The Chart of Accounts: What, Who, When and Why
When it comes to accounting, bookkeeping, and budgeting for your small business, the Chart of Accounts is foundational. It’s one of those accounting terms that most business owners would have no reason to know, unless they studied finance or accounting in college - so we’re here to fill you in! Let’s start with the WHAT.
WHAT is the Chart of Accounts?
The Chart of Accounts is an organizational system of numbered categories, or accounts, that allows you to…
(1) categorize your financial transactions in a manner that is consistent with the way your business is structured
(2) pull detailed information on how you’re making money and where that money is spent
(3) prepare a host of financial reports that are important for taxes, income / expense management, and making strategic business decisions
(4) budget effectively
Think of it as a filing system for your financial transactions, where every debit card swipe has a corresponding folder for transactions of the same type. Every file folder, or bucket, has its own properties. It may naturally have a positive or negative balance, it carries over to a specific line on the financial statements, has its own description, etc. (If you have an accounting system, some of the "behind the scenes" details will be handled for you).
The Chart of Accounts is broken down into several high-level groups (which we’ll break down in future blog posts), and within these groups come the accounts and sub-accounts:
Assets- cash, accounts receivable, equipment, inventory
Liabilities- accounts payable, loans/debt, unearned revenue
Equity- stock, retained earnings
Revenue- sales, interest income
Expenses- utilities, rent, salaries, general/administrative
Accounts are numbered to reflect (1) what type of account it is (asset, liability, etc), and (2) the sub-account structure. You don’t just number the accounts 1, 2, 3, and so on! For more information on how to number your accounts, do some google searching. :) Following the standard numbering procedures will help both you and your financial team in the long run.
WHO creates the Chart of Accounts?
You can create the chart of accounts yourself, or you can have your accountant do it. If you create it yourself, you’ll go into your accounting software (Quickbooks, Xero, etc) and look for the Chart of Accounts that was started for you automatically. Accounting softwares don’t know the details of your industry, or the specific categories you’d like to track. You’ll definitely need to add accounts beyond what the software starts you with. You can add new accounts directly through the software, or you can download a template file, fill in the accounts you need, and upload that file back into your accounting software. (This is probably the more efficient method, especially if you’ll need a lot of accounts).
You will also want to link your business bank accounts to your accounting software, so that you can see your account balance as well as incoming and outgoing transactions. Most major banks can seamlessly integrate with accounting softwares. You should be able to select your bank from within the accounting software, put in your login credentials, and be all set to feed information from your bank account into your accounting system. Small or local banks may require additional steps.
While the Chart of Accounts doesn’t have to be overly complicated, many business owners choose to let accountants do this step to ensure everything is set up correctly and thoroughly. Having a faulty chart of accounts can be costly and cause your financial reports to be inaccurate or misleading. You don’t want to make decisions based on faulty data, so have someone create it for you if you don’t have the time or prior knowledge needed to set it up.
WHEN do I need to create my Chart of Accounts?
As soon as possible. It’s much easier to create this backbone of your accounting system as soon as you open your business. The longer you wait to get organized, the more difficult it will be to retroactively categorize your prior transactions. You’ll have more difficulty tracking your business’ performance from year to year. Once you have the accounts in place, you’ll be able to see how the balances in each account differ over time. Your business will change as you grow, so you will add new accounts along and along. Typically you’ll be reviewing transactions from the prior month and you’ll get to a transaction that you aren’t sure how to categorize. At that point, you’ll create a new account to put that transaction in. In terms of the initial setup, the sooner the better!
WHY do I need a Chart of Accounts? Can’t I keep track of this in a spreadsheet?
Pretend you’re a photographer. There are four income streams for your business: engagements, weddings, graduations, and family sessions. At the end of the month / quarter / year, would you rather know that (1) you made $50,000 total, or (2) you made $20,000 from weddings, $10,000 from graduations, etc? That extra detail allows you to ask follow up questions.
Do I want to specialize in weddings, since that’s where most of my income is coming from?
Do I want to vamp up the marketing for my family sessions, since I didn’t make any money from that this quarter?
Given that graduation sessions take the longest amount of time, and I’m making the least profit there, should I stop doing those?
Bottom line: the more detail, the better.
Unpopular accountant opinion: If you have a very small business, no employees, only a couple revenue streams, and your only annual expense is a website domain, you can use a spreadsheet. You don’t need a fancy accounting software. (Don’t tell Quickbooks we told you that). But as soon as you have employees, monthly expenses, invoices to send, mileage to track, receipts piling up… it’s time to make the switch. You’ll waste so much time if you don’t have an accounting software at that point. Quickbooks generates financial reports for you, lets you send invoices and receive payments with ease, keeps track of your receipts, and just makes your financial processes so much more seamless. You can’t effectively use an accounting software without a Chart of Accounts. That’s why you need it!
If you have questions about your chart of accounts, need it created or cleaned up, or have any other questions about setting up financial systems for your small business, give us a call.