Bookkeeping Cleanup vs Catch-Up: Fix the Old File or Start Fresh

What is the difference between bookkeeping cleanup, catch-up and reconstruction?

Cleanup fixes entries that are wrong, catch-up adds months that were never entered, and reconstruction rebuilds records that no longer exist. None of the IRS sources cited here defines these words. They are working labels for what is wrong with a file, and most files need more than one. Fixing the old file generally fits when every gap in it can be named; a new file opened from the last filed balances may fit when a gap cannot be traced, and the old file is kept either way.

All three aim at the same thing: books that establish the income, deductions and credits on each return (26 CFR 1.6001-1). The month-by-month method for overdue books is in Catching up on overdue books. The fixes to make before a preparer sees the file are in the bookkeeping cleanup checklist, clearing a catch-all account is in uncategorized expenses before tax time, and personal money mixed in is in fixing commingled business and personal funds.

A case is not simple when a return is due now, a preparer has refused the file, returns were already filed from the bad books, a year has no return, several entities share accounts, records are missing, or an IRS notice has arrived. Those cases usually need a professional's review before the books change; see bookkeeping help. Gather first: bank and card statements for every month, the last filed return, an export of the old file, and payroll and loan reports.

Messy books: which do I need, cleanup, catch-up or a new file?

Cleanup fits when the months tie to the bank but the categories are wrong, catch-up when whole months are missing, reconstruction when records are gone, and a new file when the books cannot be tied to the bank or the last return. Most files show more than one symptom; reconstruction comes first because the other two need its records.

This routing is a working method, not an IRS rule.

What do my books have to show for the IRS, whichever route I pick?

The books must establish the gross income, deductions and credits on every return, and the records behind them must stay available as long as they may matter to any tax law (26 CFR 1.6001-1). The IRS requires no particular bookkeeping method, but the method used must clearly and accurately reflect income and expenses (Topic 305).

Publication 583 describes these practices: keep the supporting documents behind the books (invoices, receipts, deposit slips, canceled checks and account statements), reconcile each bank account to its statement every month, and keep business and personal accounts separate. If the books are computerized, the machine-sensible records must reconcile with the books and the return.

Accounting records also include a reconciliation of any differences between the books and the return (26 CFR 1.446-1(a)(4)). What the return gives you to tie to depends on the business. Schedule L is the balance sheet on an entity return:

A small entity may not be required to complete Schedule L; the form instructions set the size test. Where the return has no balance sheet, tie to the statements and to the prior books instead.

How do I test whether the old file is worth fixing?

This is a working test, not an IRS rule. Run three checks, in this order. Fixing the file generally fits when all three pass, or fail only in places you can name.

Tying to the bank shows the book balance agrees with the statement, not that each entry is in the right account. And a failed check 2 says the books and the return disagree, not which one is wrong. If checks 1 and 3 fail but the records exist, the route is cleanup or catch-up inside the same file. If year-end balances do not match the last filed return and no one can trace the gap, read the next section before deciding.

When does starting a new file make sense, and what do I still keep from the old one?

A new file may make sense when year-end balances do not match the last filed return and no one can trace the gap, when closed years keep changing and the file cannot serve as a record, or when the old file can no longer be opened or used. A new file never replaces the old one: books and records must be kept as long as they may matter to any tax law (26 CFR 1.6001-1).

That is generally until the period of limitations for each return (the time the IRS has to assess more tax) runs out, which is 3 years from filing (or from the due date, if later) for most support. For a partnership or S corporation, the same period also runs from the date each owner's return is due or filed, whichever is later (Form 1065 instructions; Form 1120-S instructions). It is longer in some cases, such as income left off a return that is more than 25% of the gross income shown on it, and there is no limit for a year with no valid return or a fraudulent one (Topic 305). These are the periods for federal income tax returns; other taxes, including state taxes, can differ. How long to keep business records has the full list.

A new file does not make the old problems disappear. It moves them to a list: each difference between the old file and the last return still needs an answer.

How do I set the opening balances so a new file matches the last filed return?

Open the new file on the first day of a tax year with the balances that closed the last filed year, then enter every month since from the statements. Income and expense accounts close at the end of each tax year, while asset, liability and equity accounts carry forward (Publication 583). A new file that starts on the first day of a tax year therefore opens with balance sheet accounts only.

