How to Setup Your Chart of Accounts: the Right Way, the First Time

You know that setting up and maintaining your financials properly is crucial to the financial health of your business. You know it’s important to categorize your expenses, keep track of money coming and going, and manage details like revenue by product, depreciation of your assets, and inventory. But do you know the chart of accounts - this arcane list loved by accountants and loathed by business owners - is what makes tracking all of this possible? 

The chart of accounts is a financial organization tool that lists every account in your accounting system - accounts are the ‘buckets’ where you put every business transaction. For example, when you rent a car you record it to 'Travel Expense', an expense account on your chart of accounts; when you invoice a customer for a completed project, you record it to 'Service Revenue', an income account on your chart of accounts. 

Recording transactions to a specific account is what makes it possible to review the performance of your business at a glance. That is if, and this is a huge if, your chart of accounts is organized correctly. If not, you won’t be glancing at reports and making fast decisions. You’ll be lost in the trees, unable to see the forest forever confused about your business’ finances. 

Following these three tips will help you set up your chart of accounts correctly the first time, saving you time, money, and frustration. Click the button to download our full chart of accounts template to follow along.

Download the Chart of Accounts Template (Excel)

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1.) DO NOT LET YOUR TAX CPA SETUP YOUR CHART OF ACCOUNTS FOR YOU (OR EVEN HAVE MUCH OF A SAY IN IT)

Your Tax CPA will define your chart of accounts (COA) in a way that makes filing your taxes easy - but that is a once per year event (or at most four), whereas you have to live with your COA the other 364 days out of the year. You don’t want your chart of accounts aligned solely to the IRS’s (sometimes senseless) deduction and credit rules - you need accounts that correspond to how you actually run your business, for your daily, weekly, and monthly reporting and analysis. 

2.) MEASURE YOUR MARGIN BY SETTING UP MATCHING REVENUE AND COST OF GOODS SOLD ACCOUNTS

Margin may be the single most important metric for your business. To calculate margin by product or service line you need to setup matching revenue and cost of goods sold (COGS) accounts.

REVENUE

First, for revenue, think about your different revenue streams and group them into broad functional categories. Three or four categories are usually sufficient for a small or medium-size business (SMB), or even just one might be enough. These categories become your primary revenue accounts. 

Below are a few examples, including how you may use sub-accounts to show additional detail.

Software Company

  • Consulting Revenue
  • Software Revenue
  • Other Revenue

General Contractor

  • Building Revenue
    • Residential Building Rev
    • Commercial Building Rev
  • Service Revenue
  • Parts Revenue
  • Other Revenue

Manufacturer

  • Product 1 Revenue
  • Product 2 Revenue
  • Service Revenue
  • Other Revenue

A NOTE ON LOCATION TRACKING: DO NOT use accounts specific to geographies (e.g. Project Revenue, Pacific Northwest). To report by region or location use tracking categories (a.k.a. ‘classes’), and run reports that break out revenue and costs by class. You can setup a separate list of classes in your accounting software, and then as you record transactions, you assign each to a class.

COST OF GOODS SOLD (COGS)

Now that you have revenue figured out, you’re ready to set up your cost of goods sold accounts. This is simple - create matching accounts for each revenue account. The only complication is breaking COGS out into materials and labor, so that you can track what you spend on raw material inputs versus people inputs.

Software Company

  • Direct Materials
    • Direct Materials, Consulting
    • Direct Materials, Software
  • Direct Labor
    • Direct Labor, Consulting
    • Direct Labor, Software
  • Other COGS

General Contractor

  • Direct Materials
    • Direct Materials, Building
      • Direct Materials, Residential Building
      • Direct Materials, Commercial Building 
    • Direct Materials, Service
    • Direct Materials, Parts
  • Direct Labor
    • Direct Labor, Building
      • Direct Labor, Residential Building
      • Direct Labor, Commercial Building
    • Direct Labor, Service
    • Direct Labor, Parts
  • Other COGS

Manufacturer

  • Direct Materials
    • Direct Materials, Product 1
    • Direct Materials, Product 2 
    • Direct Materials, Service
  • Direct Labor
    • Direct Labor, Product 1
    • Direct Labor, Product 2 
    • Direct Labor, Service
  • Other COGS

MARGIN

Doing the hard work of setting your accounts up correctly makes calculating margin by product or service line easy. The simplified example PnL below shows what happens when you setup your chart of accounts the wrong way versus the right way. In the wrong way, the company overstates margin because it records all labor to Payroll Expense (rather than recording the direct labor portion to COGS), and it’s not able to compare consulting margin to software margin. If your chart of accounts is right, you’ll know your true margin and be able to compare your products or services to one another.



3.) GET YOUR CHART OF ACCOUNTS ORGANIZED, AND KEEP IT THAT WAY

Even if you’re business is pretty simple with just a few employees, there will be a lot of different categories you will use, and these can get confusing. If you don’t keep your chart of accounts organized, your Income Statement and Balance Sheet will be pretty useless and you’re back to bank account business management - Money in the bank? Hire, buy, invest, spend. Cash running low? Fire, cut, trim. Not the best way to run a business.

