Transactional entries are the means by which financial data is logged into the accounting system and are recorded via checks, credit card charges, deposits, transfers and general journal entries. The end result is that informative numerical data is organized within the general ledger through a balanced transaction wherein debits equal credits. But for any given financial occurrence not all journal entries infuse the same volume of information into the system. Consider the following example.
Andrew Andrews receives a gift of 1,000 shares of Pear, Inc. stock from his mother, Andrea Andrews. Andrew’s Business Manager ascertains that Andrea purchased the stock on October 24, 2008 for $100,000. She gifted the stock to Andrew on October 30, 2013 at which time the gift tax value of the transfer is $500,000, determined by using the volume weighted average price (VWAP) method. Andrea reported the transfer on a 2013 gift tax return. As Andrea had previously used up her lifetime unified credit, the entire value of the transfer was subject to gift tax. The gift tax allocable to the appreciation on the stock was computed to be $160,000. The value of Pear, Inc. on the date of the gift was $520,000, based on a closing price of $520 per share.
Under a legacy approach the 1,000 shares of Pear, Inc. stock are recorded on Andrew Andrews’ books via a debit to securities and a credit to gift income:
DR Securities 520.000 Gift of stock
CR Gift income 520,000 Gift of stock
Immediately after the journal entry is posted the financial statements are accurate. Stock has been transferred to Andrew and his balance sheet is updated to include the fair market value of the newly acquired asset. The balancing entry to the P&L reflects a like amount of gift income. So Andrew’s balance sheet reflects and accurate value of his holding in Pear, Inc. but nothing more.
But can the journal entry be improved? Although Andrew’s balance sheet is accurate, important information has been omitted from the financial database. Under a proactive approach, the journal entry will be tweaked to take into consideration the future informational needs of those who utilize the GL. In five years when the Pear, Inc. stock is sold the tax preparer will need the tax basis in order to prepare an accurate tax return. The holding period of the stock will also need to be ascertained in order to properly classify the gain as short or long term. Any adjustments to basis for gift taxes paid by the donor would augment basis. Consider this alternative journal entry:
DR Securities – Cost basis 100,000
Cost basis in shares gifted from Andrea Andrews; Original purchase date: 10/24/08
DR Securities – Cost basis 160,000
Portion of 2013 gift tax paid by Andrea allocable to appreciation of shares
DR Securities – Valuation Adjustment 240,000
Adjustment to mark shares to Andrea gift tax value (VWAP)
DR Securities – Valuation adjustment 20,000
Adjustment to mark shares to closing market value (@ $520/share)
CR Gift tax income 500.000
Value of gift on AA books based on VWAP method
CR Unrealized gain 20,000
Mark to market as of close
Both the shortcut and expanded journal entries succeed in rendering an accurate general ledger. Both balance sheets correctly reflect a $520,000 increase in the value of Andrew Andrews’ net worth as of the date of the gift. But the Proactive journal entry has introduced significantly more data that is relevant to future analysis. The second entry has successfully captured the following information:
- The carryover tax basis attributable to the original cost of the Pear, Inc. stock in the hands of Andrea Andrews ($100,000).
- The portion of the gift tax paid by Andrea Andrews that is allocable to the appreciation on the stock and that therefore augments Andrew Andrew’s tax basis ($160,000).
- The date on which the shares were originally purchased. This information is included in the memo field. Since the holding period of the donor carries to the beneficiary of the gift, the original purchase date of the shares by the donor determines the tax classification as long versus short term gain.
- The gift tax value of the Pear, Inc. stock as of the date of the gift ($500,000). This may or may not be relevant information to Andrew Andrews. However, by valuing Andrew’s receipt of the stock at the same amount as Andrea’s gift of the stock, consistency is maintained between Andrew’s books and those of his mother. And if a question ever arose as to the value of the stock as reported by Andrea on the gift tax return, the information is readily available in the GL.
- The difference between the values of the Pear stock as determined for gift tax purposes and the fair market value of the Pear stock as of the close of the market on the day of the transfer ($20,000). This difference arises from the fact that the valuation of the transfer for gift tax purposes is based upon the average of the high and low stock price as of the day of the transfer. In this example the average price of the Pear, Inc. stock for gift tax purposes was $500 per share, determined by the VWAP method. The closing price on Pear, Inc. shares on September 28, the date of the gift, is $520 per share. The difference between the two valuations is $20 per share or $20.000. A final journal entry marks the stock to market as of the close of trading.
