What Does it Mean?
Before moving forward, it is key to remember that net income for any given year is closed to retained earnings. In addition, the ending balance sheet account balances at 12/31 become the 01/01 beginning balances. With this in mind, when a manager instructs staff to roll equity, the staff should verify that ending retained earnings balance on the prior year tax return is the beginning retained earning balance on the client’s financials (i.e., the account balance rolls over from year to year).
Many clients use software (e.g., Quicken, QuickBooks, Sage50) to maintain the books and records for their business. They provide the financial statement printouts from the software to the accountant to prepare the tax return. In a perfect world, the accountant uses the financial statements from the client and produces a tax return. In a realistic world, however, the client’s books likely need adjustment. For example, clients habitually record loan payments as expenses on the profit and loss statement (P&L), expense large equipment purchases that should be capitalized, and omit depreciation expense. Many small-mid size accounting firms are aware that clients are not trained accountants and offer a quick perusal of the books and make accompanying adjustments as part of their tax preparation service.
Therefore, in a real-world scenario, the client provides the financial statements from their software to the accountant, the accountant adjusts the financial statements for errors, and then uses the adjusted financials to prepare the tax return. Once the return is finished, the client’s software will automatically close the books (zero net income to retained earnings), and the process starts fresh the next year.
The problem occurs because a CPA’s tax preparation software (e.g., Ultra Tax, Lacerte, Axcess) will pro forma the ending balance sheet used on the tax return to the next year’s beginning balances. When the accountant opens up the tax software the next year, inputs the current year P&L, and ending financial account balances, the error will be obvious … the balance sheet is out of balance.
How is this possible? In the tax software, the beginning balance sheet balances and agrees to the ending balances on the prior year tax return, the current year income in the tax software matches the current year P&L, and the ending balances in the tax software match the ending adjusted financials. The reason the tax software is out of balance is because retained earnings didn’t “roll”–but what does this mean?
Most tax software calculates the ending retained earnings to show on the tax return. (In fact, when keying a balance sheet into tax software, the ending retained earnings is often an override only field.) The software takes the beginning retained earnings in the tax program (which, as already noted, is the pro forma from the prior year ending tax return balance), adds (or subtracts) current year income, and calculates the ending retained earnings on the tax return.
Therein lies the problem. In the prior year, the accountant adjusted the client’s financials before inputting the financials into the tax software. Therefore, the accountant’s net income that the tax software closed to retained earnings was different than the client’s net income that the client’s software closed retained earnings. When different net incomes close to retained earnings, there are different retained earnings amounts on the client’s financial statement printout as compared to the tax return.
This is a perfect example of the fact that, despite the client’s software closing the books automatically, if the wrong information is in the books, the wrong output appears on the financials.
Why Does it Matter?
Retained earnings must roll correctly for two reasons: 1) to ensure the same income or expense items are not being recorded year after year, and 2) to keep the tax return in balance.
Example 1.
Sally’s SeaShell Store has a $12,000 loan payable balance on her financials. Her accountant notices the bank’s loan statement says the balance is $10,000. The accountant further notices Sally has a loan expense on the P&L of $2,000. The accountant realizes Sally expensed the loan payments as a debit to loan expense and credit to cash instead of debiting the balance sheet account. Because loan payments are not a deduction on the P&L as an expense, the accountant makes an adjusting journal entry (AJE) to debit loan payable for $2,000 (thus adjusting it to actual) and a credit to the P&L loan expense to remove the $2,000 loan payment expense.
Sally does not record this adjusting entry on her books, meaning her net income is $2,000 less than the tax return’s net income (because she kept the $2,000 loan expense on her books). Therefore, her retained earnings will be $2,000 less than the tax return.
