There are thousands, if not millions of ways to mess up bookkeeping. Here, we are going to go over the most common issues along with ways to prevent and correct them.
The first is booking a loan payment as an expense. When thinking about loans, it is easy to think of payments to lower them an expense. After all, it is money going out, right? However, that is incorrect. It is easier to understand why when we look at the entire loan cycle. When the money is taken out, it isn’t income. When somebody buys a house, and receives a $200k mortgage, it’s common sense that they shouldn’t pay income tax on the $200k. It is the same with smaller loans, including credit cards. With credit cards, however, you never actually get the money, it goes right to the vendor you want that money to go, so the money never actually hits the bank account, but it is nonetheless a loan. It would be outrageous to think of money loaned would be income, so why should it be considered an expense. That is the underlying theory: when the money comes in, it is not taxed as income, and when the money is paid back, it is not an expense. There is one exception to that rule, and that is interest. Since the interest portion exceeds what was originally received, that portion can be expensed. In fact, interest should be the only part of the loan that shows up on the income statement. To properly book loans, account all loan deposits into a liability account on the balance sheet. This will raise the balance of the debt. When payments are made, they should be split between principal and interest, with the principal amount lowering the debt balance on the balance sheet, and the interest portion on the income statement where it lowers income.
Another common mistake is classifying owner/partner/shareholder distributions as an expense. In theory, the purpose of these payments are to distribute the net income of the business to the various partners and shareholders. This is not an expense, rather a reduction in equity. The only time a payment to an owner/partner/shareholder would be expensed is if the payment was processed through payroll (payment withheld social security, Medicare, and income tax). To account for these types of payments correctly, book them to equity in an account called Partner/Owner/Shareholder Distribution (whichever applies). This will leave the payments off of the P&L, and put them on the balance sheet where they should be.
The last common mistake we will mention here is the accounting of fixed assets. When the company purchases large items: buildings, equipment, vehicles, etc., these are not considered “expenses”, and they should not be on the income statement. The reasoning is simple; in the eyes of the IRS and Generally Accepted Accounting Principles, an item that will help the business produce more money into the future is considered a business “asset”. Assets are listed on the balance sheet and are depreciated over time. That depreciation is where the expense comes in. Assets that can be depreciated, like buildings, cars and equipment, are listed on the balance sheet and depreciation is accumulated throughout the life of the asset. For example, if a company purchases a $75,000 piece of equipment, that entire $75k cannot be expensed. It is listed on the balance sheet as an asset for $75,000 and assuming it has a five year useful life and no salvage value, the depreciation expense for the year would be $15,000 ($75,000/ useful life of five years), and that piece would be on the income statement instead of the full purchase price. Each year after for five years there would be $15k of depreciation on the income statement until the entire $75k has been depreciated.
Bookkeeping isn’t easy, but if you can stay away from making these common mistakes, you should be off to a great start! If bookkeeping isn’t your thing, or just need some help getting things straightened out, Halon offers bookkeeping review, full financial statement preparation, or CPA meeting time. We are always here to help!