By Matt Remuzzi
In previous blog posts, Brett has covered understanding financial statements and did a great job of breaking down the Income Statement and Balance Sheet.
I want to show you how to create the foundation for those reports and your business in general. The Chart of Accounts (COA) is the list of accounts that you will use to track all the funds in and out of your business. It is also the basis upon which the reporting and business intelligence you take from your business accounting are derived.
Some of the biggest messes we clean up and the origin of most of the mistakes we see in our client work result from a bad COA. If your COA is poorly constructed or flat out wrong then you won’t get much help from this normally vital business tool. On the other hand, getting your COA set up right makes the whole process of doing your bookkeeping significantly easier and more accurate.
The Different Types of Accounts in the COA
The COA is comprised of five basic types of accounts: income, expense, asset, liability, and equity. The first two are what you find on the Income Statement, the last three on the Balance Sheet.
Income accounts are just what they sound like- the accounts that track the money generated by the business from its operations. They can come in the form of actual payments or as invoices that will be collected later. Income can also be included in separate accounts for things like earned interest, the sale of assets and income earned from atypical activities. These activities might include things like a one-off side project or the sale of a part of the business to another firm. Some firms also include negative income accounts, such as accounts to track discounts were given or refunds.
Expense accounts are also pretty self-explanatory- these accounts track the costs the business incurs during operations. These are the typical things you think of with most businesses- rent, insurance, payroll, etc. It also includes expenses that are accounting conventions, such as depreciation and amortization. These are expenses that you will show on your income statement but aren’t actual cash expenses.
There is another special type of expense account called a Cost of Goods Sold (COGS) account. This account is used specifically for tracking the cost of material and sometimes labor and other inputs that go into creating a specific item for resale. The main difference between a COGS item and expense is that the cost of the item can be directly attributed to the production of the item for sale. For example, at a filing cabinet manufacturer, the cost for rent is an expense, because the cost cannot be attributed to a specific item. On the other hand, the screws, bolts and steel used to build a filing cabinet go into COGS accounts since they are part of the direct cost associated with building that item to sell.
Asset accounts are for things the company owns. This includes cash (bank accounts and savings accounts), prepaid expenses and deposits, inventory held for sale, equipment and vehicles (even if there is a loan), buildings and tenant improvements, trademarks and patents, goodwill and loans or advances the company has lent out that it expects to collect.
The main place people get confused here is on fixed assets. The general rule of thumb is if something cost $500 or more and has an expected lifespan of one year or more, it goes on the balance sheet. The thinking is that if something is going to last you five years, you should only be able to expense a portion of it each year (1/5 in this case) rather than the whole amount up front.
This is also confusing because at tax time you may get to expense the entire purchase even if it stays on your books as an asset for bookkeeping purposes. The best bet is if it meets the criteria outlined above then put it on the balance sheet and at tax time address how to handle it then.
Liability accounts are for anything the company owes. This would cover loans, lines of credit, sales, payroll or other tax owed and any bills outstanding. If you purchase a vehicle for the business, and the cost is $10,000 and you put down $1,000 and finance the rest you would then see an asset for $10,000, and a liability for $9,000. The difference would be the $1,000 down payment that left your checking account and now is part of your equity.
Equity accounts are the last type, and they are the funds the business owns or has made as profit. When you put money into a bank account to start a business that is considered equity. Likewise, the difference between your assets and your liabilities is your equity. A healthy balance sheet has plenty of assets and positive equity and not much in liabilities. The opposite is true of a business that is in trouble or on the verge of being out of business!
Setting up the COA for your business
As a new business, your COA should be fairly simple. Small businesses that operate primarily online or as a service business is even better. This is both because you won’t have a lot of activities to record and also because adding undue complication is an easy way to start screwing up.
If you are using a system like QuickBooks or Xero, they will have a default COA to get you started which you can then modify as needed. Other programs that are less sophisticated don’t use the same system, but these are not good choices except for the most basic business. I suggest starting with the right system now, so you don’t have to worry about switching later.
Here are some simple guidelines for setting up your COA to make it efficient and effective at giving you good information without overwhelming you with useless decision points:
- Be specific in how you name your accounts and use the last four digits of bank and credit card account names (ex: Chase Checking 0234)
- Don’t be too broad in creating accounts (ex: Admin)
- Don’t create accounts that have overlap in meaning and could be switched from one use to the next for the same item (ex: Office Supplies and Office Expenses)
- Don’t use dates in creating account names (ex: Project Income 2015)
- Don’t use vendors or customers as account names (ex: Gas: Chevron)
- Don’t go too granular in creating account names or create accounts that will hardly ever be used (ex: Meals and Entertainment are fine, Meals-In Town-With Clients, Meals-In Town-With Prospects, etc. is silly)
- There is no requirement to use account numbers and it is much easier not to (ex: using “4850 Office Supplies” means you have to remember Office Supplies starts with 48 instead of “O” when you start typing)
- Don’t use the same named accounts under different parent accounts (ex: having Office Supplies under Director Expenses and Marketing Expenses accounts)
- Don’t use miscellaneous as an account as it is too easy to throw all kinds of stuff in there that should go to a specific account
- Make sure credit cards are set up as liability accounts, not bank accounts
There are more, and I could go on, but this covers most of the most egregious mistakes I see from incoming clients we help get back on track. If your COA is set up wrong then by default, your books, and your financial reports will be wrong. If you take the time to make sure this foundation of your business gets the attention it deserves you will benefit in the long run. If you aren’t sure how to do this right yourself, then I recommend taking the time to get some help from someone who does before you go too far down the road.
About the Author: Matt Remuzzi is the owner of CapForge Inc. a bookkeeping service he started in his spare bedroom and has grown into a thriving firm focused on small business entrepreneurs, freelancers and startups serving clients across the US. He has an MBA, is a longstanding certified QuickBooks ProAdvisor and is the author of a popular QuickBooks Bookkeeping book on Amazon.