As a small business owner, you wear many hats—from visionary and strategist to marketer and accountant. However, with little to no bookkeeping or accounting knowledge, you may soon realize business transaction categorization is not your strong suit. 

While many SMBs opt to do it themselves to keep their costs low, the best solution is to hire a dedicated bookkeeper from doola to manage their books. 

For a hands-on approach, get started with our bookkeeping solution, which provides all the tools needed to automate record-keeping.

Even if you outsource bookkeeping to someone else, knowing how this process works will help you make sense of your financial statements and use them to grow your business.

Mastering the art of categorizing transactions is a vital step toward gaining deeper insights into your business’s health and driving informed decision-making. 

In this guide, we’ll delve into how effective categorization can save you valuable time during tax season, enhance clarity in financial reporting, and ultimately fuel growth. 

Ready to turn chaos into clarity? Let’s dive in!

How Business Transaction Categorization Works

Transaction categorization involves organizing all transactions, whether incoming or outgoing, into specific categories such as sales, expenses, payroll, and inventory. By doing so, business owners can better understand where funds are coming from and how they’re spent. 

For example, you can categorize your vehicle expenses, wages, and utility bills under business expenses so you can identify them quickly based on their grouping. You can also track expense variations across the months, such as which ones surged or dipped.

So, how does this work? Also known as transaction taxonomy, this process involves classifying financial transactions into predefined categories, such as nature, purpose, or type. The first step is to identify financial transactions within the records.

You can do it either manually or through an automated bookkeeping system from doola that reads transaction descriptions, amounts, and other relevant data. Then, it will classify and label the transactions as specific categories or groups in digital records.

You can also categorize transactions manually by using Excel accounting methods. This involves reviewing each transaction and manually assigning it to the appropriate category in your chart of accounts spreadsheet. 

However, this method is not only time-consuming but also more prone to errors and offers less room for customization when categorizing unique or irregular transactions.

Why Is It Important to Categorize Your Transactions?

One of the main reasons keeping track of business transactions is important is that it makes reconciliation much easier. This process assigns each processed transaction to a pre-defined category. 

This allows you to quickly identify and match the transactions in your bank statement with your account records during reconciliation. It also gives you an accurate picture of how much money is coming in and going out. 

This information enables you to make informed decisions about budgeting, forecasting, and planning for future growth. For example, knowing that you spend 30% of your income on utilities can help you cut down on this expense in the future.

Moreover, categorizing transactions helps maintain accurate financial records, which are essential for tax filing, audit reviews, and deduction claims. Otherwise, discrepancies in the reported income or expenses may lead to legal action by the IRS.

Businesses need to track their income and expenses to prepare for tax season. Since you have a clear understanding of how much you have made and spent in a year, tax calculations and filing become much easier.

This will also help you reduce your tax bill since you can identify expenses eligible for deductions. By organizing transactions into relevant categories, such as utility expenses or advertising costs, you get accurate records of expenditures to claim tax deductions.

It also ensures transparency in your company’s financials by providing detailed information about your business’s expenses and revenue streams. This can help establish trust and credibility, making it easier to secure funding for business growth.

The benefits don’t end here. It also enables small business owners like you to keep a close eye on cash flow. It provides insights into when clients’ payments are due or when vendors need to be paid. 

How Small Business Can Benefit from Categorizing Transactions

Firstly, any business that handles a high volume of transactions can significantly benefit from categorization. This includes retail stores, restaurants, service-based businesses such as consulting firms or beauty salons, and even online businesses. 

Most SMBs have limited resources for financial management. Categorizing transactions can help them track expenses, claim deductions, and keep their books up to date, making tax season smooth as a whistle.

If your business relies on recurring revenue or has multiple revenue streams, categorisation can help you track subscription payments, identify churn, and track each revenue stream’s performance to allocate resources accordingly.

Non-profit organisations can also benefit from categorizing their transactions. They are legally obliged to track donations and expenses to ensure transparency and accountability. 

Another type of business that can benefit from categorizing transactions is freelancers or solopreneurs who offer services to clients. They can use it to track billable hours, project expenses, and client payments.

Types of Small Business Transaction Categories

Transaction categorization helps small business owners gain a clear understanding of their financial activities, identify areas where they are spending too much or not enough, and make informed decisions about their budgeting and planning.

However, this process may vary depending on the specific needs and industry. For example, restaurant and manufacturing businesses have raw material costs. On the other hand, service-based businesses incur other expenses, such as office supplies and consumables.

