Accounting for Expenses
Expenses can be segregated into four basic categories.
Operating expense, Cost of Goods Sold expense, Capital expense and Personal expense make up the four basic categories of expenses.
When accounting for expenses the first decision is to ascertain if the expense is business (tax deductible) or personal (nondeductible).
What Can I Deduct?
Expenses are usually deductible if the business is operated to make a profit. To be deductible, a business expense must be reasonable, ordinary and necessary. An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary. Whether an expense is reasonable or not is pretty much a "common sense" type judgement.
If you have an expense that is partly for business and partly personal, separate the personal part from the business part.
After you've made the judgement call that the expense is truly business and not personal, the next step is to determine which of the following three categories it falls into; Operating, COGS or Capital. Basicaly, if the expense does not fall into the Cost of Goods Sold or Capital expense category, then it's an Operating Expense.
What Makes Up Cost of Goods Sold (COGS) Expenses?
If your business manufactures products or purchases them for resale, some of your expenses may be included in figuring the cost of goods sold. You deduct the cost of goods sold from your gross receipt to figure your gross profit for the year. If you use an expense to figure the cost of goods sold, you cannot deduct it again as a business expense. Of course, if you don't manufacture a product or buy products for resale, COGS does not apply to your business at all.
The following are types of expenses that go into figuring the cost of goods sold:
- The cost of product or raw materials, including the cost of having them shipped to you.
- The cost of storing the products you sell.
- Direct labor costs (including contributions to pensions or annuity plans) for workers who produce the products.
- Factory overhead expenses.
What are Capital Expenses?
A capital expense is an expense which must be depreciated or amortized over a period of time (such as the useful life of an asset), or can only be written off when you sell or close the business. You must capitalize, rather than deduct, some costs. These costs are a part of your investment in your business and are called capital expenses.
There are, in general, three types of costs you capitalize:
- The cost of Going into Business (for more on this topic, see Business Startup Costs).
- The cost of Business Assets.
- The cost of Improvements.