To succeed in business, small business owners must keep a close eye on expenses. Poor expense management can destroy your profit on a project or business venture. A component of expense management is expense tracking.
If you’re not keeping track of your expenses, it’s easy to go over budget. Even if you’re still making a profit and don’t think you need to pay close attention to them, if you don’t have good records you won’t be able to take all your allowable deductions on your taxes.
How important is it to Track Business Expenses?
Without detailed, monthly information on your business’ performance, it’s easy to be running at a loss for several months and not even be aware. Cash flows which don’t align, such as customers pay deposits or large sums before you incur expenses on those projects, can mask your businesses true financial health.
Tracking your expenses also helps you know if you’re on track with your financial goals. Did you want to increase your net income by 10% this year? Without detailed bookkeeping records, you may not know if you need to up your marketing efforts to hit that target.
Lastly, without strong expense tracking and excellent documentation, you won’t be able to deduct all your business expenses. If you have reconciled your bank accounts and kept receipts, as well as properly categorized your costs, it’ll be easy to hand your records over to your accountant and maximize your deductions. If everything is still in a shoebox under your desk, you’ll spend valuable time inputting data, tracking down support, and probably miss out on some deductions.
Not all receipts contain detailed information, and you might forget why you had a business meal back in June. Note that if you can clearly tie an expense to the revenue it generated you increase the odds that the IRS will let you deduct it. Spending just an hour a month making sure your expense entry is current will save you many headaches during tax seasons.
Which Types of Expenses are Deductible?
Not every business expense is 100% deductible, which is part of why accurate expense categorization is so important. Deductible expenses those that come out of your income before you pay taxes. The IRS provides some guidance on what is and isn’t allowable, but has said that deductible expenses should be helpful, appropriate, and reasonable for a business.
Standard expenses which have been acceptable in the past include; administrative expenses, auto expenses, employee benefits, and business-related travel and entertainment. These are current and can be deducted in the year they’re incurred. Other noncurrent expenses, such as depreciation on fixed assets, can only be deducted over time.
While most expenses are 100% deductible, travel and entertainment is only 50% deductible. This is because a portion of this expense is viewed as personal. As well, the IRS seeks to prevent small business owners from abusing this deduction.
Why does Expense Categorization Matter?
Project-based businesses can’t judge a project’s net profit if they haven’t appropriately categorized related expenses. If you pass some expenses along to the client, you might not be able to if they’ve been filed or identified incorrectly in your accounting system. And miscategorized costs could impact your tax deductions.
When entering an expense into your accounting system, you should make sure that the individual responsible categorizes it correctly. It will help gauge your business’s profitability, or show you were you need to trim costs or find another vendor. Putting an expense in the wrong bucket could mean you might not get to deduct all of it, or the IRS throws it out.
And some expenses shouldn’t be expensed altogether.
Capitalizing vs. Expensing a Business Cost
A cost which is expensed goes to the Income Statement and is deducted from your revenue in the year it’s incurred. A capitalized cost goes towards capital expenditures on the Balance Sheet, and only its depreciation hits the Income Statement. How a business chooses to treat an expense can reduce or raise net income, and thus, the taxes they pay.
There are no mandatory IRS rules that address when to capitalize versus when to expense; however, you could be asked to justify your reasoning in an audit. Most businesses make this decision based on whether or not the asset purchased with the cost incurred produces future benefits. If there is no future benefit to the asset, it’s booked as an expense. If it has an ongoing, future benefit to the company, it’s capitalized.
Typically capitalized expenses could be the costs incurred to purchase a large piece of machinery, or a new building. An intangible asset, such as a copyright or trademark, would also qualify for capitalization. A restaurant meal with a client would count as an expense.
If you have any questions about whether or not to capitalize or expense a cost, talk to your accountant. Once a decision to capitalize and only book depreciation through the Income Statement has been made, it can’t be reversed at a later date.
What Documentation does a Small Business Owner Need to Keep?
While the rest of the world has gone digital, the IRS still prefers paper. Supporting documents that they consider acceptable include;
- Paid bills
- Sales slips
- Canceled checks
- Credit card statements
- Petty cash slips
The IRS stresses that you must keep these documents to support the entries on your books. In general, you should keep all documentation for a minimum of three years.
You might not be required to produce receipts for expenses less than $75, but since the IRS can require you to provide a receipt for any expense it’s still a good idea to keep it if you have one. When asking them to uphold a deduction under $75 without a receipt, you must be able to tell them the amount, where and when you incurred the expense, and its purpose.
What about Electronic Recordkeeping?
While you can keep electronic records, the IRS holds them to the same standards as physical recordkeeping.
Apps from accounting software companies such as QuickBooks and FreshBooks allow you to snap a photo of the receipt, upload it into your records, and associate it with a transaction when it passes through your accounts.
If you run a large, complex business, you might want to buy a dedicated document scanner into which your administrative assistant can scan your records. Or you can use a cloud storage site such as Dropbox or Google Drive to scan and store information.
The Final Word on Expense Tracking
Whatever you do, put in place a system for expense tracking and periodically check that it’s working correctly. Having policies and procedures in place will protect your business from accusations of impropriety in an audit, save you time and money on your tax preparation, and help you run a better organization.