I know of someone who is facing a prison term of perhaps ten years and a $500,000 fine because of inputting financial information “incorrectly” in QuickBooks. This individual is an enrolled agent with years of accounting, QuickBooks, and tax experience.
Upon receipt of checks from clients and upon making a bank deposit, the individual would open the customer payments window in the customer menu in QuickBooks, select the client, record the date, amount, and number of the check, and post the entry. The result of this entry was a debit to undeposited funds and a credit to the client’s accounts receivable account for the amount of the check.
After he recorded the payment from the customer, he sometimes would enter a statement charge to the client, typically at the end of the month after all services were provided or when he had the time to do his billing.
You might wonder why he entered some of the payments from the clients first before invoicing or charging these clients. Timing. Accountants often record financial events as they occur. The receipt of the check precipitated its posting in QuickBooks. His billing or performance of services prompted his recording of the charge to the client in QuickBooks. Some accountants require a payment in advance of performing services. Others require a monthly installment for ongoing work. Upon completion of those services and when one has the time to do billing, one would then record the charge to the client.
The problem is a limitation in QuickBooks. After a customer payment has been recorded in QuickBooks, if an invoice or statement charge is then entered for that customer, although the payment is recorded in the accounts receivable ledger for that client, it is not associated or applied to that invoice or statement charge. There must be a charge or invoice already posted in the accounts receivable ledger prior to the entry of the customer payment for it to be applied. Although revenue is credited for the invoice or charge, and the client’s accounts receivable reflects offsetting debits and credits to his account, an invoice or charge remains open in QuickBooks: that is, QuickBooks is unable to associate and apply the payment to the invoice if the payment has been posted into QuickBooks prior to the invoice or statement charge.
What is the result in QuickBooks if a customer payment is recorded prior to a customer charge? Cash is appropriately debited for the correct amount. Accounts receivable for the customer has been debited and credited for the charge and payment, respectively. And revenue has been credited for the services charged to the client.
If we open the accrual basis balance sheet and P&L reports in QuickBooks, the balance in cash, accounts receivable, and revenue are correctly stated. However, if we open the cash basis balance sheet and P&L reports in QuickBooks, accounts receivable will have a negative balance and revenue will be understated: both accounts will not include the invoice or statement charge since QuickBooks has not applied the customer payment to it, and the QuickBooks cash basis P&L report excludes all revenue and expense postings that have not been associated with payments.
The trained accountant, unaware of this limitation in QuickBooks, mistakenly relied on his cash basis P&L report to prepare his Schedule C on his Form 1040, and, as a result, understated his taxable income. Consequently, he now faces a prison term for not entering his client charges prior to his customer payments in QuickBooks. The IRS’s position is that QuickBooks users should know how to use QuickBooks and that if such errors as the one mentioned above occur, then the IRS presumes that they are fraudulent, involving willful intent on the part of the user. Acts of fraud are punishable with prison sentences in addition to monetary penalties.
But the IRS’s position of willful intent on the part of the accountant because of its presumption that accountants should know how to use QuickBooks appropriately appears to me to be unjust. I searched the Intuit book’s on QuickBooks for the years under audit and was unable to discover a caveat warning the user not to enter customer receipts prior to invoicing. Nor could I find any explicit warning in the QuickBooks program during the entry of customer payments and statement charges. In the real world of accounting, often the receipt of customer payments precede the act of invoicing the customer. And one’s accounting system should reflect financial transactions as they occur in time.
So QuickBooks user, proceed with caution. Learn the program to stay out of jail. And take heed before ever entering your customer payments prior to recording their invoices or statement charges!
Accountants CPA Hartford, LLC
This is an interesting case that I stumbled on accidentally. Thanks for sharing. I am not a CPA but have a degree in accounting and worked in accounting for about 20 years, and is now a candidate for the Enrolled Agent Certification,
I was just browsing to see if there were any free Enrolled agent course or exam questions I could tap into, other than Fast Forward offering.
