Misclassifying Expenses in Accounting Systems: Avoid It or Fix It
Your accounting system is vital to your business. It’s the best way to know what is going on in your business—whether you’re making or losing money and what you’re spending money on. The information is also important for generating accurate financial statements and for preparing tax returns. If you misclassify an expense item, it can throw your perceptions out of whack and result in inaccurate financial statements and tax returns.
Bottom line: misclassification can cost you money and undermine your grip on the business. The best defense is a good offense, which means understanding how errors can occur so you can prevent them, as well as knowing what to do if problems do arise.
How Mistakes Can Occur
The integrity of the information in your accounting system is only as good as the information you input. This means including an expense in the appropriate account, applying the correct description or code, and entering the correct amount. Unfortunately, misclassification can result in two ways:
- Simple mistakes. The item is entered incorrectly into the wrong account. For example, you enter a payment to an outside contractor as a commission to an employee rather than contract labor costs. This error could result in paying higher employment taxes and failing to generate a Form 1099-MISC to the contractor. Other errors can result from typos, including transposed numbers or misplaced decimal points. With more sophisticated accounting systems, proper coding is necessary to ensure that expenses fall into the correct accounts; using the wrong code for an expense causes the expense to be misclassified.
- Erroneous account assignment. The expense is entered into an account that does not accurately reflect the nature of the expense. For example, you incur costs to create a website and enter them in the account for advertising expenses. This may or may not be a correct classification. It could, for example, be an amortizable expense entered into an account for this purpose. Classification isn’t always clear cut. For example, the IRS has not yet said how website creation costs should be treated for tax purposes, making classification for accounting purposes somewhat murky. Another dicey area of classification is the cost of fixing broken property—is the cost a deductible repair cost or an amortizable capital cost? An understanding of the IRS’ stance on this question may be helpful to your proper classification of such an expense (see final regulations).
How to Avoid Misclassification
Being careful with your financial information is the first line of defense in ensuring that expenses are properly classified. But there are other steps you can take to avoid misclassification.
- Train staff on correct data entry. Make sure employees entering expenses into your accounting system understand your accounts and descriptions.
- Do a periodic review of entries. Some misclassifications may be easy to spot because the description won’t match the item. You may also want to compare numbers from last year with this year’s entries to detect any differences that don’t make sense. You may want your accountant to periodically review your accounts to make sure that they appropriately reflect the expenses you incur and comply with generally accepted accounting principles.
- Check for differences between the budget and actual expenses. Your budget may show a certain amount of money is to be spent on a particular item or activity but the entry doesn’t match up. Comparing your actual expenses to the amount you budgeted can help you discover a misclassification (or at least an explanation for the differences).
If you experience misclassification problems or want to avoid them entirely, it’s always advisable to work with experts who can ensure that your numbers are correct. Some corrections in expense classification may trigger a change in accounting method for tax purposes, requiring you to file a request for a change in accounting method. Your accountant can guide you in this matter.