Should you put all advertising under advertising? Should you have separate categories for social media ads vs. direct marketing? Or should you go as far as to have separate categories for every advertising vendor? How much of this is important at tax time? How does this help me run my business? And how much is just personal preference? This article will help you get to the bottom of these questions.
In bookkeeping the main objective, as you probably know, is to properly categorize all your transactions. But what does that mean, exactly? For example, how would you categorize an Adobe software subscription? Software? Office Supplies? Dues and Subscriptions? Miscellaneous Expense? The truth is the only wrong answer is Miscellaneous Expense.
Categorizing expenses is a mixture of art and science. Of course, expenses should be kept within an acceptable range of like transactions, but there is a bit of wiggle room for customization on your chart of accounts. Your chart of accounts is the list of transaction categories in your finance software.
Your chart of accounts can be as simple or as detailed as you would like. Just beware that problems can arise from over simplifying or over complicating your chart of accounts. This is illustrated more below.
General Principles in Expense Categorization
As long as an expense appears in an area of the chart of accounts which generally makes sense, for the most part, it’s legally fine. There are certain types of expenses which are not eligible for 100% write-off, such as meals and entertainment, but you can learn more about these from your CPA or by looking it up yourself in IRS Publication 535 at https://www.irs.gov/publications/p535.
Other than these few exceptions, just use common sense as your guide. And if you come across a tough one, you can always Google it, or ask your bookkeeper or CPA.
The Categorization Conundrum
What do you do if a transaction fits into multiple categories? There will be some transactions which could fit into 2, 3 or 4 different categories, and it can be tough to determine where to put them.
For example, how would you categorize gasoline? A couple options are vehicle expense or travel. Neither is wrong, maybe one fits your type of business a little better than the other. In the case of a construction company that sometimes has jobs out of state, gasoline might be a better fit in vehicle expense, in order to keep it separate from the expenses of traveling to out of state worksites. Though if traveling to distant worksites is done by company work trucks, maybe travel would be better.
It is also possible that different purchases of the same item could be categorized differently, depending on the purpose of the expense. In the above example, gasoline purchased for local jobs could go under vehicle expense, while gasoline purchased to go to out of state jobsites could be categorized as travel.
This would require an additional step to ensure that the purchase gets categorized properly, maybe the purchaser notes on the receipt what the purchase was for, or maybe one credit card is used for vehicle expenses while another is for travel.
This is a great example of why limiting the level of detail to your categorization is the best course of action, when possible. But don’t be afraid to add detail when it is truly necessary.
However you decide to categorize an expense though, be consistent. It can cause undue confusion when a particular type of transaction is categorized in different ways. It can also make transactions hard to find. You can always check the history of that vendor or like vendors to refresh your memory on how it’s been categorized in the past.
How Much Detail Should Go into My Chart of Accounts?
When it comes to the detail level of expense categorization, the IRS and your CPA don’t really care. And unless you get audited, they’re probably not even going to look. The level of category detail is at the discretion of the business owner. The purpose of additional detail on the chart of accounts is to help you run your business more effectively and efficiently.
For example, you may want to examine your travel expenses. Do you want to see a single lump sum of all travel expenses or would it be more helpful to see it broken down by airfare, hotels, care rentals, parking & tolls, and travel meals? Keep in mind, you can always drill down on an expense category to see what’s in it, but the question here is, how do you want it to look at a glance? How should it look on the P&L?
If you examine your travel expenses once per year or less or you don’t do much traveling, then you’d probably do best with a single travel category. However, if you do a lot of traveling and like to keep an eye on the associated expenses, more detail might be the right way to go for you.
You can create as many sub-categories as you like (depending on your software subscription level) to breakdown expenses into greater detail. For example, maybe you just want to see airfare and all other travel expense can go into the parent category of travel. Or maybe you want to have every type of travel expense categorized separately, if it helps you run your business more efficiently, then so be it.
Is There Such a Thing as Too Much Detail?
A pitfall to lookout for when creating addition detail on your chart of accounts though, is too much detail. If you get into adding too many sub accounts or sub accounts of categories where it’s not necessary, you run the risk of over complicating it. When unneeded complexities are added, confusion usually results. Whether it’s your own confusion, your CPA’s or an employee’s, it will often come back to bite you.
The rule of thumb is to add as much detail as is needed to make things easier. When it starts making things harder, you know you’ve gone too far.
About the Author I have been doing bookkeeping for about 20 years and concurrently held a position as the head of HR for a small management firm for 14 of those years.
Currently, I am an owner of Peggy’s Bookkeeping Service with my partner and mother, Peggy. Peggy’s Bookkeeping is a small, family-owned bookkeeping service based in Clearwater, FL. You can visit our website at www.peggysbookkeeping.com.
Disclaimer: The content on this page is for informational purposes only, and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.
Comments