How to classify transactions for bookkeeping

For most CEOs one thing they struggle with for bookkeeping is how to classify transactions – should it be an office expense, cost of goods sold, or ask my accountant?  Luckily there are some guidelines to follow from a tax perspective and so your financials are easy for someone to look at and understand how your company is doing.

Why Classification Matters

In general it doesn’t matter how you classify things.  The $25 software charge you pay can be coded to software, office expenses, or G&A (general and administrative).  Here are some high level considerations of when you should start to give it a little more thought to how you classify things – 

  1. Keep it consistent each month, unless you want to make a change on how you categorize going forward.  This will help with spotting trends and understanding your expenses month to month.  If one month you code the salary costs as salary and the next you call it payroll it can be confusing what the difference is and why some months have salary and some months have payroll.  You can make a change going forward to start classifying your payroll into different categories like owner salary, office worker salary, warehouse salary etc, so that you can track how much different parts of your business are costing.  
  2. Categories with significant spend can be broken out after they are about 1% of the total expenses.  If you are a $1M company it is not necessary to break out a $50 charge for fed ex, but if you are spending $10K or 1% on Fed Ex, then I would want to see it broken out so it can be analyzed to see if there are savings opportunities to reduce overnight shipping or send through USPS or other methods.  
  3. Things you want to track to improve your business – If you had 3 company vans it would not be necessary to track gas or repairs for each van unless you wanted to track this to make better financial decisions in the future.  For example if you had 3 drivers and you noticed that one van had really high gas charges then you might want to investigate the charges for fraud.  Another area is marketing spend – you might want to know how much you are spending on Google vs Facebook so you can track your customer acquisition costs for that spend.

Important Bookkeeping Classifications for tax purposes

Meals and Entertainment – this is an important area from a tax perspective, so expenses should be categorized into the following 3 buckets

  1. Entertainment – 0% deductible.  Many years ago people used to go to concerts and sporting events and deduct those as business expenses.  In 2018 the IRS decided that even if it was to entertain clients and get new business it was still really not a tax deductible expense because it was really a fun personal expense.
  2. Holiday Parties – 100% deductible. In order for this to apply it has to be a company wide event
  3. Meals – 50% deductible.  Most meals and food are 50% deductible.  This includes meals with clients, staff, snacks for the office and travel meals.

Personal Expenses – these are not deductible and not a business expense.  Usually they should be classified as owner draw or distribution if the company is an LLC or S Corp.   If the company is a C Corp then the owner should technically reimburse the company and it should be classified as a loan until it is repaid.

Assets – Every company should have a policy defining how large purchases should be categorized.  We usually recommend to expense anything under $2500 to an expense line on the profit and less statement and anything over that would be an asset on the balance sheet that would be capitalized or depreciated.  

Annual payments – This is another tricky one and depends if you are using cash or accrual accounting.  For cash accounting, which is what most small businesses are the expense is booked all in the month that it is paid for.  For accrual accounting the expense is booked to the balance sheet as a prepaid expense account and for an annual payment 1/12 of the expense is recognized each month.   

Payroll and payroll taxes – It is an easy check for your CPA to look at your W2 / W3 or payroll summary to see if the numbers tie on your Profit and Loss statement.  A lot of the time they don’t so it needs to be researched.  One common error is that the payroll processor might include employee taxes they  pay in the tax payment that they send the accounting software.  Even though it is taxes it is part of the employees wages and not employer taxes.  Syncing your payroll provider with your accounting software should fix this.

Tricky Classifications

Credit Card Processing Fees – Payment processor only deposit the net amount of the transaction into your bank account.  So if you sell something that is $100 and you process it through square, stripe, QB payments or another processor then they charge a fee around 3% or $3 in this case.  Then they only deposit the Net Amount, which would be $97 in this case.  Depending on the integration with your payment processor there may be a transaction to match it to, but if not then you will need to find a way to split the entry so it shows $100 of revenue and $3 fees and nets out to the $97 deposit.  

Reimbursements for business expenses -these might show up as reimbursements from your payroll provider when you pay an employee back for a business expense they paid for personally.  The reimbursement should be classified based on what the expense was for, so you will need the details of the expenses before you reimburse the employee.  So if it was to reimburse for a plane ticket then you  would classify it to travel or air fare.  If it was for a plane ticket, hotel and meals, then you will need to split it into the different categories.  

Refunds – If you buy $50 of amazon office supplies and then return them the merchant can issue a refund that shows up as a deposit.  This looks like income so owners get confused on how to classify.  It should be categorized the same way the original office supplies were so that the net amount for the year for that account is $0.

Investments – These should be classified on the balance sheet as either equity or a liability if it is a loan or convertible note.  They can be segmented into the different investors so that it can easily be tracked, but some of this can be tracked in a CAP table that does not need to be reflected in the balance sheet like option pools or vesting equity schedules for employees.  

How to cleanup incorrect classifications?

There are a few ways to handle making a change in how you classify things.  

  1. Use the reclassify tool – this is only available to accountant access but if you don’t have an accountant you can assign the user to a different email you use.
  2. Start using the new classification going forward.  There is no need and it is not advised to change how you classified things in prior years as it could change your taxes and cause them to have to be amended.  
  3. Hire a bookkeeper to help with the cleanup

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