When it comes to your company’s chart of accounts, you can’t find a more elemental accounting function. Important? Yes. Sexy? No.
A chart of accounts provides a snapshot of your company’s financial health—how much money it has, owes, and spends. The most general categories are assets, liabilities, revenues, and expenses. More detailed business functions, projects, divisions, or locations are listed within those categories.
Your chart of accounts will be as complex and detailed as your company needs dictate. A small bookshop may have 50 accounts. A national healthcare company with many divisions and locations will have thousands of categories.
But not all chart of accounts are the same, and a well-structured one is the foundation of a healthy general ledger. A typical chart of accounts has two sections: balance sheet accounts and income statement accounts.
Chart of accounts, part 1: balance sheet accounts
The balance sheet accounts provide a comprehensive view of all the moving parts of your business. It will typically include assets, liabilities, and equity. Here’s a closer look at what that entails:
At a midsized company, assets that are being tracked might include:
- Cash on hand (the balance of your business bank accounts)
- Accounts receivable (money owed on pending invoices)
- Value of current inventory
- Physical property (such as owned office or factory space, vehicles, and equipment), minus the annual depreciation of such assets
- Company-owned investments (company stock, investments in other funds)
- Intangible assets (goodwill, intellectual property, etc.)
Each account can be listed separately with its own reference number. These assets may vary greatly based on the type and size of the company you’re working for. For instance, a large dairy farm may count 500 cattle (each identified with its own number), as well as a large barn, milking equipment, and feed in its “physical property.”
A software company, conversely, may have far fewer physical assets but much more valuable intangible assets: If the company has produced proprietary software code, that could be valued at millions of dollars, even if the company has minimal physical inventory beyond a few dozen MacBooks.
In ordering your assets list in your chart of accounts, your company should begin with the most liquid assets and list in order from there. Bank balances can be at the top of the chart, followed by inventory, then by short-term (easily liquidated) stocks and investments, accounts receivable (with each invoice separately numbered), and finally, physical property that you do not intend to sell (unless absolutely necessary to keep the business afloat). The visual display should help your financial team get a clear picture of what assets you have and how easily they can be leveraged.
The liabilities section refers to money that your business owes to others that hasn’t yet been paid. Some of the items you might list here include:
- Bank loans for equipment and other expenses
- Accounts payable to vendors
- Payroll expenses (for hours worked but not yet paid)
- Expenses for payroll taxes
- Employee benefits expenses
- Sales tax
- Property tax
As with assets, this list should be structured in order of urgency—most likely, your finance team manages payroll expenses on a weekly or biweekly cycle and will resolve that debt on a regular basis. You might have a biweekly or monthly schedule for vendor payments; however, you may need to prioritize certain invoices over others based on each vendor’s terms (i.e., if your company pays its power bill late, that could shut down your entire warehouse—so it’s likely worth making sure the electric company gets paid on time!).
Equity is a matter of simple math: Do the assets outweigh the liabilities, or vice versa? If the company is running with a net positive, then congratulations—you’re profitable. If the books balance perfectly, the company is on a sustainable path. But if you’re in the negative, what’s going on?
In some cases, it’s fully expected to run a net loss: For instance, if your organization has taken on $1 million in financing for construction of a new warehouse, this loan will take quite a while to pay off in its entirety. If you’re running negative due to a known expenditure that you’ve calculated eventual ROI on, this is not a cause for concern. However, if the math isn’t adding up, this may mean it’s time to either look at raising investor funds to give the company more runway to grow, or look at what operating expenses could be scaled back (more on that in a minute).
Chart of accounts part 2: income statement accounts
The other side of your chart of accounts is the income statement accounts—which should provide a snapshot of your profitability for any particular time frame, as opposed to the long-range view of your balance sheet. In this case, we’ll look at revenues and operating costs to determine profitability.
In this section, you’ll track revenues generated from business activities and the date the funds (or credits) are received, including general business income such as:
- Invoices sent (accounts receivable)
- Income received (this can be broken down by specific customers or by sales of particular products)
Non-operating revenue can be included here, such as:
- Interest from business investments
- Profits from sale of business assets
- Rental income
Note that you can also include items like discounts provided or refunds granted here, too—this kind of debit will be listed as a “contra-revenue account.”
Expenses represents the broad category of all the associated costs it takes to run a business. In this category, your finance team will track costs associated with items including:
- Product costs (such as raw materials and manufacturing, or cost to purchase wholesale goods)
- Equipment cost (likely tied to ongoing financing)
- Rental costs
- Utility costs
- Marketing costs
- Depreciation of assets
- Labor costs
You’ll likely also track some non-operational expenses, such as:
- Interest paid
- Operating losses
- Penalties and fines
With income statement accounts, you should be able to evaluate the company’s profitability on a quarter-by-quarter basis, looking at how business expenses and revenue are shifting over time.
While a good finance team can track all the raw data in a chart of accounts, it’s not always easy to slice and dice the numbers to understand what they all mean together—particularly when you’re trying to incorporate information provided by many different lines of business or even different branches of a larger corporation.
A manual ledger may be sufficient for smaller businesses. But as a company grows, it will become increasingly important to move to a software solution that will enable you to automatically update your chart of accounts based on incoming data streams (through integrating with payroll, invoicing solutions, and your business bank accounts), and will provide tools for interdepartmental teams to collaborate on sharing their budget reports. Ensure that your finance team has the right tools it needs to build a comprehensive chart of accounts—and provide effortless reporting that will guide your company on the path to profitability.
Download the eBook, Best Practices of Top Controllers, here for more information.
This content was originally posted here.