The 1st of 4 Simple Steps in Curing Tax Pain for Good
It feels amazing to finally file your tax return. To be done with it all for the year. Ahh, and just in time for Spring... It’s such a weight to be lifted off your shoulders, but everything leading up to it was just so… unpleasant. So stressful. But have you ever wondered why books and taxes are so painful in the first place? Well, to answer that question, we need to dive into the psychology of fear and how taxes inspire it.
But first, why listen to me? My name is Jonathan Sussman. I’m a certified public account with over a decade of experience in tax compliance for small business owners, and have filed over 1,000 income tax returns for small-medium sized businesses in various different industries.
So I wanted to start by describing a phenomena that people go through when experiencing fear. You see, as humans, when we are missing relevant information, we experience uncertainty. This is felt as a gap or hole in the proverbial “complete picture”. To understand this picture, and what it must represent, we instinctually fill in that gap with our assumptions or gut reaction.
If that reaction is negative, then we would not be eager to see the complete picture. We would feel anxiety as it came into frame, and we may turn away from it all together. We call that type of reaction fear.
When that same uncertainty is assumed to represent something good or exciting, then we find ourselves eagerly digging through the missing information so that we can find what might even be treasure. Ever happily binged a series on Netflix? It’s because of this reinforced justification of the positive reaction to uncertainty that you were feeling: curiosity.
But taxes inspire more fear than curiosity. Why is that? Well, with tax uncertainty, the best-case scenario is a refund. Worst case scenario? Financial hardship or even jail time. So you can see why fear would be the biggest driver of tax compliance, and why there is so much pain and suffering associated with it. Even when we desperately seek answers to solve our tax problems, it’s usually not because we’re so pleasantly curious as to do some light research into the tax code to casually solve our problems. It’s because we’re hoping to that there’s something out there that can make all this fear go away for a little while.
Well, you don’t need to do any more research like that, because I’m here to give you my process for ending tax pain all together. And it starts first with killing the source of the fear: the uncertainty. And the way to eliminate tax uncertainty is to have solid financial data. We call the culmination of that data your books and records. And when they’re in order, then you won’t have uncertainty about your tax, finances, or compliance. You’ll get that peace of mind that you find on the other side of tax time, without the pain upfront. But it starts with good books.
In reality, there is always some uncertainty about books or taxes, since they’re fundamentally records of the past, and cannot yet be done in real time. However, we can take strides to maximize our financial certainty, and therefore minimize the amount of pain or suffering associated with the tax compliance side of running a business, which frees our minds to focus on the things that we really care about.
These are the 4 steps to Curing Tax Pain:
Record, only and completely, all financial transactions that have occurred
Correctly classify all recorded transactions
Calculate taxable income and required payments for all necessary taxes
Pay taxes accordingly
What follows is how to do step one of this process with ease, as is the most fundamental step in the process of books and tax compliance for business owners.
Account Reconciliations in General
Financial statements are a structure, and as with any structure, it starts with the foundation. The foundation of good books and records are account reconciliations.
So what is account reconciliation? It’s when we prove that our accounts are consistent with the sources. I’ll use a dating example to demonstrate. If you have a big fight with your lover, and then have a talk and work out your differences to get on the same page, you are considered to have reconciled.
In accounting, we do the same thing, but instead of you and your lover, it’s your accounting ledgers and your source docs. And once they agree, then you know that you have reconciled their differences.
Why Do We Do Account Reconciliations
We do account reconciliations in the books and records for two reasons:
To ensure that all the transactions that happened are recorded
To ensure that all the transactions that were recorded actually happened
The completeness and occurrence of inflows and outflows are what we are confirming, and that is a really good start, and something that theoretically anyone who can read can do. Like digging a hole though, you need to have the time, tools, and motivation to actually do it. This is often viewed as a sort of data entry process, but it’s absolutely necessary and you need to have financial literacy, patience, and intellectual stamina to do it well.
And if you’re just starting out and don’t know how to make money yet, then yes, you should do it on your own. Key word: DO IT. You can’t ignore this task. It MUST be done, or you will suffer massive financial uncertainty, and the cure for that pain is expensive.
Clean up books can run you $5,000+ a year, before tax filing costs + tax debts. In-house hire costs vary, but outsourced labor for this usually costs $300-$1,000 per month, or $3,600 – $12,000 per year. And the tax return will be cheaper since the books will be better. It’s the financial version of brushing your teeth: it prevents holes, reduces clean-up costs from expensive professionals, and you’ll sleep better once you’ve done it.
How do we do account reconciliations
So how do we actually do account reconciliations? Well, it all follows one simple formula:
Beginning Balance + Increases – Decreases = Ending Balance
Every account follows this formula. Bank accounts, credit card accounts, accounts receivable, inventory, loans from mom, etc.
So what you need to know are those variables. Then you just record them, whether in excel, QuickBooks, Xero, or whatever you’re using.
The source docs for are the paper trails. If it’s a bank account, that would be the bank statements. If it’s a credit card account, then it would be the CC statements. If it’s cash, then it could be receipts.
