How Equity Accounts Work in QuickBooks

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How Equity Accounts Work in QuickBooks
By Doug Sleeter

From the September 2004 Issue

One of the more confusing topics in QuickBooks is how it treats equity accounts. Because the program was designed for non-accountants, it hides some important details like the closing entry and the details of postings to the Retained Earnings account. Although most business owners don’t really care about this, it drives accountants crazy. It makes it very difficult to validate financial statements and troubleshoot prior period changes since there is no way to see what was posted to the Retained Earnings account.
While I don’t have a magic bullet for you, I can hopefully help you better understand what’s going on in QuickBooks equity accounts, and I’ll give you a few tips for how you can get the information you need to feel comfortable with your financial statements.

When you set up a company file, QuickBooks automatically creates two equity accounts for you. These accounts are Retained Earnings and Opening Balance Equity. If you’re new to QuickBooks, you’ll probably wonder what the Opening Balance Equity account is for, and you’ll be tempted to just delete it because it sounds like something that you don’t need or want. However, this account is very useful during setup and for troubleshooting problems such as forced bank reconciliations, so do NOT delete it.

As you enter the opening balances during the initial file setup, QuickBooks uses the Opening Bal Equity account to offset the balances in all the other accounts. For example, when you create a bank account and enter the opening account balance in the new account screen, QuickBooks debits the bank account and credits the Opening Balance Equity account. At the end of the setup process, you must “close” Opening Balance Equity into Retained Earnings using a journal entry. From there forward, you should never see a balance in Opening Balance Equity. However, since all the opening balances are shown in the register for this account, you can go back and see what was done at setup by looking at the Opening Balance Equity register. If you find errors in the setup, it’s very easy to make changes all in one place. Also, when a user “forces” a bank reconciliation, the automatic adjustment made by QuickBooks will show in the Opening Balance Equity account, making it very easy to spot when troubleshooting problems. For these reasons, we like to keep the Opening Balance Equity account, even though we never post to it after the initial setup.

As for the Retained Earnings account, this is a special account for several reasons. First, it doesn’t have a register like all the other balance sheet accounts. Second, the reports (e.g., General Ledger) give no detail of postings to the account. And third, QuickBooks “automagically” calculates the balance in Retained Earnings when you create a Balance Sheet. The automagic calculation shows the effect of closing entries for each year in which you have data. That is, it calculates the net income for each year of data in the file and uses the net income or loss to adjust the balance of the Retained Earnings account. This theoretically gives you the right balance since all it’s really doing is saving you the trouble of manually entering closing entries each year. Also, since you don’t enter a closing entry each year, you can always look at financial statements from prior years by simply asking QuickBooks to create a report for a past year.

This is just fine as long as your client doesn’t change prior year data. However, clients do that a lot more than we would like. It’s one of QuickBooks’ best features, but it’s also the one that drives accountants up a wall. The program is so friendly, you can change whatever you want, whenever you want. Clients love it. They can just go “fix” whatever they see needs fixing, and they have no qualms about it because they don’t understand about closed periods, published financial statements or filed tax returns. It just doesn’t cross their minds. So when they make changes, how do you troubleshoot the problem? For example, what if someone deletes a transaction from a prior year? Assuming the transaction hit an income or expense account, the effect of deleting this transaction will affect the net income for that period, and therefore affect the balance in Retained Earnings. The problem is this: How do we detect the cause of the problem? Which transaction was it?

Fortunately, QuickBooks gives you a few tools to deal with this situation. The Audit Trail keeps a log of deleted and changed transactions. So as long as the Audit Trail is activated in the preferences, you can look at the Audit Trail report to find deleted transactions. It’s still quite tedious, though, because you have to sort through hundreds or thousands of transactions to isolate the problem. Also, if the file didn’t have the Audit Trail active when the client made the change, you’re out of luck. To deal with this problem a little better, QuickBooks now has a report called the “Closing Date Exception Report.” If you set the closing date in your accounting preferences to the end of your last closed period, this report will show you all transactions dated before that date that have been changed since you set the closing date. This should really help you troubleshoot the problems caused by clients messing with the data file after you’ve finalized the financial statements for the year.