How to Categorize Business Transactions
Even if you outsource bookkeeping to someone else, having a solid understanding of how the process works will help you make sense your financial statements and use them to grow your business.
In this guide, we’ll cover one of the most fundamental principles of small business bookkeeping: how to categorize business transactions.
Let’s take a look at how money is classified and recorded as it enters and exits your business.
Credits and debits
At its core, bookkeeping is the practice of tracking where money has come from and gone to. Although every business may be different on the surface, when it comes to bookkeeping, every business’s transactions are considered as credits and debits.
Simply put, a credit is money that has come from somewhere, whereas a debit is money that has gone somewhere. When transactions are described in “bookkeeper speak” they’re often being “credited” to or “debited” from an account of some kind.
One of the most important rules of bookkeeping is that for every debit there must be an offsetting credit, and vice versa. Keep in mind that debits and credits confuse many people who try to do their own bookkeeping, but once you learn to differentiate between the two, you’ll find the rest of the bookkeeping process a lot easier to understand.
These examples illustrate how transactions are recorded in bookkeeping as either a credit or debit:
- Example 1: Money has come from a sale = Credit sales revenue
- Example 2: Money has gone to a bank account = Debit bank account
- Example 3: Money has come from a bank account = Credit bank account
- Example 4: Money has gone to pay the landlord = Debit rent expense
Bookkeeping Journals and Journal Entries
While debits and credits help to keep track of money coming into and out of accounts, the record of these transactions is called a journal. Similar to a diary, a journal keeps track of the debit and credit transactions via journal entries and can ultimately tell the story of how the business operates. These records are vital for the proper preparation of financial statements, such as balance sheets and income statements, as well as for tax preparation.
Like we said earlier, an important feature of journal entries is that for every credit there must be a corresponding or offsetting debit (and vice versa). This process is known as double entry bookkeeping because at least two entries in the journal are made for every transaction that takes place.
To help clarify this, take a look at the following two example transactions. In the month of June, a small seller of beef jerky made a sale of $1800 and also had to pay their rent of $1500.
The transactions for the month of June would be recorded with the following journal entries:
June 12, 2015: Sale of delicious beef jerky to customer
- Credit, sales revenue, $1800 (money came from the customer)
- Debit, bank account, $1800 (money went to the bank account)
Payment of rent to the landlord: June 14, 2015
- Credit, bank account, $1500 (money came from the bank account)
- Debit, rent expense, $1500 (money went to the rent expense account)
When the business owner reviews her financial statements from the month of June, they will show her that cash increased by $300 after selling $1800 of merchandise and paying out $1500 in expenses.
In the example above, the places that money comes from and goes to are called accounts. These accounts are vital to properly keeping track of how money moves.
Think of an account like a type of placeholder. It can describe an internal location, like a bank account, credit card, or inventory or it can describe money moving in and out of the company, like an office expense, payroll expense, or sales revenue. Accounts can be customized to the type of business they’re used for. So, for example, a company that buys and sells chocolates might choose to have a “chocolate bars expense” account.
How money is classified as it enters or exits your business, and how these transactions are recorded, are two important concepts to grasp. A third concept that helps tie all of this together is the notion of an account type. Generally speaking, an account can belong to one of five categories (or “account types”).
An asset is something that the company owns. An asset can be physical, like cash, bank accounts, inventory, or equipment. Alternatively, an asset can be part of an agreement with someone that agrees to pay the business something in the future, like accounts receivables or loans (if the company is the one loaning the money). Finally, an asset can be something intangible, like intellectual property.
It’s common for businesses to take out loans to purchase goods or pay for services. These loans are called liabilities, which simply refers to the fact that money that has to be paid to someone in the future. One particularly common type of liability is accounts payable. This account refers to money that is owed to a vendor when they provide a business with a product or service up front and ask for payment later, for example, after 30 days of delivery.
Equity is money that comes from the owners of the company. The key distinction between equity and liability is that there’s usually no expectation that this money will be paid back.
A few common accounts of this type are:
- Share Capital: the amount of money that the owners have given to the company as startup or growth funding.
- Retained Earnings: the profit that the company has earned (i.e. total revenue minus total expense, since the company was founded).
- Dividends: the amount of money that the company has paid to the owners (shareholders) from its profits. This is counted as a negative number, since as profit is paid back to owners, the amount of profit remaining within the company decreases. Equity decreases as dividends are paid.
Revenue is money that the company has collected from customers for sales, or as payment for services.
An expense is money that is paid out by the company to keep the business running. Expense must be differentiated from investment. With an expense, the company gets a one-time benefit from the money spent. With an investment, the company will get a lasting benefit from the money spent. Investments get categorized as assets, not expenses.
The bottom line
Deciding on how to categorize transactions can be difficult at times, often because the purpose of the transaction can impact the way it’s classified. For example, if software is being developed for a business, that transaction could be categorized as an investment in the business’s technology (i.e. an asset), or as a payroll expense.
The flexibility in how things are classified can be confusing, however the most important thing to remember is that transactions should be categorized consistently however they are classified.
For more easy-to-understand guides on small business financial issues, check out Bookkeeping 101 in our Small Business Syllabus.
This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Bench assumes no liability for actions taken in reliance upon the information contained herein.