or, you can record each inventory purchase as an asset, and post regular journal entries to capture the inventory used to support your sales.
- Don’t record an owner’s withdrawal as an expense. This is a reduction of owner’s equity, but it’s not a business expense.
Step 2: Make year-end period adjustments
Now that you’ve updated your income and expenses, it’s time to tackle year-end period adjustments. These adjustments are journal entries made to your business accounts at the end of a period so your financial statements accurately reflect your business performance.
In accounting, we break up the life of a business into segments so that we can more easily follow its progress. A period can be any duration, but most companies use a fiscal year. This is so you can close out the books at the end of that fiscal year, and properly preserve the connection between expenses and the revenue they generate.
If you buy inventory for your business and then resell it, that’s a COGS expense. If you buy inventory and don’t sell it, that’s actually an asset. So throughout the year, as you buy inventory, you’ll record it as either a COGS expense, or as an asset.
At the end of the year, you’ll want to know how much of that inventory actually represents expenses, and how much actually represents assets. Then you or your bookkeeper will probably need to make some adjustments based on reality, in the form of journal transactions, in your accounting software or records.
Bad debt adjustments
Sometimes you don’t get paid for your work. If you’ve followed up with a client but it looks like you’re never going to get that payment, you can write off those invoices so that your year-end reporting can be as accurate as possible.
Reconciling loan accounts
If you’ve taken out a loan and you’re making payments throughout the year, part of those payments will be principal repayment, and part will be interest. At year end, you’ll want to look back and make some adjustments to reflect the actual amount you paid back in capital, and how much of what you paid was interest.
Make sure you don’t record a loan payment as an expense, or split the principal and interest incorrectly. These mistakes will result in incorrect financial statements, and you’ll be misrepresenting your financial position.
The assets you purchase are recorded at cost, but they depreciate over time. Some assets have physical depreciation, due to wear and tear, or exposure to the elements (e.g., a vehicle). Others have functional or economic depreciation, where the asset becomes obsolete or just less useful over time (e.g., software).
You’ll need to record your assets’ depreciation regularly. Some companies do this quarterly, some annually, and some even do it monthly. You can use a few different methods to reconcile it, including fixed percentage, straight line, and reducing balance methods. Your accountant can help recommend the best approach for your business.
Remember back in step one, when we suggested you make note of payments you’ve received where the work hasn’t been done yet? Now you’ll want to record those deposits as credits to a liability account for deposits, and a debit to your cash account. The reason you’re recording it as a liability is because you have an obligation to fulfill the work, so it’s technically not income until you have.
When you eventually ship the customer order or complete the contracted work, you’ll enter a reverse journal transaction debiting the deposit account, and crediting the relevant account.
Let’s go back to the unused, prepaid expenses that you made note of in step one. Record those payments as a debit to an asset account for prepaid expenses, and a credit to your cash account. When you eventually use that prepaid expense, you’ll enter a reverse journal transaction debiting the relevant expense account, and crediting the prepaid expense account.
Recognizing accrued revenue
Accrued revenue is work you’ve done, but that you haven’t had a chance to invoice for yet. You’ll record an accrual as a debit in an asset account for accrued sales, and a credit to services. Once you invoice for the work, don’t forget to record an entry to reverse the initial accrual.
Recognizing accrued expenses
Accrued liabilities reflect expenses on your income statement that won’t get billed until the next fiscal year, but that need to be recognized in this fiscal year because that’s when you incurred them. You’ll record an accrual as a credit in a liability account for accrued expenses, and a debit to income statement expense account. Once you receive the bill, don’t forget to record the entry to reverse the initial accrual.
Step 3: Convert accrual to cash if you file on a cash basis
There are two standard ways that you can do your accounting: accrual-based and cash-based. Accrual-based accounting means you recognize expenses and income when they are incurred, as opposed to cash-based accounting where you recognize them once they’re paid.
Under the accrual method, when you make a new sale you record the sale as income even if the client isn’t going to pay for a few weeks. Under cash-based accounting, you wait until the client pays you before you record that sale. Similarly, you record your January phone bill as an expense in January under accrual accounting, but with cash accounting you record it in February once it’s paid.
Accrual accounting is what we recommend at Wave because it gives you a more accurate picture of your business performance. That being said, when it comes time to file your tax return, most smaller businesses in North America will need to convert from accrual to cash-based accounting to do it properly.
Converting to cash from accrual
First, find your Accounts Receivable (AR) and Accounts Payable (AP) opening and closing balances through your balance sheet. Then run your income statement from start date to the last date of the year and record your total revenue from sales and total expenses. You can use this worksheet to help you.
Step 4: Send your records to your accountant
Once you’ve caught up on your bookkeeping, made the necessary adjustments, and converted your income and expenses from accrual to cash basis, you’re ready for year end. The final step is to pass your books along to your accountant to work his or her magic.
Year end is a crazy time for accountants, too, so you’ll want to make the transition as smooth as possible. Think of your accountant as someone who’s there to check your work and make recommendations, not to do the work for you. To help make that possible, make sure you share the following reports with your accountant:
- Period matching adjustments
- Trial balance
- Balance sheet
- General ledger
Now that you’ve got a complete set of accounts for the year, you’re in a great position to review your business performance, and make strategic decisions to help your business be more profitable and grow.
The information and tips we’re sharing in this article are meant to be a starting point for your year-end tax prep, so you can be informed and feel confident when working with your accountant. Be sure to check with a tax expert in your country or region for any specific advice you need, as each business (and tax district) is different. As our lawyers would say: “This article is for informational purposes only. It should not be considered legal or financial advice.”