The next year, the bank loan statement has a balance of $9,000. Sally’s books show $12,000 (the same amount from the prior year, because she didn’t record the AJE). The CPA determines the balance sheet needs adjusted by $3,000. Following the prior year’s pattern, the accountant debits the loan payable for $3,000 and credits loan expenses for $3,000. The balance sheet agrees with a third-party statement, so he assumes the P&L adjustment is accurate. Because Sally didn’t record the prior year AJE, however, the current year’s $3,000 decrease in expense includes the prior year $2,000 decrease again as a P&L reduction. If she had recorded the prior-year entry on her books, the loan balance would have been $10,000 and only needed a $1,000 current year reduction in expenses, not $3,000.
This problem will perpetuate itself year after year. How could the CPA have caught this error? By rolling equity; the taxable income will be incorrect if retained earnings doesn’t roll, and the tax return will be out of balance.
Example 2.
Lucy’s Pet Store bought a new van and opened a mobile pet shop. She provides the financial statements shown in Exhibit 1 to her CPA. (For the sake of simplicity, teaching examples show a balance sheet with current-year income already reflected in retained earnings. This example balance sheet shows a line for retained earnings and a line for current year income, as is common from QuickBooks printouts.)
Exhibit 1
Lucy’s Pet Store, 2021 Financials
The accountant observes the van is being expensed and makes an adjusting journal entry in the tax software to capitalize the van by debiting an account “Fixed Asset–Van” and crediting the expense account (Exhibit 2).
Exhibit 2
Adjusting Journal Entry
The accountant then prepares the tax return using the updated financial statements. (For simplicity, assume the van has no depreciation expense. If it did, the accountant would simply record another adjusting entry for the depreciation expense.)
As shown in Exhibit 3, the tax return software will pro forma $24,000 to 2022 as the beginning retained earnings balance, but the client’s QuickBooks will automatically close the books and roll $9,000 of retained earnings to be the 2022 beginning balance. The problem is obvious, but consider the next year.
Exhibit 3
Lucy’s Pet Store, 2021 Financials Prepared by CPA
Lucy’s Pet Store provides the 2022 financials. Lucy’s software rolled forward her prior year ending balance sheet to be the beginning balances for the current year.
The accountant believes nothing needs adjusted on Lucy’s books for tax year 2022, so the CPA opens the tax software and inputs the current year P&L from Lucy’s financials, the ending balance sheet accounts from Lucy’s financials (except R/E, which is always an override in the tax software), calculates the tax return, and is out of balance by $15,000. This is because the software is starting with retained earnings of $24,000, and Lucy’s balance sheet is using $9,000.
The accountant will make an AJE to Lucy’s books. Part of the AJE is known; retained earnings on Lucy’s books needs credited by $15,000 to match the tax return. But what is the offsetting debit? Should it just be to an expense account? No! To plug the retained earnings adjustment to a random expense account would be recording $15,000 in a fictitious expense (per Sally’s SeaShell example). The CPA might now recognize the $15,000 as the amount of the AJE the accountant made in the prior year to capitalize the van. Upon further inspection of Lucy’s books, the van is not showing as a fixed asset on the 2022 books, because Lucy didn’t record the 2021 AJE. The entry will be a debit to Fixed Asset–Van for $15,000 (to set up the balance sheet account that should have rolled forward) and a credit to Retained Earnings for $15,000 (to agree Lucy’s books to the tax return). The entry is recorded on the financials, the van account balance in the tax return is updated, retained earnings is not updated in the software (because it is auto-calculating), and the result is a balanced return and an accurate P&L.
In this example, it was rather easy to note the “missing” $15,000 retained earnings adjustment was because Lucy’s books didn’t show a van fixed asset account. But when the situation isn’t so obvious, how do accountants determine the retained earnings adjustment needed to roll equity?
How to Roll Equity
There are two main ways to roll equity. The first is quicker but less robust; the second is more time-consuming but capable for complex cases. How do staff know which method to use? The general rule is: start with Method One because it is substantially quicker. If method one fails to roll equity, the case is “complex” and requires Method Two.
