Creating a Chart of Accounts
By Brent Locks
Creating a chart of accounts can seem mysterious, if you just let your accountant do it. Here are some practical points to help de-mystify the process.
While there are some aspects of a company’s detailed accounting records that are reasonably identical across a number of different companies, it’s ultimately impossible to create a template chart of accounts that can be applied to different startups. One could create an all-encompassing, extensive and never-ending chart of accounts to account for all the potential transactions of a startup; however, this would likely lead to confusion on the part of the bookkeeper and to inefficient monitoring of performance on the part of management. Instead, below are suggestions, by financial statement type, that a manager should consider when building his/her company’s chart of accounts.
The types of assets and liabilities of a company are limited. As such, the majority of assets and liabilities can be grouped into unique classes. The general rule of thumb is that any account that makes up 5% or more of its balance sheet classification (i.e. total assets, total liabilities) should be broken down into sub-accounts; however, this is only true for some balance sheet accounts.
Accounts receivable and accounts payable are commonly two of the largest balances on a company’s balance sheet. However, by running an aging report or check disbursements report, management can quickly and easily gain insight into the granular details of each account. Hence, the rule of thumb does not apply to these two accounts.
Non-standard receivables and payables (e.g.) that account for more than 5% of their respective asset or liability class should be broken down separately. All others can be lumped into an “other receivables” or “other payables”, so long as the aggregate amount is less than 5% of the asset class.
Accrued liabilities are another common liability account. Some accrued liabilities are universal across all companies, such as accrued payroll and accrued vacation. However, unlike accounts payable, accruals are generally best-estimates and require significant judgment on the part of the bookkeeper and, therefore, should be paid close attention by company managers.
After considering all of the above, it is important for a company controller/CFO to create any other account categories that he/she deem important to monitor on a monthly basis. An example would be deferred revenue, where cash is received upfront but a product or service has not been fully delivered to a customer. This is common with pre-paid subscription businesses.
Due to the company’s youth, the types of revenue streams that a startup or small business can have are limited. Therefore, having a comprehensive list of different revenue streams (e.g. subscription, advertisings, product, etc.) seems reasonable, even if some of the revenue streams are irrelevant to the specific company in question. However, an individual revenue stream can, and sometimes should, be broken down into more detail for performance and measurement purposes. For example, a company may earn a lot of money through different advertising channels or a company may have monthly, bi-monthly or annual subscription streams that it wants to account for and track separately. That being said, if a company has a strong internal reporting tool that it uses to measure and assess the performance and granularity of different revenue streams, then detailed recording in the accounting books is not necessary. Refer to Quality of Data comments further below.
Cost of Sales
Cost of sales (also known as cost of goods sold or cost of revenues) should only include costs that are incurred during or with a sales transaction. It is important to account for these costs separately from operating expenses in order to quantify the gross profit, gross margin and marginal cost of every sales transaction.
Similar to revenue, the different types of cost of sales are limited, but the granularity of these costs is extremely important to measuring and assessing the performance of a business. Examples of common cost of sales types are included further below.
The type and impact of different operating expenses vary wildly across different startups. The rule of thumb for operating expenses is that any account that makes up 5% or more of total operating expenses OR revenue should be broken down into sub-accounts.
Other Considerations & Recommendations
A chart of accounts should not be structured according to tax documents – that’s what CPAs are for ;). When businesses are analyzed for M&A purposes, it’s always inefficient when the books are structured and organized for tax purposes—a lot of time is spent re-arranging and manipulating some company chart of accounts from a tax perspective to a performance perspective. Taxes only matter once a year. Performance matters every day. A company’s books should be organized to gauge and measure performance, not to make annual tax reporting simple.
Forensic Accounting / Auditing
It is important to examine various financial documents on a monthly basis to ensure that proper controls are in place to avoid fraud. However, a chart of accounts does not need to be setup to make the process easier, for a couple of reasons: (1) company performance should be measured daily versus forensic accounting or auditing which should happen monthly, at most, and (2) the majority of the reports you would need to perform your forensic audit are not impacted by the structure or layout of the chart of accounts.
Quality of Data
Many startups use other measurement and reporting tools (mostly internally developed), other than the accounting records, to monitor the performance of the company. So long as the data is accurate and timely, this is the correct thing to do.
A company’s performance is generally broken down into four categories: revenue, cost of customer acquisition, overhead and earnings, which is just a function of the previous three. Revenue and customer acquisition are generally monitored daily; hence, why other (automated) measurement and reporting tools are commonly used for these – it’s inefficient and costly for an accountant/CFO to enter transactions daily. Overhead expenses are generally incurred only once or twice per month, which makes the accounting records more than adequate to measure and assess. At the end of the day (or month), the different reporting tools must be reconciled with one another. Accountants, bankers, lawyers, etc. are going to use company balances per the accounting records to draw conclusions on the health of a company. Therefore, while performance may be measured using a more granular, diverse reporting tool, at the end of the month, all reporting tools must be reconciled between one another. If a company’s reporting tool cannot be reconciled to the accounting records, then no acquirer, investor, etc. is going to waste time looking at the reporting tool, which will limit their ability to assess the health and performance of a company.
Cost of Sales - Examples
Common cost of sales types are noted below:
- License / royalties COGS
- Reseller commissions
- OEM / royalty Costs
- Software / hardware COGS
- Training COGS
- Billable Expense COGS
- Support & maintenance - personnel
- Professional services - personnel
- Professional services - billable expenses
- Credit card and transaction costs
- Hosting services
- Hosting software
- Manufacturing overhead
Two expenses that are commonly mistaken for cost of sales are sales commissions paid to internal sales reps, which are selling costs of the company and accounted for in operating expenses, and sales discounts, which are contra-revenue accounts that should be included in net sales.