One Simple Way to Start Categorizing Your Business’ Financial Transactions

Often times I am asked by new (and not so new) business owners if I can help them create a chart of accounts for their new business. A chart of accounts is simply the list of categories or buckets that you use to classify financial transactions. (Throughout this article, I may use “accounts” and “categories” interchangeably but I am referring to the same thing). I am always elated to hear this question because those who don’t ask for help, often wind up making some of these common missteps (to skip right to the solution, jump to the Too Many Categories section).

  • Categories that use vendor names
  • Multiple categories that overlap one another
  • Trying to separate multiple companies or departments in the same set of books using the chart of accounts
  • Too many categories

These are just a few of the most common ones I see; and, although they are not technically wrong, they do tend to complicate things a bit more than necessary.

Categories that Use Vendor Names
If you are using any type of accounting software, there should be no need to use vendor names in your chart of accounts. When you enter transactions, you are prompted to enter the name of the vendor you made the purchase from. You can then run reports for a specific vendor(s) from within your software to see details and/or totals for that vendor if you so choose.

An example of this would be:

Dues & Subscriptions: GoDaddy
Dues & Subscriptions: Google
Dues & Subscriptions: RedBooth

Multiple Categories that Overlap
Some accounting software, especially QuickBooks Desktop, comes with a pre-built chart of accounts. I am not particularly fond of these because I feel that they are either too detailed or too vague. The result is the business owner creating new categories because they can’t find one that seems to fit the particular transaction they are trying classify (maybe because it isn’t there or maybe because there are too many to look through).

An example of this would be a category called Office Expense and one called Office Supplies.

The result of this is inconsistency because this month you might use Office Expense and next month you might use Office Supplies because you can’t remember which one you used the month before.

Trying to Separate Multiple Companies or Departments in the Same Set of Books Using the Chart of Accounts
I have seen this one more often lately because of the advent of online subscriptions for accounting software. For instance, with QuickBooks desktop, you used to be able to have as many separate company files in QuickBooks desktop at no additional charge. Taking your accounting to the cloud means you need to pay a separate monthly subscription fee for each entity you own to have a separate set of books for each one.

In an effort to save money, some business owners try to run both sets of books out of one company file (not a recommended practice). (On a side note, if you are making the move to QuickBooks online and you have multiple companies, Find a QuickBooks ProAdvisor and ask them if they can offer you any multiple company discounts. This is available to some (maybe all) ProAdvisors through their wholesale program.)

Too keep things separate, they start naming the chart of accounts for each business or department like this:

Auto Expense – Entity #1
Auto Expense – Entity #2
Office Supplies – Entity #1
Office Supplies – Entity #2

This method makes the financial reports somewhat, if not terribly, difficult to decipher and can easily result in data entry errors.

If you do have a need to track things separately in one set of books, look for an accounting software that allows you to separate entities or divisions using classes or departments or locations. This way you can use one account (office supplies) and assign it a class (Entity #1) and run reports by class to see only the income and expenses for Entity #1.

Too Many Categories

I see this one all too often. The list of categories or accounts gets so long that the financial reports wind up being several pages long – too overwhelming for even the most experienced accountant much less a new business owner who is just learning how to read their financial statements.

The easiest way to avoid this is to use the business income tax form you must file as a guide

  1. You need to identify which entity type your particular business is
  • Sole Proprietor or Single Member LLC (disregarded entity) – Schedule C (Part I and Part II)
  • Partnerships – Schedule 1065 (Income & Deductions sections)
  • Corporation – Form 1120 (Income & Deductions sections)
  • S-Corporation or Single Member LLC taxed as an S-Corporation – Form 1120S (Income & Deductions sections)

2) Click the link to the form that applies to your entity type

3) Set up your chart of accounts to match the categories in the sections noted for your form (you can break out income a little bit if you want to track different income sources; but, don’t get too crazy)

4) Only add a category if you absolutely cannot justify any of these categories for the transaction you are trying to categorize

Using this method will get you off to a good start. It won’t give you the necessary balance sheet categories you need; but, that is beyond the scope of this post and perhaps a topic for another blog post.

If you have any questions about setting up your chart of accounts, you can visit our contact page and book an appointment for a free consultation and we will be happy to answer any questions you may have.

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