One thing that is always helpful to the accountant is to have controls that will cause a red flag when things are out of balance. In this particular situation, if the Agent/Accountant had kept a sales journal that shows year to date sales, (which is good info from a management info perspective) then at the end of the year when he closed the GL, he would have seen that his revenue account was not agreeing with his sales journal. Some professionals will say that this is unnecessary record keeping–but is it really ?–the sales journal has not been abolished. Hope the IRS go easy on him. I understand the fraud implication, but could it be possible he was just naive, and careless?
Thank you for your comment.
You can never be too careful, can you. I agree, and in hindsight, the Agent/Accountant would probably agree with the keeping of a sales journal, too.
The United States Treasury Department spent big money going after this individual understating taxable revenues by $160,000. If only the United States government would expend a proportionate amount of money, time, and effort pursuing, convicting, and imprisoning all of those individuals involved in the fraud and gross negligence of those mortgage-backed securities and suprime mortgages, etc.
But is it no surprise that the U.S. government has two sets of standards: one for the rich and corporations, who get away with murder; and one for everyone else, who get murdered by it. We have a bifurcated justice system. Not one individual was indicted or convicted over the trillions of dollars stolen by the financial services industry several years ago.
So we will put this little guy in prison for 10 years, at a cost of $600,000, after fining him at least that, and after spending twice that amount convicting him, while those who steal trillions destroying the world’s economy, bankrupting nations, get away and are rewarded with bailouts, bonuses, and tax breaks.
Go figure.
The Barefoot Accountant
Now I’m scared! I do my own books, and found this post searching for “how to record client credit cash basis.” Since I am a “micro”business and hope to clear $1600, I am probably safely off the radar. If only the government would double- and triple-check their books, right?!
Nonetheless $160,000 does seem like a great deal of income to me. Perhaps we could understand this enrolled agent’s predicament better if the error were expressed as a percentage of actual income. It is much more likely a mistake if the accused’s income is $5,000,000; not so much if he pulls $500,000.
What I would like to know, in light of your thorough examination of the QuickBooks documentation, is how long has this error existed in the QuickBooks cash basis P&L report? and this experienced accountant is the first to have had this happen? The results of that survey might prove quite interesting…
The understatement of taxable income included more than one tax year. It may have been 25% of the total taxable income.
Could he not have simply opened each invoice after creating it and applied the payment he had previously recorded? This would apply the clients payment to that specific invoice, cleaning up the AR as he creates his invoices and correctin his negative AR on his P & L. The button to apply the payment is a the bottom right of the page above the total for the invoice. These are additional steps but certainly could have solved his problem prior to reporting his revenue to the IRS.
Yes, he could have done such if he had known better. The version of QuickBooks dates back to about a dozen years ago, and being an elderly man used to working in “registers”, he didn’t process invoices but merely made entries in the register to record transactions.
Quickbooks is the most awful thing that has happened to the accounting profession – ever! If you take payments before work is done you credit unearned income – a liability account. DR Cash – CR Unearned Income. In cases where retainers are taken the income is not earned until the work is done – after the work is completed remaining amounts can be billed or refunded. Law firms and construction companies use this concept more often than accountants – but I did a lot of representation work and took a retainer pretty often.
There must be more to this story than stated. Everyone knows that Quickbooks does not perform a correct accrual to cash conversion. Also, everyone should print the cash deposit report and compare that to gross cash income reported by Quickbooks on the income statement prior to filing a return.
What lets me know something might be fishy by the accountant is that we have a timing difference here that should be for no more than one year, underreport this year, overreport next, unless his revenues were substantially increasing over a long period of time. My guess is that he got caught and trying to lie his way out of it.
Also, everyone knows that if a tax preparer gets caught underreporting income, the consequences are substantially greater than a normal person’s.
Would it be advised to run reports both cash and accrual to look for differences?