Are Adjusting Journal Entries Legally Binding?

If you are not familiar with accounting, adjusting entries are commonly made by accountants and bookkeepers to fix entries that were previously made with were incorrect or which adjusted the wrong accounts.

For example, a payment by a business of a Visa bill might have included an airline and hotel expense of a shareholder or employee and treated by the bookkeeper as a business expense. 

However, later the accountant may find that this was actually a personal expense and so the expense should be personally paid back to the company by the shareholder.  To simplify this, accountant may simply make adjusting journal entries to reverse the deduction of this amount as an expense and instead charge it to the shareholder or employee. 

As well, at the year-end of a business, it is often necessary for the accountant to make all sorts of adjusting entries.  Amounts owing by the shareholder to the company are “set off” against amounts that the company owes to the shareholder.

So the accountant has to make sure that the amount owing by the company to the shareholder is large enough to cover this “set off”.  In many cases that amount owing by the company to the shareholder is based on distributions by the company to the shareholder at the year-end.

The timing is such that these entries are dated as of the year end but are actually done many weeks or months after the year end when the accountant has all the information to work on the year-end financial statements of the business.

This is very common. 

One of the decisions that is very difficult to make before the year-end financial statements are  prepared, is how to distribute “profits” from that year to the shareholders.  You usually need to know how much profit has been made before you can decide how to distribute it.

However, in closely-held private companies (such as family owned businesses), the distribution of the “profits” of the business involve an analysis of whether it is better to pay salary or to pay dividends.

Technically, a salary is a deduction (it’s an expense of the business) and so if you want to what to pay a salary to a shareholder, it should be part of the year end adjusting entries so that it is included as a deduction in that financial year.  If you deduct it later when the financial statements are done, it won’t be deductible until the next financial year.

So again, although not perfect, it is very common to do an adjusting year end entry to show a salary or bonus as a deduction to reduce the taxable income (and tax payable) of the business.

So what does a shareholder do if they want to withdraw money from the company during the year?  Since they aren’t sure if it will be classified as salary or bonus or  as a dividend, for convenience it might be recorded as a salary or dividend or charge to the shareholder loan during the year when the money is paid out, and then an adjusting entry is done at the year-end once a final decision is made as to how to treat it.

All of these kinds of decisions and adjusting entries are absolutely essential to properly prepare financial statements for the business and to minimize taxes.  Most accountants are very good at this and do a very good job.

However, the law is very clear that:

“…accounting entries do not create reality.  They simply reflect reality.  There must be an underlying reality that exists independently of the accounting entries…”[1]

It is very important that the underlying reality be legally documented in some manner, typically a director’s resolution or minutes of a directors meeting, to create the obligation of the company to pay a salary or bonus payable or to declare a dividend.

As well, if an amount owing by the shareholder to the company is to be set off against the shareholder loan account, there should be legally binding documentation that shows that the particular amounts are being charged to that shareholders loan account or are being paid by crediting that shareholders loan account, or are being set off against the other.

The Courts have said that too often, some accounting and tax professionals have a tendency to assume that the facts are shaped by accounting entries whereas in reality, the figures should reflect the facts, not the contrary.[2]

Adjusting journal entries are essential for the efficient operation of businesses.  However, they must be supported by the appropriate legal documentation.  Otherwise, there is a considerable risk that such journal entries will not be accepted by third parties such as the Canada Revenue Agency and may result in double taxation through the assessment of shareholder benefits, and possibly the imposition of 50% gross negligence penalties.

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