1. Miscoding of Loan Payments
Often business owners charge auto loan payments as auto expenses.
When a loan is taken out or a vehicle that is purchased for business use is financed, the principal portion of the loan is a liability. It represents the amount of money you borrowed from a lending institution. The interest over and above the loan amount is an expense, an amount added to your monthly payment that you must pay the lender. In order to properly account for the monthly payments, an amortization schedule is necessary to show how much principal and interest is paid with each payment. A monthly bill or statement from the lender that provides this breakdown will suffice in lieu of an amortization schedule.
2. Deducting Personal Expenses
Through the Business
Whether intentional or by mistake, business owners sometimes charge personal expenses to the business.
Proprietors should charge personal expenses to “Owner Draws”, which is a charge against equity, but not treated as taxable income. Members of a partnership may either charge personal expenses to “Partner’s Draws” or “Loans to Partner”. Shareholders of a corporation should charge personal expenses to “Shareholder Distributions”, which is a charge against equity and is technically a distribution of profits earned in the business, or an asset account called “Loans to Shareholders”. Keep in mind, however, that loans must be paid back to a partnership or corporation at an interest rate that is customary and reasonable. Shareholder distributions reduce the shareholder’s basis in the company, but are not treated as taxable income in an S-Corporation. However in a C-Corporation, personal expenses charged to shareholder distributions must be treated as dividend income, must be reported on form 1099-DIV by the corporation and by the recipient on their individual 1040 tax return. The best advice is to keep personal expenses segregated from a business account altogether.
3. Miscoding of Payroll Expenses
Some business owners deduct the net pay from employees’ paychecks as salaries and wages expense, unaware of the fact that the net pay represents payroll taxes withheld from gross pay.
It’s best to subscribe to a payroll subscription service offered by your software provider or sign up for an outside payroll service if tracking payroll becomes confusing or burdensome. If preparing payroll yourself, it must be kept in mind that the gross payroll amount paid to an employee is a deduction, while the various federal and state withholdings deducted from an employee’s paycheck are liabilities or funds that you temporarily hold and must forward to the appropriate federal and state taxing agencies.
4. Lumping Sales Tax Collected with Income
Retail business owners sometimes lump the sales tax collected from their sales with their income account.
Sales tax collected is a liability that must be separately accounted for because these amounts must be forwarded to a state taxing agency monthly, quarterly or annually. Additionally, improper separation of these two amounts will overstate gross and net income, resulting in excess income tax liability.
5. Deducting Inventory Purchased for Resale as
Cost of Sales
Some business owners deduct the costs of inventory purchased for resale that is still in stock as cost of sales.
If a business purchases inventory for resale which is an income-producing factor, the purchases made must be recorded in an asset account called “Inventory”. It is necessary to match income and expenses in this instance, which means only the cost of those items which have been sold can be deducted as a cost of sales. Periodically taking a physical inventory or using a specific identification method helps to properly state your cost of sales.
6. Failure to Reconcile Bank Statements
Often business owners neglect to reconcile monthly bank statements with the checking account balance in their accounting software.
It is common for the checking account balance in accounting software at the end of a month to disagree with the ending balance appearing on the bank statement. This situation occurs when the bank imposes charges for such items as monthly service charges, merchant charges for credit card processing, NSF or returned check charges or check printing. Additionally, checks or electronic debits issued towards the end of the month may be outstanding and have yet to clear the bank. Other factors include data entry mistakes made in accounting software and cash or credit card deposits made near the end of the month that have not cleared. When bank statements are not reconciled, this opens the door for misstatements of income or expenses, providing a false sense of net profit.
7. Deducting Fixed Asset Purchases as Expenses
Some business owners deduct the purchase price of large ticket items such as furniture, equipment or even vehicles as expenses.
Accountants often use a certain threshold, such as $500 or $1,000, to determine whether purchases should be deducted as expenses or capitalized, which means listing those purchases as fixed assets to either be depreciated or expensed under certain provisions. Purchases below a given threshold may be charged as an office expense or to another account. Assets that are depreciated are partially deducted each tax year depending on their purchase date, purchase price or basis, asset class, depreciation method and useful life. If a business has sufficient net profit in a tax year, the option exists on a tax return to take a special expense election for the entire cost of the asset(s) in the year purchased. In recent years, in an effort to stimulate the economy, Congress has passed temporary legislation allowing a full depreciation deduction for certain fixed assets in the year of purchase, but this action should be taken on a depreciation schedule for assets entered on the balance sheet.