As we are rapidly approaching the end of 2014 there will of course be those new QuickBooks users who are confused by the fact that QuickBooks is a perpetual accounting system and does not really 'close' year end periods. They will equally be confused by the fact that their balance sheet on 12/31/2014 at the last moment of the year, and on 1/1/2015 at the very first moment of the year are not the same due to how QuickBooks calculates and posts Retained Earnings.
While QuickBooks "Pro's" understand this process, they are frequently surprised later in the year when changes appear in their Retained Earnings prior to establishment of a closing period and password (or even if someone has 'snuck' the password and made a change that impacts Retained Earnings.) As such Joe Woodard published an article a few years back about the benefits of using a Retained Earnings Clearing Account, I have brushed off his article and with a few updates, here is another timeless "True Joe Ways" just in time for year's end. (Some things just never go 'out of season', and also warrant remembering when the time is right...)
How QuickBooks Calculates Retained Earnings
QuickBooks has an auto-close feature that recalculates retained earnings and net income depending on two sets of report criteria: 1) the date of the report you are reviewing and 2) the “cash” or “accrual” basis of the report. For example, a Balance Sheet dated 12/31/2014 will show a different amount for Retained Earnings and Net Income than a Balance Sheet dated 01/01/2015. When you advance the report forward into the next financial year, QuickBooks nets the amount of Net Income (or Loss) into the Retained Earnings balance – as shown below.
This calculation method for recording closing entries is creative and flexible, because it allows for the cash/accrual conversion, and it allows users to process transactions during the current financial period without any restrictions. This “soft close” also allows accounting professionals (e.g. tax preparers) to easily enter tax adjustments for the previous year even if the current period is in March – or even later. However, there are two potential issues with the calculation method that QuickBooks uses: 1) it can be difficult to track changes to a previous fiscal year even if the Closing Date protects the previous fiscal year. For example, if you merge two accounts together, the Closing Date doesn’t track the activity and there is no “red flag” indicator that lets you know something has changed. 2) You cannot show a Balance Sheet as of 12/31 where Net Income and Retained Earnings are netted together (i.e. an after closing Balance Sheet or after closing Trial Balance).
You can use the following trick to address each of these issues above:
Step 1. Change the name of the existing Retained Earnings account to “Retained Earnings Clearing.”
Step 2. Create a new Equity account called Retained Earnings.
Step 3. After you have finished making all edits to a fiscal year, enter a journal entry for the total amount of Net Income. Debit the Retained Earnings Clearing account and credit the Retained Earnings account.
Step 4. On the Balance Sheet as of 12/31, Net Income and Retained Earnings Clearing will cancel each other – positive and negative balances will be the same – and the Retained Earnings balance will show the correct amount.
Step 5. If a user makes a change to a posting transaction dated in the “closed” year, QuickBooks will immediately show the change as a balance in the Retained Earnings clearing account – for the current period. This creates an instant “red flag” for changes made to closed periods.