Opening Balances When Your Books Start Late

Do I have to record everything that happened before my bookkeeping began?

Often no for a year that is finished and filed: the books can start from that year's closing balance sheet, as long as the filed return is a sound base. Yes for any year whose return is still to be filed, because a return reports income and expenses for the whole tax year. The IRS says that, with few exceptions, the law does not require a particular kind of records, but the records must support what the return reports.

A case is not simple, and is worth settling with a preparer before you enter anything, when a return is filed or due for a year your books do not cover, when an earlier year has no filed return, when the opening balances will not agree with the last filed return, when equipment was never depreciated, or when business and personal money shared an account. Gather first:

• Statements for every bank, card and loan account, one for each month back to the first day of the tax year.
• The balance of each account on the day before the start date.
• A list of equipment with purchase dates and costs.
• The last filed return.
• A record of money the owners put in or took out.

Keep the papers behind the earlier years. The IRS says to keep records for as long as they may be needed to prove a return's income or deductions, and an opening balance does not replace them: how long to keep business records.

Which start date should I pick, and why does the tax year matter?

The usual start date is the first day of a tax year: January 1 for a calendar-year business. A tax year is the yearly period a business uses to keep its records and report its income and expenses.

• The books match the return. Income and expense accounts are closed at the end of each tax year, while asset, liability and net worth accounts carry forward. Starting on the first day of the year makes the first profit and loss cover exactly what the return covers.
• Equity is easier to support. Opening on any other day puts the profit earned so far this year into the opening equity, a figure no filed return contains.
• A new business starts on its first day, with only what the owners put in. An entity that did not exist for a whole year files a return for the shorter period it did exist. A fiscal-year business starts on the first day of its fiscal year.

A business that has never filed adopts its tax year and accounting method with its first return, unless it must use a particular tax year, and after that return changing the method generally needs IRS approval. Both choices have their own rules: cash or accrual for a small business, fiscal year or calendar year.

What goes into an opening balance?

An opening balance is the balance of every asset, debt and owner account on the start date. Assets minus debts leaves equity.

Money received for work not yet done may be a liability in the books, yet generally counts as income when received unless an accrual-method deferral applies: customer prepayments and deposits.

Equity is a result, not an input. When it comes out unexpectedly large or negative, it needs an explanation: a missing account or a wrong number, or, for a negative figure, losses or withdrawals that really exceeded what went in. Opening Balance Equity.

How do I log the transactions from the months before my bookkeeping began?

Enter them from statements, month by month, starting at the first day of the tax year. An opening balance dated on the day the books were set up does not replace these months; a profit and loss built from these books would leave their income and expenses out, and a return prepared from that profit and loss would too.

1. Set the opening balances on the first day of the tax year, or on the day the business began if that is later.
2. Enter each earlier month from the bank and card statements, using one source for each month.
3. Reconcile the month before starting the next. Publication 583 says to reconcile the checking account each month so the statement, the checkbook and the books agree.
4. Sort the deposits by the accounting method. Under the cash method, customer payments are income when received. Under the accrual method, a payment on an invoice already recorded clears the receivable and is not income again. Money the owner put in, loans and transfers between accounts are not sales: which deposits are not income.
5. Keep the invoice or receipt behind each cost. Proof of payment alone does not establish a deduction: lost receipts.

If business and personal money shared an account in those months, sort it before entering: fixing commingled business and personal funds.

How do I value equipment and other assets I owned before the books started?

Use cost for what the business bought. Basis is the amount depreciation is figured on. For something a sole proprietor, or the owner of a single-member LLC taxed as a sole proprietorship, moves in from personal use, the depreciation basis is the lower of its market value and its adjusted cost on the day its use changed. Then show the depreciation already taken or allowable.

The date of the change is the day business use began, not the day the books began. A laptop used in the business since last year changed use last year, so its value that day sets the basis and last year's depreciation may already be allowable. An item an owner puts into a partnership generally keeps the owner's adjusted basis (26 U.S.C. § 723). An item put into a corporation in a qualifying exchange for stock (section 351, which needs control right after) generally does too, but if the items are worth less in total than the owner's basis in them, the corporation's basis is limited to market value. The owner and corporation can instead agree in writing to reduce the owner's stock basis, with a statement filed on the timely original return for the transfer year; the election cannot be undone (26 U.S.C. § 362(e)(2), 26 CFR 1.362-4, Publication 542). An LLC taxed as a corporation follows this corporate rule even with one owner. Which rule applies is a preparer's call: putting personal assets into your LLC.

Equipment written off in full, for example under section 179, still belongs on the list: it has recovered its basis, so it shows at cost with accumulated depreciation equal to cost.

If an earlier return skipped depreciation, the cost is still reduced by what was allowable. Depreciation that was allowable in an earlier year cannot be made up on the current year's return; an amended return or an accounting method change fixes it, and which applies depends on the facts (Publication 946): rebuilding a missing depreciation schedule.

What is the journal entry for accumulated depreciation or amortization as an opening balance?

Accumulated depreciation goes in as a credit balance next to the equipment's cost, inside the one opening entry that also holds the bank balance, the debts and the equity. It is not an expense of the current year: the earlier years' depreciation belongs to those years.

• Debit each asset: the bank balance, equipment at cost, inventory at cost.
• Credit accumulated depreciation and each debt. Credit equity for the difference, or debit it if the difference is a deficit.
• Total debits equal total credits, as double entry requires.

Accumulated amortization works the same way for intangible assets such as start-up costs: debit the asset at its full cost and credit accumulated amortization for the part already deducted. For equipment the word is depreciation. The Example shows the depreciation entry with numbers.

