Don't Risk Misclassifying Expenses in Your Accounting System
A cloud accounting system can help small businesses detect misclassification errors through the promise of more efficient and effective financial reporting. A cloud system may also reduce computational mistakes. Yet, no matter what system a business uses, bookkeepers still must review accounting data and check for expense reporting accuracy in tax and financial reports.
Types of Misclassification Errors
Certain expense misclassifications are more common than others. Based on the industry and complexity, proper expense reporting may become a challenge. Here are a few errors to look for when reviewing accounting reports.
- Capital Assets Misclassified as Expenses: Misclassifying expenses which should be labeled as a depreciable asset is one common reporting error. Asset purchases such as furniture and equipment may need to be depreciated over a certain number of years. Thus, the entire cost cannot be deducted in the year of purchase.
- Misreported Startup Costs: Business startup costs are another expense classification challenge. Some costs must be amortized over a certain period, while others may be expensed as incurred. The tax and accounting treatment for startup costs can be complex. Consider conducting additional research and seek expert advice.
- Expense Assigned to Incorrect Business Entity: If more than one line of business is tracked in the cloud accounting system, expenses can sometimes be associated with the wrong income producing product or service.
- Expenses Assigned to the Wrong Account Number: This may be the result of data entry errors or lack of knowledge by the person inputting expenses.
- Data Entry Errors: Check for extra digits or transposition. These errors can usually be spotted when a double entry system is used, as accounts will not balance.
The Impact of Misclassification Errors
Investors rely on accounting statements to paint an accurate picture of a business. With incorrect expense classification, this picture becomes distorted. Misclassified expenses may also impact the business in other, costly ways.
- Incorrect expense reporting can distort a company's computed operating profit margins or could result in over-reporting of income.
- Misclassification or failure to include business expenses may result in the failure to report a deductible expense.
- Increased costs associated with error correction, because correcting classification mistakes on the back end is time-consuming for employees already busy with year-end reporting.
- Late payment fees and interest owed when expenses slip through the cracks. When misclassification errors are discovered later in the accounting cycle, invoices may be past due and result in additional fees and interest.
- Improper matching of income and expenses. Misclassified expenses may cause incorrect reporting for companies using accrual accounting. Expenses should be properly matched with the income they generate. If expenses are classified in the wrong month or year, this will not happen as it should.
How to Spot the Misclassification of Expenses within a Cloud Accounting System
By leveraging the checks and balances built into a cloud accounting system, small businesses can limit potential reporting errors associated with misclassifying expenses. A reasonableness test should also be performed when reviewing each individual expense account balance. Further review by someone other than the person who originally entered the expense may also catch errors, and comparison of actual expenses to budget is another way to highlight misclassifications.
Avoid the need to fix mistakes on the back end by incorporating formal expense reporting review procedures. Leverage the investment in a cloud accounting system by designing custom reports to assist management's high-level financial reviews. The built-in expertise in a cloud accounting system assists with the proper assignment of expenses to the correct income statement accounts.