What is a complex case? As noted previously, retained earnings will not roll if the accountant made journal entries that the client failed to record. In addition, retained earnings will not roll if the client made changes to the prior year’s books after providing them to the accountant to prepare the prior-year return. Unfortunately, this happens frequently. A client might realize they didn’t cash a check they anticipated cashing and deletes the check from income, or the client receives some other news, adjusts the books in their software, and fails to consider that the CPA already prepared the tax return off the old books; such a scenario requires Method Two. Rarely will a CPA know this is the case, as many clients simply forget to tell the accountant. Therefore, most accountants use Method One, and, if they realize equity won’t roll, proceed to use Method Two under the assumption the client altered the books.
Method One.
The first method to roll equity is to record a current-year AJE by accounting for the prior-year AJEs made to the balance sheet accounts only and plug the remaining amount needed to balance the entry to retained earnings. Why balance sheet accounts only? Any of the entries made in the prior year to the P&L would have altered net income, which closed to retained earnings. Therefore, the prior P&L activity would be reflected in the AJE’s plug to retained earnings and should not be accounted for again in the current-year P&L. This is illustrated in the example below. (Note: As is the case with most trial balance softwares, such as CaseWare or Engagement, the current-year net income is not closed to retained earnings yet as the information is presented trial balance style. Furthermore, the debits are positives and the credits are negatives.)
Example 3.
Luke’s Pizza provided the 2022 financials to their accountant. Knowing Luke never records the prior entries, the accountant pulls up the trial balance software for the prior year and observes the 2021 financials as provided by client, the adjustments, and the final, adjusted tax return amounts. Then, using the 2021 adjustments (figure 4 column D), the accountant records the AJE in Exhibit 5 on the current year (2022) financials.
The current AJE to roll equity accounts for the prior-year balance sheet only AJEs and plugs the rest of the current year entry to retained earnings. Again, the prior-year P&L entries are not recorded in the current year lest the current-year P&L duplicate prior-year income/expenses. After the AJE, Luke’s retained earnings agree with the prior tax return, meaning the correct prior-year net income was closed to retained earnings so no P&L AJEs are needed in the current year.
Coincidentally, the “plug” to retained earnings is not a plug at all, but a verifiable amount. Recall that Luke’s unadjusted books from the prior year (2021) would show net income of $10,000 but the adjusted tax return showed $9,900 (Exhibit 4). In 2022, Luke’s books will have retained earnings overstated by the $100 difference. This $100 difference in retained earnings is the “plug” in the AJE shown in Exhibit 5. All goals are accomplished: retained earnings rolls, the balance sheet accounts are accurate starting numbers, and the current-year P&L is not duplicating prior-year expenses.
Exhibit 4
Luke’s Pizza, 2021 Financials 01/01/2021–12/31/2021
Exhibit 5
Adjusting Journal Entry
Method Two.
The second method is more time-consuming but useful for larger trial balances or when numbers have been altered from when the prior-year information was provided to the CPA. In brief, the updated 12/31/2021 (prior-year) balance sheet will be pulled from the client’s software. If the client went back and changed numbers after providing the prior-year financials to the accountant, the static, prior-year copy in the accountant’s files would not reflect the changes. Printing a new prior-year ending balance sheet from the client’s software reflects the updates and demonstrates which balances are flowing into the current-year (2022) retained earnings.
To illustrate Method Two, prepare a spreadsheet. In Column 1, put the client’s updated prior-year (12/31/2021) balances. In Column 2, put the prior-year ending balances that were used on the prior-year tax return. In Column 3, calculate the difference between columns 1 and 2. This difference is the AJE needed on the 2022 books to roll equity. As with Method One, only the balance sheet accounts are recorded and the “plug” is to retained earnings.
Example 4.
Take Luke’s Pizza, but now after Luke provided the 12/31/2021 (prior-year) financials, he changed inventory from $1,500 to $1,200 and cost of goods sold (COGS) from $100 to $400.
