There are many reasons to use a clearing account. The most common one that I see is when a vendor is also a customer. You do work for them as your customer, and they do work for you as your vendor. So you build up a balance you owe them and another balance that they owe you. They hang around forever on your AR report and also on your AP report, driving everyone who uses the reports crazy. So how do you get the money from one to the other, short of trading checks with them (that is the ideal way, but in my experience is almost impossible to make happen). You will find many business owners who are concerned about booking the income because they are worried about the tax liability. However, you can reassure them because the income is offset by an equal expense, so there is no net effect. Regardless, it IS income and HAS to be recorded.
There are a couple of ways to deal with this situation. I will only deal with my preferred method, because it is the same as it is when you pay any other vendor or receive payments from any other customer, you just use a different bank account. I find that the other popular method is confusing to many, so I don’t recommend it. Since there is no actual money changing hands that will be deposited in any real bank account, you have to make an imaginary account for this imaginary exchange. So make a new account in your accounting file and call it something like “Trade Clearing Account.” Don’t worry, it is an imaginary account that will never show on the balance sheet if you are doing things right.
OK, so now you are ready to get rid of those pesky AR and AP balances. Start with whichever balance is smaller. Let’s assume that the customer balance is smaller. To begin, receive a payment from that customer for the amount of all the open invoices, apply it to those invoices, and deposit it directly to the clearing account. I recommend not going through undeposited funds, because there may be others who use that account and expect every transaction in it to go to a real account. Now look at the account balance for the clearing account, it shows either a positive balance in the amount of the payment, and you have cleared one half of the balances. Now just reverse the process and pay the vendor the same amount you received from them as a customer, again using the clearing account to pay it. All cleared up, the clearing account balance is zero, and the vendor balance now shows what you still owe.
If the vendor balance is the smaller one, then start with the payment to that vendor and then reverse the process as above. Now the customer balance shows what they still owe you.
There are many other potential reasons to use such a clearing account. They can be a handy place to work with employee reimbursements and owner expenditures for business purposes. In those cases you may want to show the purchase made as a regular transaction with the actual vendor’s name and code the job, category, etc. as you would with the regular company spending, but in this case, it isn’t your money until you pay it back. For example, either the owner or an employee made a purchase at Wal-Mart for a company purpose and turned in the receipt to you. You can use a clearing account to enter the transaction to Wal-Mart. Then when you pay them back, the check or paycheck is coded to the clearing account instead of the job, category, and vendor, etc. In the case of an owner, if they don’t want to be paid back, then make a payment to them from the clearing account and code it to owner draws, loans from the owner, or whichever account you use for such owner-related expenditures (which depends on company structure and accountant/tax-preparer recommendations).
Another use for a clearing account is when a contractor receives joint checks for work done by a subcontractor. This is a common practice to make sure that the subcontractors get paid and the owner or general contractor doesn’t end up having to pay the amount twice if the company in the middle doesn’t pay their bills. So the check is made out to two companies. The general contractor (or higher-tier subcontractor) receives the check, but they can’t deposit it, because it is also made out to the subcontractor. Even though it isn’t going to be deposited by that company, it is still a payment received and has to be recorded. So the payment is received, applied to open invoices for the payor, and deposited to a clearing account which I call Joint Check Clearing. Then a virtual payment is entered to the subcontractor, applying it to their open bills you owe to them, in the same amount as the check received. Then the company endorses the joint check and sends it on to the subcontractor. They also endorse it and deposit it in their bank.
So there are three common uses of a clearing account. If you have a reason to do more than one kind of clearing, then I would use separate clearing accounts to make it easy to see what is going on when you look at the account register. And remember, if the balance of the clearing account is ever not zero, then you did something wrong. Happy clearing!
Courtesy of Brent Blackburn
Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties. Please contact your tax professional for advice.