Credits and Debits

When it comes to bookkeeping, every business’s transactions are categorized as credits and debits. A credit is money that has come into your business, whereas a debit is money that has gone out. 

These often confuse people who are new to categorizing transactions, but once you learn to differentiate between the two, the rest of the bookkeeping process will be much easier to understand. 

In simple terms, every debit must have an offsetting credit, and vice versa. For example, money from a sale is categorized as Credit Sales Revenue, and when it moves to a bank account, it shows up as a Debit Bank Account.

Sales/Income

Any payments you receive for products or services are recorded as sales/income. While large businesses break down sales further into multiple categories, this is not required and is usually irrelevant for a small business.

Expenses

Any money that you pay to keep the business running is expenses. Expenses are different from investments, which are categorized as assets. With an expense, your business gets a one-time benefit from the money spent. But with an investment, you will get lasting benefits in the future.

Payments To Contractors

Nearly every business hires contractors, which requires a general category to record the payments made to them. However, it’s useful to use a more descriptive category, like marketing or legal fees, to identify the right expenditures for which to claim deductions.

While this is not required for taxes, it will help you with the 1099 filing requirements for U.S. contractors if you pay them $600 or more in one year.

Payments To Employees

While you can manage your employees’ wages yourself or through a payroll management solution like Gutso, you must record these transactions in your books as well. This includes money owed in taxes, net pay, and any other payroll deductions as liabilities.

Since there are additional legal and labor laws to consider, you must ensure detailed breakdowns of wage expenses in your books. However, be sure to track how much has been paid out since this amount should match the payroll reports.

Loans

Loans are money coming into your business that is not sales, making them tax-free credit transactions. You must record these transactions accurately since you have to pay back this money with interest. 

Each loan payment should be divided into principal (amount borrowed) and interest (cost of borrowing), which then needs to be further classified into specific categories based on its purpose. It will help you deduct the interest you have paid as an expense on your taxes. 

Operating Expenses

Most debit transactions a small business makes are payments to keep the business running. These include things like marketing, office expenses, rent, licenses and software. Most common small-business transactions will fall into this category type but must be broken down into subcategories.

Other expenses that do not fall into any specific category but are still necessary for running a business may include legal and consulting fees, advertising expenses, or charitable contributions.

How to Categorize Business Expenses and Other Transactions

Step 1: Define Your Categories

The first step in categorizing transactions is to define the categories that are relevant to your business. This will depend on the nature of your business, but some common categories include sales/revenue, expenses, assets, liabilities, and equity. 

Once you’ve identified the major categories, find any common expenses that you group or separate into unique categories. You can also create clear guidelines to assign transactions to specific categories and ensure that these rules are applied across all transactions.

You may also have more specific categories, such as office supplies, travel expenses or marketing costs. Remember to use subcategories within main categories when necessary. Also, develop a process for handling transactions that cannot be easily categorized or require further review.

Step 2: Implement Categorisation

The next step is to categorize each transaction within your spreadsheet manually. This method can be time-consuming and not feasible for businesses with a high volume of transactions. For automated categorisation, you’ll need a third-party tool or bookkeeping software from doola.

This can make categorizing transactions much easier and more accurate than using a spreadsheet. It has pre-defined categories that match standard accounting principles, saving you time and effort while ensuring accuracy in categorization.

Step 3: Review and Update

Once you have categorised your transactions, you can review your category structure and make adjustments as your business operations evolve. This practice helps prevent errors that could occur if you wait a long time before entering them into your records.

Remember to take time regularly (preferably daily) to review your bank or credit card statements and record each transaction under the correct category while they are still fresh in your mind. 

Improve Your Bottom Line by Categorizing Transactions with doola

Since the purpose of the transaction can impact the way it’s classified, deciding on how to categorize transactions can be overwhelming and time-consuming at times. That’s where doola fits in the puzzle.

With doola Bookkeeping, all your transactions are automatically imported from different sources, such as bank accounts and credit cards. This means no more manual data entry or sifting through receipts.

But why stop there? With our dedicated bookkeeper service, you can get in touch with a team of experts who will review and categorize all your transactions for you. This will give you a clear breakdown of where the money is coming from and going towards your company. 

We go the extra mile by keeping you ready when tax season comes knocking. By separating all expenses and income into their respective categories, tax filing becomes less complicated and prone to errors.

Connect with our tax experts to learn how we can help you take one step closer to smoother business transaction categorization, improved cash flow, and reduced tax liabilities.