Let’s assume a small business has been in operation for awhile with either a manual bookkeeping system or no system at all. If you’re setting up records for the first time, where do you start?
The answer lies in the accounting framework itself. Coming out of that framework are the reports that show us where to begin.
Every financial activity in business ends up in one of two financial statements: the balance sheet or the income statement. There are simply no other places to post activity. Every account makes its home in one statement or the other.
The balance sheet tells us the financial condition of a business at a point in time: yesterday, last week, six months ago, last December 31. It lists the assets of a business (what the business controls of value) and its obligations (debts, unearned income, and the like). It also reports the accumulated contributions and withdrawals of its owners, and the accumulated earnings of the business over time.
The income statement itemizes those accumulated earnings and expenses over time: a week, a month, a year. The net income figure at the bottom connects this statement to the balance sheet, appearing as current period earnings in the equity portion of the balance sheet.
Since the balance sheet reports the condition of the business on a specific date, it’s the logical starting point for launching a set of books. This is good news, because you can usually recreate opening balances with a small number of documents like bank and mortgage statements.
Let’s say it’s October 2019 and you wish to recreate records for 2018, the prior calendar year. How would you begin? You’d start by creating a balance sheet on December 31, 2017. Next you’d post your 2018 activity, classifying transactions for the year in appropriate accounts. Finally, you’d confirm your balance sheet on December 31, 2018. What will this accomplish?
If you’re filing taxes for 2018, here’s what it will do. It will establish that your beginning and ending balance sheets are correct. If these two statements are correct, then it follows your income statement for all of 2018 will be correct in total. The opening and closing balance sheets function as bookends. If they are correct, there’s simply no other place for 2018 transactions to go except the income statement for the interval in between. True, you could post 2018 expenses as income or vice versa. But unless you move dollars between income statement accounts that are taxed differently, it doesn’t matter. Your 2018 income statement – which is the primary source for determining taxable income — will be substantially correct. This is a huge comfort!
Moreover, you will have prepared yourself for an audit should the IRS challenge your return. The IRS examines opening and closing balance sheets to help determine whether your income statement is correct. Nice to know you’ll already be prepared.