Why should I care about a chart of accounts? Money in, money out. What’s left over is profit, right? Sales minus expenses equal profits, right?
Such are the type of questions we often hear from people who are considering opening a small business. We also speak to this topic with new clients who have decided to get more value and in-depth information about their financial reporting. Formally, it is the fundamental foundation of your general ledger.
Frankly put, your chart of accounts can speak volumes about the good, bad and ugly about your business operations. Understanding how a well-defined chart of accounts can help improve your day to day management of your business creates a story of how your business is performing.
Time of Year-Time for Analysis
It’s December, and you are looking at the results of the year’s efforts, so it is a splendid time to consider the New Year ahead. Planning for next year is the best decision you can to make use of the downtime. It’s a week to think quietly about how well the past year has gone, and what can be done to experience a better outcome in the year ahead.
The problem… your data is not organized and you cannot get a good understanding of what happened or why. Where do you start? A good place to start is with your chart of accounts.
The solution…enough accounting speak already…What is this chart of accounts you are professing? Remember what was stated at the onset. Your chart of accounts is a structure for the financial data that can tell a story about your business activities. Setting up a detailed chart of accounts to keep track of data so that vital information can be reviewed quickly and accurately. The trick is to learn how to read the information to arrive at proper outcomes. We can help. No more guesswork.
Your Book of Business
You can think of a chart of accounts like a table of contents of a book. The chart of accounts is used to organize the data into a format that is both understandable and more importantly searchable.
Here is an example of what the chart of accounts would look like in a table of contents format:
My XYZ Company – Year 2016
The book comes in 5 parts, and each has sections to break down the information into manageable bits for understanding.
Part 1 – Assets
Chapter 1 – Cash
- Section 1 – Cash – Big Bank Account #1101
- Section 2 – Cash – Big Bank Account #1102
Etc. Use as many accounts as needed to identify from where the money originated.
Chapter 2 – Accounts Receivable
- Section 1 – AR – Product Sales – Account #1201
- Section 2 – AR – Service Sales – Account #1202
Establish an AR account line as needed to match up with Chapter 1
Chapter 3 – Property Plant & Equipment (these are capital assets)
- Section 1 – PPE – Vehicles – Account #1301
Etc. Establish as many lines as necessary to provide an in-depth view of your asset pools.
Part 2 – Liabilities
Chapter 1 – Liabilities
- Section 1 – Accounts Payable – Account 2101
These can be broken down as specific as needed to capture the data in small sections for better analysis
Part 3 – Equity
Chapter 1 – Equity
- Section 1 – Retained Earnings – Account 3101 (money withheld from paying out and held to be reinvested into the business)
Part 4 – Revenue
Chapter 1 – Revenue
- Section 1 – Product Sales – Account 4101
Part 5 Expenses
Chapter 1 – Expenses
- Section 1 – Payroll Expense – Account 5101
- Section 2 – Rent – Account 5102
Notice that the Part, Chapter, and Sections numbering are organized in a logical sequence. In this case, all Assets start with the number 1. Then based on the “Chapter” the second digit changes and the sections within each are numbered as well.
**Tip – You may wish to leave some gaps in your numbering sequence for something that may come up later. For example, maybe only use even section numbers to start, and you can then use the odds if you need to make changes).
Wisdom from a Cliché
I am sure everyone has heard about garbage in — garbage out and the same applies with your financial data. If you want to be able to tell the difference between types of revenue or expenses, for example, you need a separate code in your chart of accounts. In developing the chart of accounts, it also makes sense to think about the story you want to be able to tell. What is important to track?
**Warning – Some people take this too far. You should probably not be spending time coding legal pads vs. regular sized notepads, or different sizes of trash can liners. Taking matters to finitely can only cause confusion and additional work. Before you add an account step back and think about if it will provide value).
Sample Case Study
Let’s take this a step further. Let’s assume you own a café. What is important to track from an expense standpoint? How about payroll? Rent and utilities? Beans? The spend on paper goods? All these are likely necessary enough to matter as a line item, but breaking them down into several sections is more than likely superfluous.
You probably don’t, however, need to track each cup size on your chart of accounts. That is not to say it matters but it could be very labor intensive to track items to that level of detail for a small business. That is what inventory control is best utilized. For restocking purposes, stock line items on a separate chart are very useful, but that is a topic for another time.
Ok. Now you understand the concept, but it sounds like much work! Are there any tricks? Sure, go to Google and type sample chart of accounts and the industry in which you operate. There are some great examples, to use as a starting point. Be careful though as you need to remember that this is your story. Make sure the sample chart of accounts includes what is important to you. Feel free to make changes and tweak it to meet your needs.
Caution: You may also want to make sure to have an “ask the accountant” or “miscellaneous account.” It is a good idea to include an expense account that can be used as a placeholder for expenses for which you need to ask your accountant. Even better, if you are using a program like Xero and have a designated advisor you can just ask the question in the software.
A well-defined chart of accounts is a valuable business tool, and can explain a great deal about a period, whether it be weekly, monthly, or quarterly. If your data stream is entirely automated, a daily, unofficial review can be available should you wish to manage completely by the numbers. I say unofficial because there might be some data that doesn’t make into a given moment of day, or day of the week. The human factor sometimes creates variables.
Learning to understand a chart of accounts may seem confusing and a bit overwhelming at the onset. That is entirely rational. However, spending some time to establish a good chart of accounts can pay significant dividends when trying to understand your business. With some guidance, patience and a documented list of what should be measured, tallied or to which it might be compared, establishing an in-depth chart of accounts is not that difficult.
If you need some help in going through this process, we are here for you.