Cleaning up Messy Books (#227)
/In this podcast episode, we discuss how to handle a situation where the books are a mess. Key point made are noted below.
This is a fairly common problem, especially if you’re in the bookkeeping business and a new client has basically been operating out of a shoe box. In short, there really aren’t any accounting records, there are just source documents. Or, someone might have tried to keep the books, but they had no idea what they were doing, so the accounting records are incredibly bad.
Stop Any Further Damage
So, the first step is to stop the damage from occurring from this point forward. That means routing all of the new, incoming source documents through a reliable bookkeeping system. This presents a bunch of problems. First, is the original bookkeeper still going to be involved? That might be bad, because the person clearly hasn’t demonstrated any ability to keep the books so far. This is going to be a judgment call. If the person is clearly incompetent, then remove him from the accounting operation immediately. If the person simply didn’t have any training, then it may be possible to correct his behavior.
Take Control of the Source Documents
The next issue is taking over control of the source documents. Make sure that all supplier invoices and employee expense reports are being routed straight to you. The same goes for payroll records and customer billings. It’s impossible to keep the books if the paperwork is scattered all over the company.
Enter Transactions Properly
Then set up a chart of accounts in a simple accounting software package and start entering the accounting transactions the way they’re supposed to be entered. The emphasis is on getting an operational system running as soon as possible. What this does is give you a functional general ledger from the current day forward. With just this information, you should be able to construct an income statement without too much trouble. The problem is that it’s impossible to create a balance sheet without the prior records – and that brings us to the second step, which is using the old source documents to construct general ledger transactions for prior periods. And this presents another bunch of problems.
The first problem with reconstructing the old records is that you may not be able to load them into the new accounting software that you’re now running the business on. Some of these packages don’t allow you to create accounting periods prior to the current period. If so, you’ll need to initially store these old transactions on an electronic spreadsheet. When you’re done researching the old records, you may need to start up a brand new accounting software package and load in both the old accounting records and the new records that you’ve been maintaining since you took over the books.
An alternative that’s less messy is to initially set up the earlier reporting periods in the accounting software and leave them empty, and then start recording entries in the current period. Then re-open the earlier periods when you have transactions to record in those periods.
Determine What to Record from Prior Periods
The next problem is figuring out what to record for the prior periods. There are two key principles to follow. One is that every transaction has to be verified, which means that there must be a source document. If you record an accounting transaction and it’s not based on a source document, then, if you’ll excuse the expression – you’re just making shit up. The other principle is to verify every transaction you’re recording through the company’s bank statements. There’re actually some situations when a source document doesn’t appear in the bank statements, which I’ll get to in a minute.
The bank statement is the best possible record of what the business has been doing, since it shows all cash inflows and outflows, and the bank should have an online image scan of every check and deposit that was processed through the account – which is valuable evidence.
So, based on these two principles, the reconstruction of prior period accounting records involves coming at the work from two directions. You can start with the source documents in that shoe box and verify that they happened by checking them off on the relevant bank statement. Once you’re sure it happened, create a double entry journal entry for it in the correct reporting period and then move on to the next source document.
Then turn the situation around and trace all items that have not yet been checked off on the bank statements back to the source documents. This might result in clear evidence of a cash payment or receipt, but no source document, in which case you may have to dig around for it, maybe by contacting a supplier or customer for the relevant document.
At this point, you’re probably going to have a set of supplier invoices that didn’t trace through to the bank statement, and that’s because they haven’t been paid yet. These are recorded as accounts payable. And, along the same lines, there’ll be customer invoices that don’t appear in the bank statements, and that’s because they haven’t been paid yet. Those are recorded as accounts receivable.
As you might expect, this is a slow and incredibly painful process. The longer the books have been a mess, the longer it will take to conduct a complete clean up. At some point, a reasonable question to ask is whether it’s really worthwhile to keep going further back in time.
Complete Financial Statements and Supporting Reports
After going back to the beginning of the current fiscal year, you’ll be able to put together some semblance of a balance sheet, and you’ll have sales and profit figures for the entire current year. And, if the rollback work was for at least three months, you’ll probably have reconstructed something pretty close to the actual aged accounts receivable and aged accounts payable reports.
With this information available, the business is operational. So, depending on the circumstances, you can then restart the general ledger as of the beginning of the year and load in all of the earlier transactions. Or, if you initially set up the general ledger with a bunch of empty earlier reporting periods, then you should have now populated those periods with transactions.
Switch to the Accrual Basis of Accounting
Here’re another consideration. When someone is operating out of a shoe box, they are probably operating on the cash basis of accounting, which means that they record revenues when cash is received and expenses when bills are paid in cash. This would be a good time to switch the company to the accrual basis of accounting, since you’re putting their books through a complete overhaul anyways. And THAT means going back into the accounting records to record accruals for the prior months that you’ve reconstructed, so that each month now has accrued expenses on the books. By doing that, the reported profit levels are likely to be more consistent in the earlier periods, rather than gyrating around, depending on the dates when cash came in or went out.