By Dave Costello, TCV Growth Partner -
One of the issues I see sometimes in small companies is that not enough attention is paid to setting up the chart of accounts. Many times, the chart used is the pre-fabricated chart set up by accounting software companies to help users get up and running quickly. I can understand why this occurs as it helps companies get an accounting system going when they have been using a shoe box or maybe excel to track activity prior to this. But setting up a chart of accounts that is going to be helpful in managing the business takes some knowledge of accounting and financial analysis and, if done properly, can save time and effort down the road.
Let me give you an example and then I’ll discuss some other thoughts that might be helpful.
Your company is small but has three sources of revenue or lines of business. The first line of business has to do with installation of equipment for a specific purpose. The second line of business deals with maintenance of that equipment you installed or maybe that was installed by others. The third line of business deals with consulting expertise that you provide to companies or others about the proper equipment for a particular installation or purpose. Many small companies start with one account for sales/revenues and that likely is a mistake.
What do you think the chart of accounts for sales or revenue should look like? The pre-fabricated chart of accounts might have one account for sales and revenue, or it might have ten, most of which don’t make sense for your business. So how do you know what you need, and why do you need it? Having some accounting experience and beginning with the end in mind would be vey helpful in this situation.
The goal with accounts for sales/revenues is to track where your main sources of income are coming from. In this example, you would want to have at least three accounts for sales/revenues, one for each line of business. If you think about beginning with the end in mind, what kind of analysis do you want to do with this information on sales/revenues? Certainly you want to know your biggest sales/revenue generator to help manage the effort to generate those sales. Over time if installation is growing from 60% of revenues to 90% of revenues and consulting is declining from 30% of revenues to 5% of revenues it may not make sense to continue to offer consulting. But you need this information to be able to make that decision.
Let’s dig a little deeper into this question. Suppose its important to know the geographic area of one of these lines like installations. If you are doing business across multiple states you may need to file state income tax returns in those states. So you might set up your chart like this:
Account #300100 – Installation sales
Account #300101 - Installation sales: Maryland
Account #300105 - Installation sales: Delaware
Account #300110 - Installation sales: Virginia
All these sub accounts would be the actual transaction accounts and would roll up or add up into the Prime account #300100 for Installation sales. In this way you can track your sales by state for tax purposes or potentially for marketing purposes and staffing.
Another need might be to track the type of sales by what the equipment provides. Just for this example let’s say the differences in equipment are measured by some size metric: 0 to 1,000, 1,001 to 10,000, and over 10,000. If you need this information to manage your business then you might have a sub account structure as follows:
Account #300101 - Installation sales: Maryland
Account #300102 - 0 to 1,000 size
Account #300103 - 1,001 to 10,000 size
Account #300104 - over 10,000 in size
In this example these sub accounts to capture the size of the equipment would be the transaction accounts and would roll up or add up into the major sub account #300101 – Installation sales: Maryland.
You see that it can get fairly extensive pretty quickly but its all driven by what information do you need to manage your business. You and your accountant are in control of how the chart should be set up and beginning with the end in mind, that is, what information you need to have, will drive the set up and organization of the chart.
Following along on the income statement which records sales at the top and reports net income from the company’s operations, it is a great idea to capture within your chart of accounts the direct costs of providing the revenue from the different lines of business. This section is called Cost of Goods Sold and is helpful in determining how efficient you are in delivering sales to your customers. Sometimes this is difficult as its not always easy to determine which costs belong to which sales. But you should try to capture this information. Items of cost that generally are included in Cost of Goods Sold categories are:
Inventory or materials cost
Salaries and benefits of the staff doing the work that relates to the sales
Cost of equipment used related to the sales
Other direct costs of the sold item
Allocated overhead costs
Once you have all the costs associated with generating the sale the difference is defined as the Gross Margin. That is, Revenue minus Cost of Goods Sold = Gross Margin. The Gross Margin is often reduced to a percentage defined as Gross Margin $ divided by Revenue $ = Gross Margin Percentage. Using the Gross Margin Percentage enables a comparison of sales efficiency between companies of different sizes within the same business. But that is a topic for another day. The important concept here is to capture the costs related to generating the revenues and record that in the chart of accounts section for Cost of Goods Sold.
Following down the income statement the next section is typically called Sales, General and Administrative Expenses, or SG&A for short. This section captures all the remaining expenses incurred in running the company and includes:
Salaries/benefits for areas not involved in direct revenue production (examples of those departments would be HR, Accounting, Marketing, Research & development, etc)
Marketing expenses (could include salaries/benefits for marketing or could just be expenses for marketing other than salaries/benefits)
All other expenses
Below SG&A is typically titled Income Before Taxes if the company is responsible for paying taxes. This is derived by taking Revenues minus Cost of Goods Sold minus SG&A. If taxes are paid by the company the tax provision is calculated on this net amount and recorded in a group of accounts labeled Taxes. The tax accounts could include federal income taxes and state income taxes. If you are required to pay taxes in other states you may need accounts in the tax section to capture those expenses as well.
Finally, below the tax expense section you get to Net Income. Hopefully yours is a positive number after all this effort!
As you can see there is a good amount of planning that should be associated with setting up the chart of accounts. It is not necessarily intuitive to entrepreneurs or those without some knowledge and experience in accounting. But its not rocket science. And the descriptions above only relate to the Income Statement; we have not talked about the Balance Sheet yet which has its own but similar questions and issues.
If you want someone with lots of experience in this area to have a look at what you are using reach out to me at firstname.lastname@example.org. I’m happy to have a conversation to help get you to the place of having the information you need to manage your business. After all, that’s the goal of a good chart of accounts!