Normally the old file's own closing balance sheet is the source and the filed return is only the check. Here the old file cannot be trusted, so the ending column of the filed Schedule L may be the best closing balance sheet there is. Treat each of its lines as a total to support with a document where one exists (year-end bank, card and lender statements, the depreciation schedule). On a partnership return, beginning total assets must generally equal the prior year's closing total assets, and a difference needs an attached statement (Form 1065 instructions).

List every gap with its amount, and where a document disagrees with the filed figure, note both. Do not force a gap to zero: the filed balance is only as good as the books it came from. Which figure to open with, when a document disagrees with the return, is a decision to take with a professional, because it may mean the return was wrong.

Without a Schedule L (a sole proprietor or a small entity), build the opening balances from the statements and from loan and asset records. Opening balances after changing accountants has the full steps. For equity that will not match, see retained earnings that do not match last year's return. If the business ran for a while before any books existed, see opening balances when books start late.

My old books were used to file returns: do those returns have to be fixed?

Not automatically. A return may need correcting when an amount it reported is wrong, so compare the corrected books with each filed return, year by year. An individual who finds an error after filing may need to amend. An S corporation files an amended Form 1120-S, with amended Schedules K-1 where owner figures change (Form 1120-S instructions), and a C corporation files Form 1120-X (Form 1120 instructions). A partnership, including a multi-member LLC, is under the centralized audit regime unless it elected out on its timely filed return with Schedule B-2, which only a partnership with 100 or fewer eligible partners can do. A partnership under that regime generally files an administrative adjustment request, not an amended return or amended Schedules K-1; one that elected out amends its Form 1065 with amended Schedules K-1 (Form 1065 instructions). Check Schedule B-2 on each filed return.

Line up the corrected gross receipts, each expense and the Schedule L balances against the return. There are three outcomes:

A refund claim is generally due within 3 years after filing the original return or 2 years after paying the tax, whichever is later (IRS); how long the IRS has to assess more tax is in How long to keep business records. The steps, forms and owner-return effects are in Correcting a filed business return.

Can I change my accounting method while cleaning up the books?

Correcting a posting or math error is not a change of method; switching methods, or changing when a recurring item is counted, is a change and needs IRS consent first (Publication 538). A taxpayer who changes the method used to keep the books must get consent before computing income on the new method, even if the new method would be a proper one (26 CFR 1.446-1(e)). The request is made on Form 3115 (About Form 3115), and the deadline depends on the procedure. A request for advance consent is generally filed during the tax year of the change (26 CFR 1.446-1(e)(3)). An automatic change (Publication 538) is attached to the timely filed return for that year, extensions included, and a signed copy goes to the IRS no earlier than the first day of that year and no later than the date the return is filed (Instructions for Form 3115). Check which procedure applies before the books or the return change.

Consent applies to a change from the method already in use. A taxpayer may adopt any permissible method on the first return that reports the business, and the method first used, as shown on that return, must be followed consistently afterwards (26 CFR 1.446-1(e)(1) and (d)(1); Publication 538). An unfiled later year does not reopen that choice: the established method generally continues unless a permitted change is made. Whether an item's treatment already set a method depends on the facts, a question for a professional before the books are redone.

The trap is quiet. A return's method is tied to the books' method: the same method for a sole proprietor (Publication 334), the method regularly used in keeping the books for an S corporation (Form 1120-S instructions), and a method reconcilable with the books for a partnership (Form 1065 instructions). If corrected books change when an item is counted, compared with the filed returns, that may be a method change. A change may also require an adjustment so that income and expenses are neither duplicated nor omitted (Schedule C instructions).

If the filed returns used different methods in different years, the IRS can figure income under a method that, in its view, clearly reflects income (Publication 538). That needs a professional's review before anyone changes the books. For choosing a method going forward, see cash or accrual for a small business; for how to switch, see switching from cash to accrual accounting. Accrual books beside a cash-basis return are a separate question: accrual books and a cash-basis tax return.

Should I move to another accounting package and start properly?

Moving to another package does not change the answer. The IRS sets what the books must show and prove, not the software that holds them (Topic 305; Publication 583). The three checks, the opening balances and the duty to keep the old records all stay the same.

Importing the old file's history into a new package copies its errors with it. Opening the new package from the filed balances leaves the history in the old file, which must then stay readable. What to bring into a new package is in switching accounting software mid-year.

Export the ledgers, reports and account lists before a subscription ends. Records to keep when cancelling accounting software lists them.

