How accounts are classified is fundamental to a company’s accounting and bookkeeping process. You record financial transactions to show economic activity and add or subtract accounts. Small businesses often hire a certified public accountant to create the chart of accounts. They use financial software designed for small businesses to create a chart of accounts that includes a standard chart of accounts appropriate for their type of business.

Understand account

All accounts belonging to a balance sheet or income statement. On a balance sheet, you draw a bookkeeping list of assets and liabilities and classify accounts as assets, liabilities, or equity. Income statement accounts are classified as income, expenses, or withdrawals. You can debit or credit an account. Debits are always in the left column, and credits are always in the right column. The account type determines whether a debit or credit increases or decreases the account’s value. The “normal balance column” of an account is the increasing side of the account.

Balance sheet

The balance sheet’s basis is the accounting equation, equal assets and liabilities plus equity. A balance sheet snaps a company’s financial position at a specific time. Balance sheet accounts, or permanent accounts, include assets, liabilities, and equity. Your company owns assets. Liabilities are what your company owes. Equity, also known as owner’s capital or equity, is what a business owes to the owner. Most small businesses run a balance sheet at the end of each fiscal year after the income statement accounts are closed.

Income statement

Profit divided by loss equals revenue minus expenses, the basis of an income statement. Any income statement, whether a profit or loss statement, shows your company’s profit or loss for a specified time. Income statement accounts include income and expenses. Revenue is the income your business earns. Expenses are your business expenses. Withdrawals are funds withdrawn from a company by owners or shareholders. Nominal or temporary accounts are income, expenses, and withdrawals. According to the Institute of Corporate Finance report, these accounts are sub-accounts of equity and are consolidated with the equity account at the end of the fiscal year.

Account Classification

The first step in recording a company’s financial transactions is to create a chart of accounts. You will use this list of accounts to categorize financial transactions. Every account you create is an asset, liability, equity, account, or income account. Select the account type according to the bookkeeping purpose of the account. For example, bank accounts are classified as assets because bank accounts hold the company’s funds. Assets are things that a company owns. Classify the supplies account as an expense because you spend money on supplies to run your business.

How to classify recorded transactions?

For most CEOs, one of the everyday things they struggle with regarding bookkeeping is classifying transactions; they should be office expenses or cost of sales or ask my accountant. Fortunately, from a tax standpoint, there are guidelines to follow, so it’s easier for anyone to see and understand how your business is doing.

Why does proper classification matter?

Usually, it doesn’t matter how you categorize things. The AED25 program fee can be coded as Program, Office Expenses, or G&A (General and Administrative). Here are some high-level considerations on when you should start thinking about how to categorize things. 

Be consistent from month to month unless you want to change how you rank. This will help identify trends and understand your monthly expenses. If wage costs are coded as paychecks one month and payroll the next, it can confuse the difference between the two and why some months have wages and others have payroll. 

From now on, you can change things up and start breaking down your payroll into different categories like Landlord Pay, Office Worker Pay, Warehouse Pay, etc., so you can keep track of costs for different parts of your business.

Keep track of your business growth

 If you have three company trucks, there’s only a point in tracking each truck’s gas or maintenance if you want to track it to make better financial decisions in the future. For example, if you have three drivers and notice high gas bills on one of your trucks, you may want to investigate allegations of fraud. Another area is marketing spend – you should know how much you’re spending on Google and Facebook to track the customer acquisition costs of that spend.

Tax Classifications for Bookkeeping

Catering and Hospitality: This is an important area from a tax perspective, so expenses should be broken down into three categories.

Entertainment – 0% discount. Many years ago, people were used to attending concerts and sporting events and deducting them as business expenses. In 2018, the IRS decided that it’s still not tax-deductible even for entertaining clients and acquiring new business because it’s an interesting personal expense.

Holiday Party – 100% off. To do this, it needs to be a company-wide event

Meals – 50% off. 50% off most meals and food. This includes meals with clients and employees, office snacks, and travel meals.

Personal Expenses: These are not deductible and are not business expenses. If the corporation is an LLC or S Corp, it should generally be classified as a withdrawal or distribution of the owners. If the firm is a C corporation, the owner technically must repay the company and be classified as a loan to be repaid.

Assets: Every company should have a policy defining how to bulk purchases are classified. We recommend spending less than AED2,500 on the expense line item on the income and minimum statements. Any expense over that becomes an asset on the balance sheet that can be capitalized or amortized.

Annual Payments: This is another tricky process, depending on whether you use money or accrual accounting. For cash accounting, in most small businesses, the expense is booked in the month the expense is paid. For the accrual basis, the expense is recorded on the balance sheet as a prepaid expense account, with monthly recognition of 1/12 of the annual payment.

Payroll and Payroll Taxes: Your CPA can be easily checked by looking at your W2/W3 or Payroll summary to see if these numbers relate to your income statement. They usually don’t need to be searched. A common mistake is that payroll processors may include employee taxes when paying the taxes they send to the accounting software. While they are taxes, they are part of an employee’s salary, not an employer tax. Synchronizing your payroll provider with your accounting software should take care of this.

Challenging Classification 

Credit Card Processing Fee: The payment processor only deposits the net amount of the transaction into your bank account. So if you sell something for AED100 and process it through whatever processor, they may charge about 3% or AED 3. Then they only deposit the net amount, in this case, AED97.

Depending on the integration with your payment processor

There might be a matching transaction, but if not, you’ll need to find a way to split the entry so it shows AED 100 in revenue, AED 3 in fees, and AED 97 in deposit.

Business Expense Refunds: When you reimburse employees for business expenses they paid, these may show up as reimbursements to the payroll provider.

Reimbursements must be categorized according to the expenses used, so you need to detail the expenses before you can reimburse employees.

So, if you’re paying for airfare, you’ll classify it as either travel or airfare. Regarding flights, hotels, and meals, you need to separate them into separate categories.

Refunds: If you buy AED50 of office supplies from Amazon and return them, the merchant can issue a refund showing as a deposit. This looks like income until the owner needs clarification about classifying it. They must be sorted like the original office supplies so the account is netted at AED0 for the year.

Investments: If loans or convertible bonds, they should be classified as equity or liabilities on the balance sheet.

It can be broken down into different investors

So, it can be tracked easily but some of them can be tracked in a CAP plan and don’t need to be reflected on the balance sheet, like option pools or employee stock grant plans.

How are incorrect bookkeeping classifications cleared?

There are several ways to change the way you categorize things.

• Use the reclassify tool – it’s only for accountant access.
• If you don’t have an accountant, you can map the user to a different email you use.
• Start using new tabs in the future. 
• Changing how you filed for previous years is optional and desirable, as this could change your taxes and cause them to adjust.
• Hire a bookkeeping service in Dubai to clean it up for you.

Final Thoughts

Classifying accounts in the ledger helps the accounting department create financial statements.

If the purchases and sales of assets are recorded correctly.

It will be easier to see the classification of assets that you must report on your balance sheet. Hiring a Bookkeeping Services Dubai will make your finances stress-free.