Expense records for one quarter, and the four errors hiding inside

The case below is invented. The business, the figures and the people are made up so that the mechanism can be shown end to end; nothing here describes a real company. What is real is the pattern, because every bookkeeper who has taken over a set of books has met some version of it.

A small design studio has three people, one the owner, and the owner has done the books from the bank feed for two years. At the end of the financial year, the accountant asks for the books.

Looking at the last quarter, the accountant says the cost line cannot be right. This is the quarter as recorded, the four things wrong with it, and what the corrected version shows.

What to take away

The quarter as the owner recorded it

The owner's method was simple: every payment leaving the bank became an expense in the month it left, coded by the name on the bank line. Every deposit became income. Three months of that produced this (figures invented, rounded):

Month 2 shows a loss. The owner's explanation was that it had been a slow month. The accountant's question was why costs had nearly doubled in a month when income had barely moved.

Finding one: a payment that was never a cost

The largest item in month 2 was a payment of 9,000 coded to "equipment" in the expense section. It was an installment on a loan the studio had taken out to fit out its office the year before. The lender's schedule showed the payment as 8,600 of principal and 400 of interest.

Only the 400 was a cost. The 8,600 reduced what the studio owed, which lives on the balance sheet, not in the profit and loss. The entry that should have been made:

Month 2 costs fall from 26,900 to 18,300 on this correction alone. The balance sheet had been carrying the loan at its original amount all year, because none of the repayments had ever touched it.

Finding two: a cost with no payment yet

The studio uses a freelance developer on most projects. The developer invoices at the end of each project and is paid within a few weeks of that. Under the owner's method, the developer's cost appeared whenever the payment happened to leave the bank.

In this quarter, a project delivered in month 3 was invoiced by the developer at 4,800 on the last day of the month and paid in the following quarter. The quarter's books showed the income from that project and none of the cost of producing it. Month 3's profit was overstated by the whole 4,800.

Whether the books are kept on that basis at all is a decision with consequences beyond the ledger, described in the federal guide to accounting periods and methods. The fix here is the entry that records the cost when it was incurred:

When the payment goes out next quarter, it clears the amount owed and touches the profit and loss not at all. This is the whole subject of the expense recording guide, and it is the correction that changed the owner's understanding of the quarter most.

Finding three: a year of insurance in one month

Month 2 also carried an insurance payment of 3,600 covering the twelve months from the start of that month. Charged in full in month 2, it made that month carry a cost that belonged to eleven others as well.

The corrected treatment records 3,600 as a prepayment, an asset, and releases 300 into costs each month. Month 2's cost falls by a further 3,300. The other 3,300 will arrive, 300 at a time, over the rest of the policy year, including one more month of it in this quarter.

The reason this matters more than it looks: the owner had been renewing this policy every year, and every year one month had looked like a bad one.

Finding four: an asset consumed in an afternoon

Month 1 included 2,400 for a new workstation, coded to "computer costs" alongside software subscriptions and cables. The workstation will be used for years. Charging all of it to the month of purchase treats a machine that is still on the desk as if it had been used up.

The correct treatment depends on a policy the accountant sets. The machine is recorded as an asset. A slice of its cost is charged against profit each period over the years it is expected to serve.

There may be a threshold below which small items are expensed. The studio had no such policy written down, so the accountant set one.

The same line between used up and bought to keep runs through the federal guide to business expense resources. For the current position, look there, not to any figure quoted in an article.

For this case, direction matters: month 1's cost line carried something that was not a month 1 cost.

The exact monthly charge depends on the policy adopted, which is why the table below uses a placeholder rather than a figure that might be read as a rule.

The corrected quarter

Taking the four corrections together, and using 100 a month for the workstation charge purely to make the table add:

Month 2 was never a loss. Month 3 was never as good as it looked. The quarter made about 21,000, not 12,100, and the bank balance is identical under both versions, because none of this touched cash. What changed is that the profit and loss statement now describes the quarter rather than the bank statement.

What the owner changed

None of this took more than an afternoon to set up. The routine it fits inside is described in the bookkeeping foundations guide.

Common questions