How do I treat money the owners put in or took out before the start?

Money an owner puts in or takes out as the owner is not income and not an expense. A sole proprietor's withdrawals are draws even when the owner works in the business. A corporation's pay to an owner who works there generally goes through payroll. A partner's service payments follow partnership rules; guaranteed payments are those set without regard to partnership income (26 U.S.C. § 707(c)). For earlier years it is already inside the opening equity. For the months of the current year that you enter from statements, record each transfer as a contribution or a draw.

Whether money an owner put in was a loan or capital changes the books and the return. If no paperwork shows which it was, settle that with a preparer before the opening entry: owner contribution or loan, loans to shareholders and partner capital accounts.

If I filed returns before, how do my opening balances tie to the last return?

Compare totals with the balance sheet (Schedule L) on the last filed return, if it has one. A sole proprietor's return does not.

The instructions for Forms 1065, 1120-S and 1120 all say the Schedule L balance sheets should agree with the books and records. If the earlier return was prepared without books, its Schedule L may rest on estimates that statements do not support.

When the opening balances differ from the filed Schedule L, forcing a match, or leaving the gap in a catch-all equity account, hides the difference. Writing down the difference and its cause keeps it visible. A difference that points to an error on a filed return is a preparer's decision: retained earnings that do not match last year's return. For books being moved from an old accountant or software, use opening balances after changing accountants.

What did I spend before opening day, and how are start-up costs treated?

Spending before the business began is generally a start-up cost: part is deducted in the first year and the rest is spread over 180 months. The day your books began is not the day your business began, and the business's start date is what the tax rules use. Operating expenses after the business began but before your books began belong to the year the accounting method assigns, even if you record them only now. Equipment, inventory and other capital spending follow their own rules.

Start-up costs are what you spend before business operations actually begin. They count if they would have been deductible in a business already running; interest, taxes and research costs follow their own rules (26 U.S.C. § 195(c)). A corporation or partnership has a parallel rule for organizational costs. Equipment is different: its cost is usually recovered through depreciation.

In the books, the part of the start-up costs not yet deducted is its own asset in the opening balance. Section 195 gives no test for when a business begins, except that an acquired business begins when you acquire it. If that date is unclear, or the costs are large, settle it before the opening entries. The amounts and the election: start-up costs for an LLC or sole proprietor. Costs paid personally: startup costs paid personally before the LLC.

How do I check that the opening balances are right?

The opening balances are right when the new books agree with the statements, the asset list and the last filed return, or when each difference is written down and explained.

A first reconciliation that will not start from the right balance: reconciliation beginning balance wrong. Ongoing close routine: month-end close checklist.

Example

These examples are illustrative; all amounts are in US dollars.

A freelance developer starts books in July

A developer began freelancing on February 1 and received $40,000 from clients by the end of June, with $4,000 of software and subscription costs. She starts her books in July. Her Schedule C covers the whole year, so she sets the start date to February 1 with an opening balance of zero, then enters February to June from her bank statements. Opening the books on July 1 with a bank balance would leave those five months off the profit and loss, and a Schedule C built from the books would omit the $40,000. Had she been freelancing for years with last year's return filed, she would set the opening balances on December 31 of last year from her statements and asset list, and enter January to June from her bank statements.

A two-member LLC opens its books on January 1

Two equal partners start books on January 1, with equal contributions and equal draws. Statements show $12,000 in the bank and $5,000 owed on a loan. The asset list shows equipment bought for $8,000 with $3,000 of depreciation to date. Equity is what remains: $12,000 + $8,000 − $3,000 − $5,000 = $12,000, $6,000 each. If their contributions or draws had differed, each capital account would follow its own contributions, share of profit and draws.

The net equipment of $5,000 and the total capital of $12,000 are then compared with the last filed Schedule L and with the partners' ending capital on their Schedules K-1. If a Schedule L was not required, there is nothing to compare, and the statements and the asset list are the evidence.

A laptop moves into a sole proprietor's business

A sole proprietor bought a laptop for $1,800 for personal use. When she starts using it for the business it is worth $900. Its basis for depreciation is the lesser of the two, $900. The opening entry is a debit to equipment and a credit to owner's equity, both $900. The other $900 cannot be depreciated, and a later sale uses different basis rules for a gain and for a loss (Publication 551).

Different for you?

• A return is due for a year the books do not cover, or a filed return may not be sound: which start date to use, which earlier months to rebuild and how to bring the pre-books balances in are judgment calls that depend on the facts. See catching up on overdue books and bookkeeping help.
• Returns for earlier years were never filed: see catching up on unfiled business returns.
• The opening balances will not tie to a filed return, or a large unexplained amount sits in an equity account: see retained earnings that do not match last year's return, Opening Balance Equity and bookkeeping help.
• You have an old accountant's reports or an earlier file: use opening balances after changing accountants.
• You bought goods to sell with your own money before opening: see starting inventory you already owned.
• Depreciation was never claimed or the asset list is gone: see rebuilding a missing depreciation schedule and bookkeeping help.
• Partners' capital was never tracked: see rebuilding partnership capital accounts and bookkeeping help.
• The business is a rental property: see catching up on rental property books.
• You own the US company from outside the US: see bookkeeping for a foreign-owned US company.
• You paid employees or collected sales tax in those months: see behind on payroll taxes and catching up on uncollected sales tax.
• You are unsure whether to clean up, catch up or start a new file: see cleanup or start fresh.
• The business is in Canada: see books after incorporating a sole proprietorship and Canadian books behind.