Business expenses are the costs incurred in running a business. Business owners need to know what constitutes a legitimate business expense and how to record them to satisfy reporting requirements. The proper recording of these costs is used to create the profit and loss and income statements. These statements determine the overall health of the company by comparing revenue against expenses to determine net income.
The Internal Revenue Service (IRS) also requires accurate reporting because business expenses are deducted from revenue, and a reduction in income reduces the amount of taxes to be paid. Anything involving the IRS requires a good understanding. The information below will give you the basics of what a business expense is, when to report it, and examples of the most common expenses. Some of the topics can be quite complicated. When first starting out, it might be a good idea to consult a bookkeeper or accountant
Necessary and Ordinary
According to the IRS, an expense, to be deductible, must be necessary to operate or maintain the business. It also needs to be ordinary, meaning must be a typical expense in the industry. Consider a grocery shopping business. As a business owner, you want to keep your costs as low as possible. Review all your expenses and do some online comparison shopping to find cheap car insurance. For a business that uses a car, auto insurance is an essential and ordinary expense.
Personal or Business
Personal expenses are generally not business deductions. However, anytime a portion of a personal expense is used on the business, keep accurate records and split the expense to record only the business portion as a deduction.
Cash Vs. Accrual Recording
The recording of expenses used in the business will generally follow one of two standard accounting methods, cash or accrual. The cash method recognizes revenue when received and expenses when paid. This is the easiest of the two methods. Expenses are recorded when paid.
The accrual method provides a better financial picture of the business but can be more complicated. In this method, income is recorded as soon as an invoice is created. Expenses are recorded at the time incurred, not when actually paid.
When a business is first started, the owner selects one of the methods. In the future, if the business desires to change, the company must request approval from the IRS.
Some Common Expenses
Mileage. If a personal vehicle is used in business, mileage and other vehicle costs may be deductible. To claim a deduction, keep track of the number of miles driven for your businesse and allocate expenses between personnel and business use.
Home Office. If operating a business out of your home, certain expenses such as a portion of the mortgage interest, utilities, and maintenance may be deductible. Split these expenses between personal use of the home and the amount of home used for the business.
Cost of Goods Sold. If you are producing a product, the cost associated with the production is calculated into the Cost of Goods Sold and not treated as individual business expenses. Examples in this category would be the raw materials used in production, the rent on any storage space, and the shipping costs. Also, this could include the cost of labor to produce the product. These expenses are deducted from revenue but are rolled up through the Cost of Goods Sold.
Capital Expenses. Certain expenses must be capitalized and not deducted as business expenses at the time of purchase. These are generally large dollar items that are considered assets and will be used for many years. Basically, instead of deducting the entire cost at the time of purchase, you spread the costs out over several years.
To understand business expense is to know what a legitimate expense is and how to accurately record it. These are just the basics. Depending on the size of the company and the industry, the type of expenses will vary.