Categorizing Transactions – Expenses

Before I can explain what an expense is, I will need to talk about costs. A costs is what you give up in your business to make money. A cost can be either an asset or expense. For example, an internet business will need a website so will have to give up cash to host its website. An expense is a cost that is used up within short period of time (normally within 30days) after value has been exchanged.

On the other hand, a cost is that has future value (that is, not used up in a short period of time) is called an asset. Both expenses and assets are needed to grow a successful business.

Expenses are classified into operating and non-operating expenses.

Operating expenses

Operating expenses are the expenses incurred as part of the regular operation of the business. Before you classify operating expenses in your business, you should start by asking yourself the following questions:

  • What is the purpose of my business?
  • What expenses will I need to attain the desired revenue level?
  • Are there any accounts that should be classified separately because of the way it is treated for tax purposes? Some examples are meals and entertainment, gift expense, supplies and repairs.

Once you know the expenses your business will need to bear, break the expenses down into categories. These categories are the expense that will be monitored in your financial software. Any expense that has a special rule for taxes should be kept in its separate account. You will need to consult with your certified public accountant to decide what these expenses are.

Example

Joe Blow who owns an internet business subscribed to an online accounting software. Joe needs to figure out how to set up his chart of account. Joe’s revenue are from 3 main sources namely:

  • E-Book sales
  • Advertising revenue
  • Subscription revenue

To make the income above, Joe Blow needs to spend money in four main categories namely:

  • Marketing
  • Subscriptions
  • Administrative tasks
  • Growth initiatives

Now that Joe knows his four main expense categories, he can take each of them and make accounts that detail the activities under each category.

Marketing

Joe uses the marketing category to classify expenses that has to do with promoting his business. Joe plans to place ads online, take potential clients to lunch and hire a marketing assistant to follow up on leads. Therefore Joe creates the following sub accounts under marketing:

  • Advertising expense – this will be used to classify any expense that has to do with his online or offline advertising
  • Networking meals – used to classify lunch with clients and potential clients. Meals will need its own category because only half of these expenses are deductible for tax purposes
  • Mileage expense: this is mileage expense Joe reimburses himself from his business. Joe travels to meet clients and potential clients.
  • Marketing staff/ subcontractor – used for any subcontractors hired to promote Joe’s business.

The expenses that fall under marketing are discretionary in nature. This means that if business is not doing as well, you can look at this account to see what expenses you can cut off. If you have a fixed marketing costs such as a subscription service, then you should classify them under the subscriptions category.

Subscriptions

When running a business online, there are a variety of applications you can subscribe to help increase your bottom line. Since these subscriptions are a big part of your cost of doing business, they should have their own category. For example, Joe subscribes to 3 services: one for hosting his website, one for his subscription services and one for his email subscription service. Joe will create a subscription account and create the following subaccounts:

  • Website hosting: this account is used to save transactions that have to do with hosting Joe’s website.
  • Subscription hosting: this account is used to save transactions that has to do with Joe’s subscription membership site.
  • Email marketing hosting: this account is used to save transactions for Joe’s email marketing software.

The expenses that fall under subscriptions are fixed in nature. This means regardless of your level of business activities, you will keep paying these fees. As you take on more fixed cost, be careful of how it affects your bottom line.

Administrative expenses

Administrative expenses are expenses that are required for compliance and other administrative tasks. Even though administrative tasks may not have a direct bearing to revenue, they are needed to run a smooth business. For example, a business that does not keep goods accounting records will not last for very long. Administrative expenses for Joe will include:

  • Accounting fees: fee for paying an accountant and a bookkeeper to keep books and file taxes.
  • Legal fees: are fees paid for legal advice.
  • Virtual assistance: fee for paying an assistant to do other administrative work.
  • Insurance expense: this is insurance Joe pays to protect himself from possible business liabilities.

Growth initiatives

Any business that wants to grow should leave time for planning and growth. These accounts are used to house all expenses that Joe pays to ensure the future growth of his business. Expenses that will fall under growth initiatives are:

  • Salary expense: this is the amount Joe pays himself. It is very important to separate business activities from personal activities. The best way to do that is to take a salary. Joe spends his time overseeing the business and thinking of new growth initiatives which falls under growth initiative tasks. However, if Joe spends most of his time marketing, his salary will fall under marketing.
  • Education & Training: Joe attends workshops, seminars and webinars to enhance his knowledge. Any transactions that Joe embarks on for future growth should be classified under education and training.
  • Mastermind group: Joe meets with a group of other internet entrepreneurs on a monthly basis. The monthly fee for joining should be classified here.

Growth initiative transactions normally do not bear a direct relationship to current revenue but are necessary to make sure the business continues to grow in the future.

Words of caution

The more accounts you have, the more difficult it is to manage your books. Accounts should be as few as possible: Only classify transactions into accounts that are needed to give a clear picture of your business. Also, be sure to watch out for accounts that need to be maintained for tax purposes as discussed below.

Accounts that should be maintained for tax purposes

Certain accounts should be classified separately because of the way it is treated for tax purposes. Examples of these accounts are:

Automobile/ Mileage expenses: Depending on your tax structure, you might have the option of deducting mileage or actual vehicle expenses. Keeping track of automobile expense in a separate account makes it easier for your accountant during tax time.

Meals and entertainment: Meals and entertainment are limited to 50% of the total expense so should be classified separately.

Gift expense: gift expense is limited to $25 per person so should be classified separately.

Supplies: supplies that have a life of more than one year and exceed $200 should be classified in an asset account.

Non-operating expenses

Non-operating expenses are expenses that do not result from operations. Non operating expenses could result from:

  • The sale of an old business asset, or
  • Cost of investing in other businesses or
  • Cost of borrowing money.

For example, Joe sells his old business computer at a loss. The loss will be a non-operating expense.

Interest expense – a non-operating expense

One mistake I often see while reviewing client books, is classifying loan payments as expenses. When you borrow a loan and make a payment on the loan, the payment is not an expense but a reduction in the loan amount. However, the portion paid on interest is an expense and should be classified as a non-operating expense. This is because interest expense is not a core part of operations.

Summary

In summary, expenses should bear a relationship to revenue. In other words, each dollar that goes out should either help contribute to increase revenue or decrease other costs. Expenses should be classified according to the function it plays in making the business profitable. Finally, accounts should be as few as possible: this makes it easier to keep the books clean.