Setting up a chart of accounts

The Chart of Accounts is the list of all the accounts you use to book financial transactions that occur in your business. For double-entry accounting, the type that uses debits and credits that offset each other, each transaction will hit two Chart of Accounts accounts. There are five main categories these accounts will fall into:

• Assets - the record of the items of value the company uses to continue supporting its operations. Assets are things like cash, cash equivalents, receivables, prepaid expenses, property, plant and equipment.
• Liabilities - the records of all of the debts of a company. Liabilities are things such as accounts payable, unearned income, credit cards, and loans. In aggregate, these accounts represent how much of the asset base is owned by the debt holders.
• Equity - the records of the owners’ investment in the company and the share of earnings that belong to them. Equity accounts have names like paid in capital, additional paid in capital and retained earnings.
• Income - the accounts used to record the revenue generated by the company’s lines of business. Income accounts can be called income, revenue, sales, or other more specific names associated with the company.
• Expense - the accounts used to record money paid to the people and companies who provide products and services to your business. The two main categories are Cost of Good Sold (also called Cost of Sales) and Operating Expenses. The first is a record of the expenses incurred directly related to making sales, such as the supplies necessary to produce a product. The second are indirect costs associated with running the company, such as rent and utilities.

Now let’s dive into some considerations on how to structure your Chart of Accounts so you get the most out of it. This is not an exhaustive list of considerations, and we won’t cover what you should add to your Chart of Accounts because that will be specific to your business. However, as you sit down to design it, thinking about each of these items will ensure you get a great outcome.

Best Practices and Industry Standards

There are two sets of industry standards that govern best practices for US companies’ financial reporting - Generally Accepted Accounting Standards (GAAP) and Financial Accounting Standards Board (FASB). It is important that you understand these standards at least at a high level before undertaking any project related to bookkeeping or restructuring your Chart of Accounts. If you don’t want to research the accounting principles related to these standards, it might be helpful to contract with an knowledgeable outside party to review or create the Chart of Accounts under your direction.

In addition to the specifics of these standards, a common best practice is not to change the Chart of Accounts too much after it has been set. You want a consistent way to judge the company’s performance period over period, and cannot do so if the numbers fall into different buckets each period.

Strategizing

Before getting too deep into the weeds of the rest of these items, sit down and think out all the ways the Chart of Accounts will be used. Here are some items I would consider:

• Who are all the stakeholders involved in the company’s financial reporting?
• Will employees be asked to reference these accounts when creating expense reports?
• Is this a new business or is there an existing Chart of Accounts in use?
• Which systems will integrate with the Chart of Accounts and is there sufficient mapping ability between the two systems?
• What are the top three reasons the company needs a new Chart of Accounts?

This type of strategic thinking will serve you well as a guidepost when making the more tactical decisions to come.

Naming Conventions

This is probably where most of the time will be spent. The naming convention is arguably the single most important piece of the project. Here are some considerations:

• Names need to convey exactly what goes in that specific account with as little ambiguity as possible. Remember that outside stakeholders to the accounting department will need to understand the names themselves. Don’t use names that are heavy in jargon that only accounting people will understand if you can avoid it. Sometimes you can’t, and that’s OK, but you don’t want to have to explain every account’s purpose.
• There are rules that govern the naming process (see the first point above). For example, you can’t label something in the expense section as an asset, nor a liability as revenue.
• The names shouldn’t be too long. A lot of third-party systems you might integrate with will have different character limits, and you don’t want your name being cut off in the user interface of those third-party applications.
• Try not to duplicate or create similar names. This will confuse users and stakeholders.

Numbering Conventions

One way to add extra richness to the level of detail in your Chart of Accounts is to add account numbers. Like account names, this too has its own special considerations.

• Break the number into a pattern that connotes additional information. You can take a sequence such as ‘1020100’ and break it into three parts. The first part, ‘10’, can be used to place it in the correct division of the company, ‘20’ can be used to refer to a department, and ‘100’ denotes that it is an Asset account. Over time that will provide you with a way to quickly know where a transaction came from.
• Create and follow a format convention based on account type. Using the example above, for the account code section of the number, you could make all Asset numbers start with ‘1’ and Liabilities with ‘2’.

Granularity

This one is tricky. Basically, you want only the amount of detail you need to get the job done, and no more. Account structures that get too granular rarely get used correctly, thus making the data a mess. If people have too many options, they will naturally tend towards putting things in the first thing that sounds remotely close to their option instead of scrolling through the hundred others you’ve given them. Early in my career, I didn’t understand this and would create way too many accounts. After years of seeing how people actually interact with the Chart of Accounts, I lean towards starting leaner and expanding as needed based on actual reporting requirements.

For example, if the expense isn’t a closely monitored cost-center, I am not going to create ten different Dues and Subscription related accounts. You will get a sense over time for what you need, but I recommend you think about collapsing as much as you can to start, and expanding as you go. Just like salting you food, you can always add more, but it is hard to take away.

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