Bookkeeping for Expenses: A Step-by-Step Process

Bookkeeping is the practice of recording and organizing a company’s daily financial transactions. A systematic approach to managing expenses provides a clear view of where money is being spent. This financial clarity is necessary for building accurate budgets, managing cash flow, and making informed operational decisions. Properly tracking expenses is also a matter of regulatory compliance. Tax authorities require businesses to maintain accurate financial records to substantiate the deductions claimed on tax returns, which simplifies tax preparation and provides the necessary documentation in the event of an audit.

Identifying Business Expenses

For an expense to be a valid business deduction, the Internal Revenue Service (IRS) requires it to be both “ordinary and necessary.” An ordinary expense is one that is common and accepted in your specific trade or industry. A necessary expense is one that is helpful and appropriate for your business.

A strict separation of business and personal finances is required. Using business funds for personal items is a practice known as commingling funds, which creates accounting challenges and can lead to serious issues during tax season. The IRS looks for commingling, and its presence can trigger more intense scrutiny of all claimed deductions, potentially leading to penalties or a full audit. For incorporated entities like LLCs, it can also “pierce the corporate veil,” putting personal assets at risk in legal disputes.

Business expenses fall into two broad classifications: Cost of Goods Sold (COGS) and Operating Expenses. COGS, also called direct costs, includes all expenses directly tied to the production of goods or services, such as the purchase price of inventory for a retailer or raw materials for a manufacturer. Operating expenses, or indirect costs, are the expenditures a business incurs to keep its operations running. These day-to-day costs do not fluctuate directly with sales volume and include rent, utility bills, marketing, and administrative salaries.

Common Expense Categories

A well-organized system for categorizing expenses, often structured as a Chart of Accounts, allows for consistent tracking and provides clear insights into spending patterns. This simplifies the process of preparing financial statements and tax returns.

Office Expenses

This category covers the day-to-day costs of maintaining an administrative environment. It includes tangible supplies like paper, pens, and printer ink, as well as recurring costs such as subscriptions to business software and cloud storage services. Other items might be small office furniture, bank service charges, and fees for business publications.

Marketing and Advertising

Expenditures made to promote the business and attract customers fall under this heading. This includes costs of digital advertising campaigns on social media or search engines and traditional methods like print ads or direct mail. Other common marketing expenses are website hosting fees, printing promotional materials, and expenses related to attending trade shows.

Professional Fees

This category is for payments made to external professionals for their services. Common examples are fees paid to accountants for tax preparation, legal counsel for business matters, and consultants for strategic advice. It can also include payments to marketing agencies or information technology specialists.

Utilities

Utilities represent the costs for essential services required to operate a physical business location. This includes electricity, natural gas, water, and sewer services. It also encompasses modern utilities such as internet service and business telephone lines, including mobile phone plans used exclusively for business. This category may also include trash and recycling collection fees.

Travel

Expenses incurred while traveling for business purposes are grouped here. This includes the cost of airfare, train tickets, or mileage reimbursement for using a personal vehicle for business trips. It also covers lodging expenses, such as hotel rooms or short-term apartment rentals. The cost of business meals, including those consumed while traveling, is also a travel expense, though generally only 50% of the cost is deductible.

Employee Compensation

This category includes all costs related to paying employees. The most significant expense is gross wages and salaries paid to full-time and part-time staff. It also includes payroll taxes the employer is responsible for, such as contributions to Social Security, Medicare, and unemployment taxes. Other expenses are payments for employee benefits programs, like health insurance premiums and retirement plan contributions.

Required Documentation for Expenses

To substantiate business expenses for tax purposes, specific documentation is required to verify each transaction. The IRS mandates that business owners maintain adequate records to support claimed deductions. Without proper documentation, a legitimate business expense may be disallowed during an audit, leading to a higher tax liability and potential penalties.

The primary forms of documentation are receipts and invoices. A valid receipt or invoice should contain the vendor’s name, the transaction date, a detailed description of the goods or services purchased, and the amount paid.

While keeping detailed receipts for all purchases is the best practice, the IRS does not require a receipt for an expense under $75, with the exception of lodging. For these smaller expenses, you are still required to maintain a record of the transaction, including the amount, date, place, and business purpose.

Bank and credit card statements are useful for tracking transactions but are generally not sufficient on their own as proof of an expense. This is because they often lack a detailed description of what was purchased.

For certain expenses, additional notation is needed to clarify the business purpose, particularly for expenditures like meals or travel. When documenting a business meal, it is advisable to write on the receipt the name of the person entertained and the business topic discussed. For travel, a log should be kept detailing the destination, dates, and specific business activities conducted.

The Process of Recording Expenses

Once an expense is documented, it must be recorded in the financial books. The timing of this recording depends on the accounting method used. Under the cash-basis method, expenses are recorded when money actually changes hands—that is, when a bill is paid. This method is simpler and is commonly used by small businesses.

In contrast, the accrual-basis method requires expenses to be recorded when they are incurred, regardless of when payment is made. For example, if a business receives a utility bill in December but pays it in January, an accrual-basis business records the expense in December. This method provides a more accurate picture of a company’s financial performance by matching expenses to the revenues they helped generate.

The process of recording an expense involves making a journal entry in a double-entry bookkeeping system, where every transaction affects at least two accounts. When an expense is recorded, an expense account is debited (increased), and another account, like Cash or Accounts Payable, is credited. For instance, paying a $200 electricity bill means debiting the Utilities Expense account and crediting the Cash account by $200.

Modern accounting software largely automates this process. Instead of manually creating journal entries, the user enters transaction details from a receipt into the software. The user selects the appropriate expense category, enters the vendor name, date, and amount, and the software automatically generates the correct debit and credit entries.