Why Is The Chart Of Accounts Important ?
Setting up a chart of accounts is one of the first, if not the first, task you perform when setting up an accounting system whether a manual or computerized system. A business needs and should want to know where the money is coming from and where it is going !!! Your chart of accounts is a tool for gathering and organizing this type of information.
A business must have useful information in order to be able to survive in today's competitive business world. You notice that I said information - raw data is not very useful until it has been "massaged" and summarized into meaningful information. Your accounting system should be designed and used to provide much of this detailed, summarized, and needed information. The information available for your financial reports (summary and/or detailed) often depends on how well you designed your chart of accounts.
One of the main keys to a properly designed accounting system is your chart of accounts.
The chart of accounts is the Foundation that your financial record keeping system is built upon.
What Needs To Be Considered in Planning and Setting Up A Chart Of Accounts ?
Let's begin by listing and discussing some considerations.
- What I call the Goldilocks and the Three Bears Rule:
In the fairy tale, as most of you are aware, Goldilocks, a little girl, ventured into the home of the three bears - Mamma Bear, Poppa Bear, and Baby Bear. While there, amongst other things, she tried Poppa Bear's porridge , Momma Bear's porridge, and Baby Bear's porridge. Poppa's was too hot - Mamma's was too cold - and Baby Bear's was just right. In setting up your chart of accounts, you're trying to find the porridge that is just right - not too hot and not too cold. The too cold represents a simple basic chart of accounts while the too hot represents a very detailed and complex chart of accounts. What we're striving for is the just right. In other words, try to keep your chart of accounts as simple as possible yet designed with enough detail to provide the information and reports needed for managing and controlling your business. There is a trade-off between simplicity and the amount of detailed information your business needs.
- The Easy Part - many accounts that make up the chart of accounts are obvious and common to all types of businesses such as Cash - Accounts Receivable - Accounts Payable are needed and used by businesses both big and small.
- The qualifications and knowledge of your accounting staff whether its just the owner, a bookkeeper, or a full blown accounting department. If you set up a complex system your staff may need special training.
- Your type of business (retail, wholesale, service, manufacturing, etc.), your industry, and your specific business. Even businesses that are the same type and industry might have special or unique requirements. While a service business may not have a need for a Merchandise Inventory Account a retail or wholesale type of business normally would. In addition, there are likely to be differences even among the same type of business. One service business might have only one cash account, regular checking, while another service business might have three cash accounts such as - petty cash - regular checking - payroll checking.
- Whether you use the Accrual or Cash Basis of accounting. If you use the Cash Basis, some accounts such as Accounts Receivable and Accounts Payable would not be a part of your chart of accounts.
- Complexity of the structure of the business. Is the business a small Ma and Pop operation or a Super Corporate Conglomerate composed of many divisions, plants and departments ? A complex structure will probably require a chart of accounts that provides the capability of reporting on the results of the business segments such as divisions, plants, departments, etc.
- The reports you want, are required, and/or need for internal use and to satisfy owners and government or regulatory agencies. First define and determine what reports are required and then determine and set up the chart of accounts that will satisfy your reporting needs. What you're actually doing is working backwards using the reports to determine the structure of your chart of accounts that will be able to supply the information needed for your reports.Special consideration should be given to any Governmental or Regulatory Reporting Requirements that may pertain to your chart of accounts. An example for USA businesses would be IRS requirements to have accounts for meals, officer salaries, travel, and entertainment. Other Countries usually have similar tax rules.
- The importance of a logical numbering or coding system that provides the necessary detailed information and is flexible enough to allow you to add accounts as necessary.
- Computerized or Manual System.
Keeping track of detailed information manually is time consuming, and few small businesses have the staff to do it. The more detailed the information your business requires, the more likely you are to need a computer and accounting software. While a computer and accounting software are not an absolute necessity for a small business, with the low price and availability of computers and accounting software (some free), I'm hard pressed to think of a valid reason not to use these tools.
- Do It Right The First Time !
Even though you can always add or remove accounts, you should attempt to initially do a good job of determining the accounts your business needs. Adding and/or Removing accounts distorts comparisons between periods. Monthly, Quarterly, Yearly, etc. comparisons can be extremely beneficial in analyzing your business.
Let's make a simple list based on our discussion to serve as a simple aid as to what to consider when setting up your chart of accounts.
- Manual or Computer System.
- Financial information and reports needed to manage your business.
- Financial reporting requirements and to whom.
- Information needed to prepare tax returns.
- Information needed for any special regulatory reporting requirements.
- Type of business.
- Size and complexity of the business.
- Staff size and capabilities.
- Need for a simple or more complex Coding System.
What's Next ?