Then what you do is record the first transaction. If it’s an increase, then add it to the beginning balance. If it’s a decrease, then subtract it. This equals your new balance, or running balance.
Then you do that for the second transaction, and the third, and all the transactions for the period. If the running balance matches the balance on the source docs, then you’re reconciled.
Repeat for all accounts that need reconciling, and you’ve successfully recorded everything and nothing more, even if it’s not classified perfectly. This gives your financial statements substance.
When do we do account reconciliations
How often should you do account reconciliations? It depends.
For income tax purposes, at least once a year
For sales tax, at least once a month or quarter, depending on state and local tax compliance for where and how you do business
For payroll, monthly, quarterly, or annual, depending on state and reporting requirements
This ensures that you’re at least at a bare minimum able to be comfortable with what you’re paying. This mitigates the fear that you paid too little, i.e. a dept that can end you up in a case with the IRS. And mitigates the fear that you paid too much, i.e. giving an interest-free loan to the government.
What accounts must we reconcile
What accounts must be reconciled?
Well, it depends on your basis of accounting. For most businesses, the cash basis of accounting is the go-to. This mean that you only record transactions when cash swaps hands. The other basis is called accrual basis accounting. This means that your record transactions when cash swaps hands, and when cash is due to you, or to someone else regardless of whether or not a payment has been made– aka, accrued transactions.
For cash basis:
Bank accounts + Credit card accounts + Cash/Undeposited Funds
For accrual basis:
All in Cash Basis + Accounts Receivable +Accounts Payable
Other transactions, such as accrued interest or depreciation are usually done by an accountant, so don’t worry about it when you’re doing your reconciliations.
Bank Account Recons
You don’t need to reconcile every account in reality, but you definitely need to have your bank accounts reconciled. For many businesses, every transaction hits the bank account at some point. Therefore, if the bank account is reconciled, you can be certain that every transaction has been accounted for, and nothing extraneous exists, like phantom income, or doubly counted expenses.
Credit Card Accounts
Credit card accounts are a bit tricker to reconcile, because usually the statements are closed in the middle of the month. But it’s fundamentally the same process as reconciling a bank account. You look at the transactions on the credit card statement, then compare them to what’s in the account for the credit card on the books. If they’re all there, and there’s nothing extra, and the ending balance in the credit card balance on the books is the same as the credit card balance on the CC statement, then you can be confident that the account is reconciled.
But this doesn’t always pan out perfectly, even if you do everything perfectly, because of timing differences. For example you made a credit card payment that hit your bank account, but the credit card company did not yet receive it. In this case you’ll have a lower credit card balance in your books than the statements say. Don’t panic. This is just a timing difference. You keep the transaction in your books, but you don’t record it as cleared until the credit card company records it. It clears on the next period, and is reflected on the next credit card statement, then you reconcile it, and the books will match the statements exactly.
Accounts Receivables
If you’re not on the accrual basis of accounting, then recording accounts receivable may not be necessary. But if you are tracking income received as well as income earned, then you’ll need to reconcile the accounts receivable account.
So what is an account receivable? It represents an amount owed to you.
For example, let’s say that you and I are playing a game of pool.
I’m feeling confident, so I bet $1,000 you that I can sink a particularly difficult shot. You accept the bet, and I take the shot. I line up, take the shot, and it rims out. I missed the shot.
You’re going to say, “you owe me $1,000”, and I’m going to say “ok, I’ll Zelle it to you tomorrow.”
At that moment, you don’t have the $1,000, but I do owe it to you. That debt that I owe to you would be $1,000.
When you wake up in the morning and see that $1,000 has been sent to you from yours truly, you have cash, but you no longer have a receivable with me.
In accounting, you don’t always have to record receivables, but you do always have to record the cash hitting your account. But if you are tracking receivables, then you need to reconcile the amounts that are owed to you with the amounts on the books.
If those are correct, then you can be confident that your balance sheet account for accounts receivable is correct, and so will be the income associated with those receivables.
Accounts Payable
Accounts payable are particularly important to reconcile for people who sell inventory, but can also be relevant if you owe vendors money for whatever reason.
The reason you’ll want to reconcile this account is that it will ensure that you are tracking expenses, and inventory properly.
Because when accounts payable increase, generally it increases either inventory, or expenses. Expenses can sometimes be deducted to reduce your taxable income, and inventory once it’s sold can be recognized as cost of goods sold to reduce your gross income, which also reduces your taxable income.
So reconciling accounts payable is often a way to find more expenses, and overall have more accurate books, but it is not necessary for every taxpayer, especially businesses on the cash basis of accounting.
Different methods of reconciliation
The methods of account reconciliation are all fundamentally the same: record transactions, confirm transactions, repeat.
Here are some methods for recording transactions, from cheapest to most expensive:
Record everything manually in your phone’s notes, an excel sheet, a piece of paper, or otherwise (generally a mess, wouldn’t recommend)
Manually record every transaction in your general software – QuickBooks, Xero, etc.
