Have you ever misplaced a document or a receipt and thought to yourself “If I was just better organized, I would be able to find things easier!” Having a well-designed chart of accounts is the same as having an organized filing system; except it’s located in your accounting software, not your office desk.
A chart of accounts includes the names of accounts that a company utilizes for recording its accounting transactions. Every chart of accounts is unique. There is no defined set of names that every company uses. There is, however, a basic framework of typical accounts that are universally common (checking account, accounts payable, etc.) but after that, companies have the flexibility to tailor their chart of accounts to best suit them. Most accounting software provides recommended accounts, although it is usually better to create your own.
A chart of accounts can be a balance sheet and basic operating revenues and expenses. It can also be organized further by business functions like direct cost of goods sold and administrative expenses — and even further by product lines, divisions, etc. Also, it is highly recommended to use account numbers in addition to names.
For example, if you wanted to know how much you paid in electricity in the past year, a report could easily be produced from the accounting software that shows total electricity costs. However, if the chart of accounts was only set up for utility expenses, that balance would include gas and water charges and you wouldn’t be able to find the answer to your question easily.
An alternative method is to create a category (utilities), then within that category individual accounts like gas, electricity, and water. Sub-categories allow the company to produce detailed reports showing total utilities cost, as well as providing the ability to dig down deeper to understand what makes up the total amount and see how much of the total utilities expense was just electricity.
It’s important for a company to consider its needs when designing a chart of accounts. The users of the accounting records should be considered when designing the chart of accounts. Will a banker be reviewing them? What will they be looking at? What information is important for management to help run the business? As a best practice, it would be smart to have your accountant or a consultant review the chart of accounts to ensure it will function properly for your needs.
Now let’s move from the past to the present. An accounting software allows the user to enter a budget by line item. A well-designed chart of accounts that generates useful financial reports will also allow you to compare your current activity versus your budget.
For example, if the chart of accounts was only set up for utilities and you noticed utilities were over budget, you would not be able to tell without further effort why this was the case. A comparison of actual versus budgeted expenses produced with a more detailed chart of accounts would tell you that electricity is higher than budget, but water and gas are comparable.
Finally, remember to plan today for what information you may need in the future. Some accounting software provides forecasting tools. As entrepreneurs are looking at growing or expanding, forecasts can be created by using assumptions for specific accounts anticipated to change while the other accounts maintain their normal growth patterns.
It’s best to understand how different accounts are defined and are utilized. You want to keep the chart of accounts simple, but robust enough to allow you to find information you need. And financial reports produced with a well-designed chart of accounts provide timely and meaningful information that help manage your business.