Is this additional data helpful? If it is October 12, 2017 and you are preparing Andrew Andrew’s tax 2016 return, the return for the year in which he sold the Pear Inc. stock, the information is not only helpful but critical. Basis data is often a poorly tracked component of a high net worth individual’s financial history, particularly for privately held stock. The omission of accurate basis tracking from the database can have material consequences. In the example above, the gift tax allocable to the appreciation of a transferred asset is often overlooked in calculating tax basis. Such an omission will result in the overpayment of income tax on the subsequent sale of the asset. Depending on the magnitude of the asset’s appreciation, that tax overpayment can run in the tens or even hundreds of thousands of dollars. In the example above, omission of the allocated gift tax would result in the overpayment of federal tax by about $72,000.
Enriching a journal entry with pertinent financial information is also helpful for routine transactions. Consider the consequences when a donation is made to a qualified charity.
Doris Dogooder donates $10,000 to the Snail Society. The donation entitles Doris to attend the annual Snail Society Awards gala held at the local Burger King. The gold embossed invitation includes fine print indicating that the goods and services value of attendance at the gala is $500. This means that although Doris is donating $10,000 to the charity, the tax deductible value of the contribution is only $9,500.
The donation may be booked as:
DR Charitable contributions $9,500
DR Meals & entertainment 500
CR Cash $10,000
The transaction listing for charitable contributions will show $9,500 as the donation for the Snail Society, along with other donations made during the year:
01/15/12 Snail Society 9,500
03/20/12 American Heart Association 1,000
08/30/12 Red Cross 5,000
The amounts reported in the charitable contributions section of the P&L are accurate. The amount posted for Snail Society has properly taken into account the reduction for the non-deductible goods and services element. But could the journal entry be improved? If you are the tax manager reviewing charitable donations, one standard inquiry is whether the reduction for goods and services has been taken into account. An expanded transactional entry will proactively answer the question before it is asked by bringing transparency to the accounting. Consider the following alternative entry:
DR Charitable contributions $10,000
CR Charitable contributions $500
DR Meals & entertainment $500
Nondeductible goods & services (annual gala)
CR Cash $10,000
The transaction report for charitable donations will now look like this:
01/15/12 Snail Society 10,000
01/15/12 Snail Society ( 500)
Nondeductible Goods & services (annual gala)
03/20/12 American Heart Association 1,000
08/30/12 Red Cross 5,000
The alternative journal entry reveals the accounting underlying the net entry of $9,500 for deductible donations. The tax preparer’s question has been answered before it even had to be asked. The books have proactively documented the elimination of the nondeductible goods and services by revealing the components of the transaction. Both journal entries result in an accurate donations account. But the second journal entry conveys additional relevant information and assures the tax preparer that the amount reported on the tax return as a charitable donation has been adjusted for the nondeductible portion. In this regard, the transactional entry has been proactive: the entry has been recorded with the goal of taking into account the future informational needs of the users. And this was all accomplished by merely adding a single line in the check split.
One more example will illustrate the advantages of comprehensive transactional entries. As we have seen many accounting practices record transactions on a net basis. Under this net-posting approach, courtesy discounts, adjustments and other accommodations on invoices are not accounted for in the general ledger. Consider a legal invoice that includes a negotiated discount. Lawrence Lawson’s Law firm billed Patty Petunia $180,000 in connection with their defense of a law suit that had been initiated against Patty. Patty was horrified when the invoice crossed her desk and called Lawson to demand an adjustment. Lawson agrees to a 20% discount. The revised invoice shows the gross fee of $180,000, the $36,000 courtesy discount and the net amount due, $144,000. Patty’s bookkeeper prepares a check. Cash is credited for $144,000 and legal fees are debited for the same amount. As in the previous examples, the transactional entry is fundamentally accurate but utilitarian information has been omitted. The next time Patty pays Lawson she may ask “didn’t Lawson give us a discount on our last bill?” Perusal of the financial statements will not answer Patty’s question because the underlying accounting trail is not incorporated into the GL. On the other hand, had the check recorded the split between the gross legal fee and the discount, the books would have yielded information beneficial to Patty and her Business Manager.
A high net worth individual’s balance sheet and income statement may be numerically accurate in the sense that the assets and liabilities reconcile with external reporting. Although accurate, the underlying general ledger may be deficient in information that is not only useful, but critical, to strategic analysis and decision making. It is in this sense that all journal entries are not created equal.