Bookkeeping 101: How to Categorize Transactions?
TL;DR
Income: Money received from selling goods or services.
Expenses: Fees or costs incurred in the process of business.
Refunds: Record decreases in expenses and increases in bank account when returning supplies.
Assets: Resources with economic value owned or controlled, expected to provide future benefit.
Asset Examples: Cash, bank accounts, cash equivalents, vehicles, equipment, buildings, land, inventory.
Liabilities: Money you owe to another party.
Loan Payment Recording: Differentiate between principal and interest payments, recording the former as a decrease in loan liability and the latter as an expense.
Business Vehicle Acquisition: Record the vehicle as an asset and the loan as a liability, with payments reflecting principal reduction and interest expense.
Owner Transactions: Categorize personal contributions or withdrawals as “drawings” on equity, not wages, unless specifically advised otherwise.
Categorizing transactions can be tricky, but it doesn’t have to be! Use this guide to help your business!
Types of Transactions
Transactions come in a few basic types, income, expenses, assets, loans or liabilities, and finally contributions or drawings. There are more, but for basic bookkeeping, especially for small businesses, they are often unnecessary and can overcomplicate your books. Fit every transaction into the above types and you’ll have no problem.
Income
Income and expenses are pretty straight forward. They are the most basic and will form the bulk of your transactions.
An income transaction occurs when your business sells goods or services and receives money in return. Keep in mind that there is a difference between money simply coming into your business and money coming in from the sale of goods or services. We will get to the distinction in a bit.
As an example, let’s say you are in the lawn-care business and received $500 cash for landscaping services you provided, and you deposited that cash into your bank. Here, we would record a $500 of income and at the same time we would record a $500 increase in your bank account.
Expenses
Expenses are likely the most frequent transactions in your business—after all, "You have to spend money to make money!"
Expenses occur when your business incurs costs during its operations. These are often subdivided into categories (e.g., Supplies, Contract Labor) to reflect their purpose accurately.
To continue our lawn-care example, in the course of business, you spent $150 on supplies and $100 on labor. In our books, we would record two transactions here: one for $150 as an expense categorized as Supplies Expense with a corresponding decrease in our bank account, and another transaction for $100 categorized as Contract Labor, again with a corresponding decrease in our bank account.
What happens, then, if we return some of the supplies we purchased? Well in that case you would simply record the opposite: a decrease in the Supplies expenses and an increase in our bank account.
Pro Tip: Payments to yourself as the business owner are generally not recorded as expenses. (See the “Contributions/Drawing” section for details.)
Assets
Assets can be a little more tricky, but we have seen one type already, the bank account. The accountant’s definition of asset is: “a resource with economic value that an individual, a company, or a country owns or controls with the expectation that it will provide a future benefit.” (Quite the mouthful, eh?). But, for most small business, simply knowing that assets are either cash, bank accounts, or tangible objects is enough. Generally, they will be recorded at the price we spent on them.
After our work and expenses in the lawn care business, we have $250 left in our bank account (an asset). If we decide to take the money and upgrade our lawnmower, a tangible object that we will use in our business, we would record a new asset with a corresponding decrease in our bank account. If it cost $150 for the lawnmower, then we would record a decrease of $150 in our bank account.
Examples of assets include:
Cash
Bank accounts
Cash equivalents like cashiers checks or gold/silver bullion
Vehicles
Equipment
Buildings
Land
Inventory
We use up assets through a process called depreciation, but that will be a topic for another article.
Liabilities
Loans
To purchase some assets, or to fund our business venture, we will take out a loan, which in the accounting world is referred to as a liability. A loan generally incurs interest in the process of paying it off, which can make it tricky to record.
So how do we do it?We need to differentiate between the payment to the loan’s balance (or principal) and the payment on the interest that has been incurred. Often I see business owners listing the entire payment on a loan as an expense, but this is incorrect. What we need to do is go to the statements that the loan provider gives or calculate the interest expense ourselves.
We need a work truck for our business, so what do we do? We don’t have $30,000 to go buy one in cash, so we’re gonna finance it through the dealer. How do we record this, then?
The vehicle comes in as an asset and at the same time we will record a new liability: the vehicle loan for $30,000. A payment on the loan will include the amount paid to principal and the amount paid in interest.
Let’s say our monthly payment is $600, and the interest on the first payment is $200. We would record a payment from our bank account for $600, a decrease in the work truck loan by $400, and an expense, Interest Expense, of $200.
Credit Cards
Credit cards are another type of liability commonly used in business, but they function differently from traditional loans.
When you make a purchase using a credit card:
The expense is recorded in the appropriate category (e.g., Supplies, Travel).
A corresponding liability is created in your books under the credit card account.
When you pay the credit card bill:
Record the payment as a reduction in the credit card liability.
If the bill includes interest, record that portion as an Interest Expense.
Contributions/Drawing
Transactions of you taking out or putting in your own money are collectively referred to as “drawing” transactions. The accounting term would be “equity”. In most cases, money you pay yourself isn’t classified as wages or expenses unless explicitly advised by an accountant. This is a common error among small business owners.
Wrapping It Up: Simplify Your Business Finances
So there you have it, the basic types of transactions that you need to know in order to take care of your business’s expenses. It can seem daunting at first, it’s quite a lot of information. But, once you start using them you it will become like second nature to you.
If you’d rather not worry about bookkeeping, McCartney Bookkeeping, LLC can help. We offer affordable, reliable services tailored to small businesses. Let us handle your finances so you can focus on what you do best!
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