How Do I Categorize Income and Expenses Correctly To Avoid Tax and Reporting Issues?

If your financial reports aren’t adding up or your CPA keeps asking questions you can’t easily answer, you’re far from alone. You might even have a pretty good understanding of how to categorize income and expenses correctly in QuickBooks, but the numbers still just don’t add up.

Getting financial reports in order can be challenging for small business owners. But most issues come down to one of a few root causes, like inconsistent bookkeeping habits, blending personal and business finances, and miscategorized expenses in QuickBooks.

This article will dive into that third item by exploring some of the most common bookkeeping categorization mistakes, their impact, and how to mitigate them through improved bookkeeping practices or working with an outsourced accounting services provider. 

Why Does Correct Income and Expense Categorization Matter for Your Business?

Getting your income and expense categories correct is critical for maintaining accurate financial records. It also has an impact on your company’s ability to maximize tax deductions, ensure audit readiness, and improve cash flow management. 

When you’re able to work with records that are complete and up to date, accurate categorization also gives you financial data you can actually use to help manage cash flow, plan ahead, and make informed decisions for your business.

When your categories aren’t set up properly, the relationship between expense categorization and tax reporting becomes more difficult to understand. This confusion can negatively affect profitability while increasing tax liabilities and making tax season more stressful than it needs to be.

What’s the Difference Between Income, COGS, and Expenses in QuickBooks?

Income, cost of goods sold (COGS), and expenses all relate to the profitability of a small business. 

Income

Recorded in QuickBooks when you create an invoice or sales receipt, income refers to revenue generated from selling products or services. “Income” can include product income, service revenue, and consulting fees.

Cost of Goods Sold (COGS)

COGS refers to direct costs directly associated with the production of the goods or services being sold. These can include raw materials, labor costs, and shipping or freight costs. 

Expenses

Operating expenses include a range of indirect costs necessary for daily operations (but not directly tied to the production of a specific product or service). Common small business expense examples include rent, utilities, marketing, insurance, software subscriptions, and so on. 

It’s important to examine income vs. expenses vs. COGS in QuickBooks because your P&L treats each differently. Specifically, COGS is subtracted from income to calculate gross profit, and operating expenses come out after. 

If you were to miscategorize a COGS item as an operating expense (logging a contractor’s fee as something like office supplies, for example), your gross profit margin will be overstated with inflated operating expenses. This all-too-common scenario gives an inaccurate picture of your company’s financial health, and the downstream effects of reporting and decision-making can be significant.

How Does Putting Expenses in the Wrong Category Affect Your Tax Return?

When you categorize business transactions in QuickBooks incorrectly, you’re likely to run into issues when handing your books over to your CPA for tax preparation. Consider the fact that some expenses are deductible, while others aren’t. If transactions are landing with the wrong accounts, deductible items can get buried while non-deductible ones appear where they don’t belong.

A common example of this relates to owner draws. They don’t represent a business expense, but sometimes are mistakenly recorded as such, distorting net profit figures. Fixing miscategorizations weeks or months after the fact can be time-consuming and tedious; any time you’re unsure how something should be classified, you should flag it and ask your CPA or accountant.

What Are the Most Common Categorization Mistakes Small Business Owners Make?

Some of the most common bookkeeping categorization mistakes include using “catch-all” categories, mixing personal and business expenses, recording owner draws as business expenses, and neglecting to create sub-accounts.

“Catch-All” Categories

Relying on categories like “Uncategorized Expense” or “Miscellaneous” is probably the most common categorization error small business owners make. These accounts exist as a sort of temporary landing for certain expenses, not their permanent category. 

When too many transactions fall into these “catch-all” categories, your financial reports lose valuable meaning. And without clean records, sorting out your QuickBooks categories for tax deductions becomes a guessing game for your CPA.

Mixing Personal and Business Expenses

This issue is especially common among sole proprietors and early-stage founders who haven’t fully separated their finances. But it doesn’t take more than one or two personal transactions intermingled in your business finances to create reconciliation headaches and added stress at tax time.

Recording Owner Draws as Business Expenses

Owner draws are best understood as equity transactions, not costs of running a business. As such, recording owner draws as business expenses is a misclassification that distorts profitability. 

On a similar note, treating all contractor payments identically, regardless of their purpose, can muddy the distinction between COGS and operating expenses in ways that impact gross margin reporting.

Skipping Sub-Accounts

Many small business owners make the error of skipping sub-accounts during the chart of accounts QuickBooks setup process. 

They end up with one broad account (like “Professional Services”) that covers too wide a range of expense items to provide the level of granularity needed for financial reporting, while making it considerably more difficult to achieve profit and loss accuracy in QuickBooks.

How Do You Set up Accurate Categories in QuickBooks and Keep Them That Way?

Getting bookkeeping categories for your small business set up correctly  is one of the most important things you can do, and with QuickBooks, it’s a fairly straightforward process. Within the QuickBooks platform, it only takes a couple of clicks to add new accounts and edit existing ones as needed. This should be done before recording a single transaction.

You can also use QuickBooks’s bank feed categorization rules to automate recurring transactions and add sub-accounts when reporting requires them. 

The platform also makes it easy to keep your categories in order through a monthly category review meant to catch and correct errors before they have a chance to compound.

You want to address categorization errors as soon as they’re identified, so knowing how to fix wrong categories in QuickBooks is worth learning. Fortunately, QuickBooks makes it relatively easy to reclassify individual transactions, fix uncategorized expenses, and make corrections to reconciled transactions.

One final categorization tip: It’s best to only add sub-accounts when your reporting requires that level of detail. While many small business owners over-categorize because they equate it to being greatly organized, it can have an adverse effect by creating cluttered reports that are hard to read, increasing the potential for data entry errors, and making analysis difficult.

When Does It Make Sense To Have a Professional Manage Your QuickBooks Categories?

It’s one thing to manage DIY categorization when you have a straightforward business model and low transaction volume. As a business grows or becomes more complex, however, the margin for error shrinks.

This might not seem like a big deal, but it can cause substantial bookkeeping problems your accountant or CPA will have to sort out when tax time arrives. Remember, CPAs and accountants typically bill on an hourly basis, and every categorization error they have to correct has a cost attached to it.

When you’re spending more time on bookkeeping tasks like identifying and addressing categorization errors than you are on running your business, hiring a professional to help create QuickBooks expense categories for your small business makes sense. It’s certainly the best way to ensure that your chart of accounts will be set up correctly and that your business will be both tax-compliant and audit-ready.

Milestone’s accounting and bookkeeping services can help you create the right categories, produce accurate financial reports, and provide the kind of documentation your CPA can work with. If you’re ready to discuss how a partnership can give you accurate, CPA-ready books every month as well as at year’s end, reach out today.