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Misclassification of Expenses in an Accounting System

Accounting
Article
04/24/2019

Your accounting system is the key to understanding what's happening in your business. It's also vital to tax return preparation and other government compliance obligations. That’s why getting things right is essential. Unfortunately, mistakes can happen, whether you use a cloud-based or desktop accounting system. Understanding what can go wrong and how it can impact you is important. Even more important is knowing how to correct accounting errors and avoid future ones.

How accounting errors can occur

The integrity of the information in your accounting system is only as good as the information you enter. 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 or erroneous account assignment. 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 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. Know your industry standards for proper categorizing.
  • 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

Errors may be minor or substantial. Either way, they can have serious consequences:

  • 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. 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 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. If you use a cloud accounting system, there is some built-in expertise with respect to assigning expenses to the correct accounts.
  • 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).
  • Adopt best practices. Set deadlines for data entry and reconciliation so that errors are found quickly and can easily be corrected.

Fixing problems

Some accounting errors can be fixed by simply making or changing an entry. For example, a company's payment to an independent contractor for $500 was not entered in the books. This error can be fixed by making the appropriate entry. 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. Other errors may have ripple effects (e.g., you may need to restate previous financial statements).

If you experience misclassification problems or want to avoid them entirely, it's always advisable to work with experts who can ensure that your accounting systems are working well and your numbers are correct.

barbara weltman
Barbara Weltman is a tax and business attorney and the author of J.K. Lasser's Tax Deductions for Small Business as well as 25 other small business books.
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