Download the Chart of Accounts Template (Excel)

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Use the mechanics below to keep the chart of accounts organized. Scroll down to see an example or click the button to download our full chart of accounts template.

CREATE A LOGICAL HIERARCHY

A hierarchy of accounts will make your reports much more useful - you can glance at a summary Profit and Loss statement to get a quick understanding of business performance, and then drill down into the detail accounts to identify the cause of any unexpected results. Create this hierarchy by using accounts and sub-accounts, also referred to as parent-child accounts. But be careful, your hierarchy will do more harm than good if you let it get out of control. To keep the chart of accounts in check, limit your hierarchy to no more than four levels, and make sure your accounts are grouped appropriately - see next paragraph. The below table shows an example of this chart of accounts hierarchy using the revenue and COGS accounts discussed above.

 
 

GROUP ACCOUNTS IN A WAY THAT MAKES SENSE

You should organize your accounts into meaningful groups, i.e. accounts that you’ll want to total up on your reports to help you quickly review performance. The top level groupings (Level 1 in our 4-level hierarchy) are fixed, they are the six generic account types (ALERCE): 

  • Assets
  • Liabilities
  • Equity
  • Revenue
  • COGS
  • Expenses 

Within each of these top level accounts, create sub-accounts (Level 2) that belong there, and then do the same for Level 3 and Level 4. Below is an example of what some of your expense groupings on your chart of accounts might look like.

 
 

Grouping accounts under Personnel Expense and Office Administration Expense on your chart of accounts lets you easily see the total cost of personnel, or of administering the office. And, when necessary, you can drill down to the lowest level (Level 4) and see, for example, the exact cost of providing benefits to your team and how it compares to their salaries. 

DON’T LET ACCOUNTS MULTIPLY BY HAPHAZARDLY CREATING NEW ACCOUNTS

Many business owners who are doing their own bookkeeping, or even some inexperienced bookkeepers, end up creating way to many accounts, especially for expenses. When it comes to keeping the chart of accounts organized, the expenses section can be the most challenging. To develop your hierarchy and create appropriate groupings within “Level 1 - Expenses”, follow these guidelines:

  • Level 2: You should have only the following three accounts in your Level 2 hierarchy within expenses. Grouping expenses in these three categories allows you to calculate each as a percentage of revenue, which is how businesses nationwide monitor their Opex (Operating Expenditures) costs:
    • General and Administrative (GnA), 
    • Sales and Marketing (SnM), and
    • Research and Development (RnD)
  • Level 3: Within each of those three broad categories, you should have no more than 10 accounts. These accounts should group the costs of your operations in a meaningful way, helping to answer questions about your business, such as:
  • Level 4: The lowest level account should still be a category of revenue or expense, not a specific person or item, i.e. never use a vendor or customer name, or a service in an account name. For example, you shouldn’t have an account called ‘Adwords Expense’.  Instead, the account should be ‘Online Advertising Expense’. Use Items or Vendor Names (different tracking tools available in your accounting software) if you want to track costs of a specific service or vendor. 

 

KEY TAKEAWAY: Don’t let accounts proliferate! Keep it simple.

 

USE A NUMBERING SYSTEM TO STAY ORGANIZED

Use numbers to keep your chart of accounts hierarchy organized - since you have a four-level hierarchy, every account will get a four digit number. Start with ALERCE and then work your way down:

  • Assets 1000s
  • Liabilities 2000s
  • Equity 3000s
  • Revenue 4000s
  • COGS 5000s
  • Expenses 6000s

This is probably easiest to understand with an example, below is an example each for a liability, revenue, and expense account: 

To see a working example of the entire hierarchy, click the button to download the chart of accounts template that we actually use as a starting point on our engagements.

BONUS PRO TIP!

Implementing your finished chart of accounts in your accounting software is a little different in QuickBooks and Xero, the two most popular accounting packages for SMBs: 

  • In QuickBooks, you will want to create just a two-level hierarchy of accounts and sub-accounts (also referred to as parent-child accounts) using levels 3 and 4 of the hierarchy you defined. The QuickBooks ‘account type’ serves as level 1 in the hierarchy. Level 2 is completely excluded because the reporting limitations of QuickBooks - the expand/collapse function of QuickBooks reports can only show the highest or lowest level. The work around is to include the Level 2 abbreviation (GnA, SnM, or RnD) at the beginning of the parent account name (e.g. GnA - Facilities) to group accounts together on reports. 
  • Xero does not offer parent-child account functionality, which actually increases its flexibility - use the report layout designer to group your accounts into the hierarchy you created - the layout can vary by report to create summary and detail views.

READY TO REDESIGN YOUR CHART OF ACCOUNTS?

Follow these tips and you will actually enjoy reviewing your PnL and Balance Sheet - and you’ll be able to make better, faster, more-informed decisions. Don’t hesitate to get in touch with us if you need a hand. Good luck!

 
Download the Chart of Accounts Template (Excel)

Access for FREE the template we actually use with our clients!