Tally up each transaction in excel and do a journal entry in your accounting software. (fastest but won’t stand up to an audit without support for the journal entry)
Auto import transactions form your bank or credit card into your GL software. (most expensive but fastest, however requires review since auto imports are usually incorrect on their own)
Here’s then how you confirm the transactions:
Identify transactions in your source docs
Identify transactions in your books
Compare transactions in books to those in source docs
Confirm each one individually
Confirm ending balance
Record timing differences if they exist
In excel, this can be with an X or a check or something
In your general ledger software, there will be a tab called “reconcile”, where you will input the balance and confirm each transaction individually.
Go through each transaction in the source doc, and your general ledger account, and confirm every single one. If the balance that you have in your account is the same as your source doc, you’re done. If there’s a difference, you’re not done yet.
I’m not going to lie, every accountant at some point has lost their mind trying to reconcile a bank account perfectly. It’s a pain sometimes. But once it’s done, you can be confident to the dollar that your accounting is accurate. And that’s the first step in obtaining financial certainty.
Putting it all together
The first step in obtaining financial certainty, and the subsequent peace of mind, is knowing that your transactions are completely recorded, and that everything that is recorded has occurred in real life. You confirm this by doing account reconciliations on the most important accounts in your business. Although this is often the most time-consuming process in all of bookkeeping, and the one that takes the lowest amount of skill, it is also the only sure way (that I know of) to be confident in your financial statements.
Once the reconciliations are complete, that’s when the conversation begins about your financial statements, and that’s when you get to do accounting.
Who can do Recons for You?
Most people think that bookkeeping is just recording all the transactions of the business. This is called account reconciliation, and although it is an important step in having good books and records, it is not the only one. However, it is often the most time consuming, and the one that is theoretically the easiest to delegate.
Here are some people that can do it for you:
Nobody/The Demons in your Head/The IRS – If you decide to not do this at all, then the IRS, having records of your income via 1099s and other sources, will calculate what they believe your net income should be, and it will usually be with the most adverse positions that they can come up with. Even if they don’t send you a letter or audit you, you’ll always have that voice in the back of your head that is screaming the worst-case scenario about what your unknown financial position and tax obligations may be. There’s not a price in the world that would justify that degree of mental wear and tear. This is the most time-consuming and expensive option, and I would never even joke about choosing this option.
DIY It – it’s your responsibility in the end, and you can be the one to handle it. It doesn’t cost you anything but your time to do this, but that is a hefty price to pay. So your hourly rate is higher than a bookkeeper’s hourly fees, then it’s time to hire someone to do this for you – I’d recommend doing this maybe once you’re over $50 an hour, and definitely once you’re making more than $100 per hour
Your Kid or Spouse – a good way to keep money in the family, shift income to lower brackets, and teach your kids how your business works, but should only be done if you can already do this task well on your own, since they’ll mess it up if you can’t teach it well. And some business owners use their spouse to do this task. You can’t shift income using this method, but you can avoid bookkeeping costs by doing this, although you will likely pay clean up costs at tax time unless your spouse is a professional.
Outsource Bookkeeper – good for ensuring that recons get done completely. Don’t shop for price on this one, but rather for skill. You don’t need a license to do bookkeeping, and many people in the outsourced bookkeeping space are inexperienced or ill-experienced, since bookkeeping is sold to the general public as a skill that anyone can learn with little to no prior skill or education. Don’t let someone learn on your dollar. Make sure you get someone reliable for this task.
Your Accountant – your accountant will generally be able to do this well because they depend on your books for the tax return. However, this is often more expensive in the short run, as their recurring fees will be often higher for an accountant than a pure bookkeeper. However, they won’t charge you for bookkeeping clean-up at tax time when they’re doing the tax return, since they were tasked with having clean books in the first place. So if you’re weighing this on per project cost, than your tax preparer is a great candidates to handle your books, especially if they’re charging you annual clean up fees already.
In Conclusion
If you are going through it, keep going. If you got this far, then you know that books and tax can bring out the worst in us. But that’s the time to push through, or to get help. This is the hard part, and it’s something you must navigate well. And it doesn’t have to be painful. In fact, I’d even go as far as to say that since the people in your life depend on the energy you share with them - whether that’s your friends, lover, partners, business associates, or whoever - that it’s your duty to do what you must in order to stay mentally healthy.
You don’t need to have an annual panic at tax time followed by a year of financial uncertainty. You have the power to keep yourself in good mental condition and maintain your peace of mind at tax time and beyond. An ounce of prevention is worth a pound of cure with books and tax, and it’s amazing what you can get done when you actually start doing it. Whether that means doing it yourself, getting someone to help you, or simply paying more attention to this important task, then you owe it to yourself to get it done.
And if you’ve read this far, then you’re an action taker who wants more out of life, and for that, I think that I can help you. So if you want to get on the other side of tax pain by taking care of your account recons or otherwise, then book a complimentary CPA consultation at this link here.
Our team has accumulated experience of over 30 years of cultivating the skills necessary to help you on your path towards tax compliance, and peace of mind. If that sounds good to you, then head on over, and I look forward to speaking with you.
Until next time,
Jonathan Sussman, CPA