The original records used to prepare the 2021 prior year tax return are in the third column (agrees with Exhibit 4) and the updated financials from the client are in the fourth column. This is shown simply for clarity and comparison to Method One, but it is not strictly necessary.
The CPA prints a new prior year (2021) set of financials (fourth column). In the fifth column, the prior-year tax return (adjusted financials) are shown (it agrees with the fifth column in Exhibit 4); then, the final column calculates the difference between the preceding two. The CPA uses this column to record the AJE. The 2021 inventory on the client’s books is $1,200; the tax return showed $1,300. The client’s books need to be debited by $100 to agree with the tax return. The accountant must then proceed through each remaining balance sheet account to record the AJE and plug to retained earnings.
Once this entry has been recorded to the current-year (2022) financials, retained earnings rolls.
Example 5.
Consider Luke’s 2022 activity in the seventh column of Exhibit 8 (sales of $7,000, COGS of $1,500, inventory reduction of $300, and cash received of $5,800). Luke provides his 2022 financials in the eighth column; these are the same as the client’s 2021 financials from the fourth column (because his software is using his updated, unadjusted 2021 amounts) plus the 2022 activity. The 2022 entry to roll equity is recorded as AJEs in the eighth column of s. The final column reflects the CPA’s adjusted 2022 trial balance to prepare the tax return. Beginning equity for 2022 is $10,200 on the adjusted financials. This agrees with the 2021 prior-year tax return retained earnings of $10,200 (originally provided retained earnings of $300 + 2021 tax return net income of $9,900). The balance sheet accounts are accurate starting points and retained earnings rolls without any 2022 P&L adjustments, which would be fictitious expenses.
Exhibit 6
Luke’s Pizza, New Financials, Method 1
Exhibit 7
Adjusting Journal Entry
Exhibit 8
Luke’s Pizza, New Financials, Method 2 01/01/2021–12/31/2021
Upon closer inspection, Luke picked up $300 more in COGS expenses in 2021, shouldn’t this amount be deductible? The answer is no, because these are not legitimate expenses, as here was no change in cash/payables. The goal of this example is not to “fix” the client’s prior-year unadjusted income (2021); rather, to ensure that the client’s current-year P&L is correct by adjusting the balance sheet (because the amounts carry over from year to year) to accurate starting numbers. Because P&L accounts close every year to retained earnings, there is no reason to account for the client’s prior-year P&L inconsistencies. Once the client’s amount of retained earnings agrees with the tax return, it can be assumed the prior-year P&L inconsistencies have been addressed, because retained earnings wouldn’t agree with the client’s records and tax return if different net incomes were still flowing into retained earnings.
Troubleshooting
There are a few troubleshooting items to note when it comes to rolling equity. If cash has altered from the time the prior-year financials were provided to the accountant compared to what is currently in the client’s software and is reconciled to a bank statement, accountants should not reconcile cash. A reconciled cash balance should always be correct, so by adjusting cash to roll equity, cash would no longer reconcile. This is the one case where the amount by which cash changed from the prior year would be due to an additional income/expense item and the difference would run through the current-year P&L and plug to retained earnings. Any time that cash differs, a CPA will most likely find an entry recorded after the tax return was prepared which indicates that the client debited/credited cash and debited an expense or credited income. Because cash actually changed and reconciled, these are legitimate income or expense items not reflected on the prior-year tax return, but which must be accounted for on the current-year P&L. Under these circumstances, CPAs should generally not amend the prior year return, but simply record the income/expense in the current year and plug retained earnings.
How to Avoid Equity Issues
Rolling equity, while completely necessary for an accurate tax return, is challenging. How can accountants and their staff avoid this process? If the accountant makes any AJEs, be sure to let the client know. Some firms even offer to go to the client’s location and assist with making the AJEs to ensure the client’s books agree with the tax return. This small investment in time can save hours rolling equity during the next tax season. Another option may be to ask clients to “lock” their books after year end. Some software can prohibit changes from being made to the prior year once locked. A few small steps can save hours of work for staff come next tax season.
