The Chart of Accounts (COA) is the foundation of financial reporting, as every aspect of your financial reporting is directly or indirectly sourced from your COA. An organized, logical COA can be drawn on to both combine and parse a business’s financial records for management and other stakeholders.
In many small businesses, however, we notice that the COA is far from optimized. It can be too simple and therefore unable to detail what is really going on “under the hood.” Or it can be too complex and hard to pull together in any meaningful way. Or it may have lost its effectiveness over time, as new codes were haphazardly added without regard to the overall logic of the original design.
A new or revamped COA can immediately improve your management insights and drive your business to new levels. Here are five tips for designing or redesigning your COA.
1. Focus on what management needs
In its regular reports, not just what you need for tax reporting or investor reports. A COA organized for the benefit of the IRS or investors is unlikely to organize things in ways that will help management make better decisions on a daily, weekly, or monthly basis. How does your company organize its budget? How does it set its prices or rates? How does it gauge profit margins? How does it monitor its supply chain? How does it factor in expenses?
These are the things owners and managers use to plan and make ongoing decisions, so these are things they need to be able to quickly and clearly assess in order to make good decisions and maximize returns.
So the first step for creating or revamping your COA should be “how can this be set up in a way that generates reports that will reflect the way management visualizes the business?”
2. Use numbers for coding, not alphanumeric or other methods
While this is the norm for many companies, some companies - especially small ones - unwittingly start off with homegrown codes like A101 or B-SALES. This type of alphanumeric coding makes it difficult to sort and connect relevant accounts, and is prone to errors in data entry. One common numeric method uses the acronym ALERCE:
Assets - 1xxx
Liabilities - 2xxx
Equity - 3xxx
Revenue - 4xxx
COGS - 5xxx
Expenses - 6xxx
3. Make it detailed, but not too detailed
A COA is an organizational tool, and it can be too simple to be useful, or it can be too complex to aggregate and understand. If you had a filing cabinet with all papers related to “assets” in a single folder, it would be hard to find any one item or pull together a group of related assets. On the other hand, it would be equally cumbersome to have a room full of filing cabinets full of folders with only one or two items in each.
The typical recommendation for a COA is to have main categories. This level of detail should allow you to generate financial reports with broad categories and calculations, plus be able to break down those categories into manageable component parts for further analysis as required.
4. Specifically assign someone the responsibility of maintaining the COA
Once a framework for a COA is put in place, it is important to maintain it according to the logic and rules used to create it. This can be problematic over time if different people or departments begin to add codes or categories in an ad hoc way. By assigning one person the responsibility of monitoring any changes, you are more likely to keep your COA optimized and able to effectively inform management.
5. Consider outsourcing your COA setup or overhaul
Designing or redesigning a COA is a rare event for a business - you might do it once in a decade - while a bookkeeping or accounting service like Mountain Top Bookkeeping may go through the process regularly for different clients and be familiar with the best practices and subtleties. Be careful, though, that they follow tip #1 above - focus on what the business needs. Some accounting consultants will emphasize what they need - strict GAAP accounting and tax preparation details - which, as we’ve seen, is rarely the best method for making good management decisions throughout the fiscal year.
Conclusion The Chart of Accounts can be a powerful tool for analysis, planning, and growth, but only if you approach it the right way. Focus on what it can tell management, rather than the IRS, and create and maintain a logical blueprint that won’t become bloated and inefficient over time.
If you’re ready to get your Chart of Accounts up to date, BKE can help. We offer bookkeeping and accounting services, along with reporting and payment solutions. We’ll provide you with a team of bookkeepers with expertise in your industry to make sure you’re getting the most out of all the work you do. We can work with your existing accounting software and tools, or can help you make the move to newer technologies.