What should I have ready, and when should I hire someone to fix the books?

Have these ready before anyone quotes or starts:

• Statements for every bank, card, loan and payment-processor account, for every month in the period.
• The last filed return for each entity, with all schedules and Schedules K-1 (each owner's share of income).
• An export of the old file: ledgers, account list and reports as of the last filed year-end.
• Payroll reports, loan statements, and asset and depreciation records.

Hiring help makes sense when any of these is true. Each one adds a tax question to the bookkeeping one:

• A return is due and the books do not tie to the bank or to the last filed return.
• A preparer has said the file cannot support the return.
• Returns were already filed from books that now look wrong.
• A year has no return filed.
• Several entities or owners share accounts.
• Payroll or sales tax balances do not match what was filed or paid.
• You have an IRS notice about a return.

For what the work costs and what to ask a provider, see catch-up bookkeeping cost and choosing a catch-up bookkeeping service.

Example

These examples are illustrative; all amounts are US dollars.

A bakery LLC: every month ties, but US$40,000 sits in one account

A single-member LLC (Schedule C) has two years of entries. A catch-all account holds US$40,000: US$25,000 from Year 1 and US$15,000 from Year 2. Every month's balance matches the bank statement, so the book balance agrees with the bank and the bank check passes. Assume each year's Schedule C was prepared from the books as they stand.

This is cleanup of the existing file, not a restart. Each item is sorted into the account it belongs to, such as supplies, owner draws or loan payments. Then each year is compared with its Schedule C. If sorting moves a line in Year 1 or Year 2, that return is compared with the corrected figure. A restart would throw away two years of reconciled history to fix a category problem.

A two-member LLC: 14 months with nothing entered

An LLC taxed as a partnership entered nothing for 14 months but kept every bank statement. Three of the months fall in Year 1, whose Form 1065 is filed. Eleven fall in Year 2, whose return is not yet due.

This is catch-up in the current file. The three Year 1 months go in first. The Year 1 closing cash of US$12,000 is compared with the cash on the filed Schedule L, or with the year-end statement if the return had no Schedule L. A difference goes on the list, and Year 1 is reviewed before it is called settled. Then the eleven Year 2 months go in one at a time, each reconciled before the next. No restart is needed.

An S corporation: the file does not tie to last year's balance sheet

The filed Year 2 Schedule L shows cash of US$30,000, equipment of US$45,000 and loans from shareholders of US$50,000. The old file shows cash of US$26,000, equipment of US$38,000 and shareholder loans of US$20,000. Closed years were edited after the return was filed, and the previous bookkeeper is gone, so no one can say which entries moved. Three accounts are off and the history cannot be traced.

The new file opens on the first day of Year 3 from the filed balances. The old file is kept. The list for the preparer records three gaps: US$4,000 of cash, US$7,000 of equipment and US$30,000 of shareholder loans. Statements and loan records show which side of each gap matches the facts. If the return was right, the gap sits in the old file and the opening balance stands. If the return was wrong, that year goes on the list for review, along with any shareholder figures that came from it, and the opening balance changes with it.

Different for you?

• A return is due and the books do not tie to the bank or the last filed return: which route fits depends on what records exist and what may need amending, so get bookkeeping help. An extension generally must be requested by the return's due date and extends filing, not payment (Topic 304; Form 7004 instructions). The catch-up guide covers the month-by-month method and the extension steps.
• Returns were already filed from the bad books: compare the corrected figures first, then use Correcting a filed business return. If the books themselves need redoing, get bookkeeping help.
• A preparer has declined the file: work through the cleanup checklist, or get bookkeeping help if the file still will not tie.
• Records are missing: see rebuilding books from bank statements. If the statements themselves are gone, get bookkeeping help.
• A year has no return filed: see catching up on unfiled business returns.
• Several entities or owners share accounts: see books for several companies and get bookkeeping help.
• Payroll balances will not clear: see payroll liabilities that will not clear, and get bookkeeping help if they still do not match what was filed or paid. Unpaid withheld payroll tax can be assessed against a responsible person who willfully did not pay it over, not only the business (IRS); see the trust fund recovery penalty guide.
• You have an IRS notice about a return: the response deadline is on the notice. See an IRS notice to your business, and get bookkeeping help if the books behind it do not tie.
• The company is Canadian: see catching up on overdue books in Canada.