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  • Honey Hive Bookkeepers

What is a Chart of Accounts?

One of the first steps in setting up your bookkeeping software for your small business is creating your chart of accounts. It's also one of the first things that pops up when you Google how to set up your books, but it's one of the hardest to grasp concepts.

What Is The Chart of Accounts?

Your chart of accounts represents the accounts that you use to track your business transactions. Accounts generally fall into 5 basic categories: assets, liabilities, owner's equity, revenue, and expenses. But within each of those categories we have numerous accounts. Those accounts represent more specific categories. For example our expenses can have our cost of goods sold, utilities expense, salaries and wages, etc. The chart of accounts list all of these accounts and typically has some basic information on how the accounts are categorized.

The Main Purpose of All These Accounts

For small business owners there are two main purposes, first to make sure that the information you need for tax purposes is neatly organized. Second is to make sure you can use the information in a way that helps you understand what is happening in your business and evaluate management changes that you make. There may be other purposes for some of the accounts such as information for investors and lenders, but the main concerns for small businesses tend to be summarized by those two goals. Let's take a look at them a little closer:

Tax Purposes

When setting up a chart of accounts it's a good idea to take a look at the categories you will need for your tax return. Some industries such as the agriculture industry have their own tax schedule (Schedule F). Many small businesses will be flow through entities and use Schedule C. These schedules will give you an idea of the division of accounts needed for your returns. If you have a partnership or business taxed as a corporation you can also take a look at Form 1065 (partnership), Form 1120S (s-corp), and Form 1120 (c-corp). Being able to generate statements with these categories contained in certain accounts makes tax season that much easier. If you work with a tax professional get their input as well. Since they are the ones preparing your taxes they will most likely have a preference for your chart of accounts.

Management Purposes

Management purposes are a little more varied from business to business and really depend on a number of things. First off does your business have multiple segments such as a retail versus wholesale operation? Perhaps you have a restaurant with a catering business as well. Splitting these two activities can be done in the chart of accounts, but would be better completed with different features of your accounting software (such as with classes in Quickbooks Online). When creating a chart of accounts think about what decisions your financial reports should be able to help you make. If you are utilizing numerous paid advertising channels it may be helpful to split out your advertising costs from each channel instead of lumping them all together in advertising. This way you can track what advertisers you spent more with during times of increased sales. With that information you can determine what advertising channels provide a better return on your investment.

There's a couple of different ways to split the information out depending on what accounting program you are using. If your program allows you to use sub accounts we encourage you to utilize those. This way you can generate financials that are tax ready (showing the whole advertising expense) and you can generate reports that will dive deeper into the parent accounts (such as dividing out the various advertising channels).

Advertising is just one example of how this can help you, the best way to utilize your chart of accounts is going to depend on your business, if your accounting program allows you to create other types of filtering mechanisms (such as classes, locations, etc), and what changes you are planning on making in your business and therefore need information that will help you evaluate those decisions.

Questions To Help

Take a minute to answer the following questions, they may help you identify some areas that you should be customizing your chart of accounts:

What type of entity do you have?

If you have a sole proprietorship or a qualified joint venture take a look at Schedule C (or the schedule that fits your industry) to help you determine what accounts you need for tax purposes

If you have a partnership take a look at Form 1065

If you are taxed as a S-Corp take a look at Form 1120S

If you are taxed as a C-Corp take a look at Form 1120

Does your accounting program have the ability to track transactions by class, location, project, job, etc?

If it does not and you need this functionality it may be time to either re-evaluate your accounting program or you may need to build it into your chart of accounts (which can get complicated and messy).

What advertising channels are you utilizing?

If you are using more than one advertising channel and/or are planning on changing up your advertising plan being able to segment your advertising expense can help you determine what campaigns have generated more revenue.

What payment processors are you using?

If you are operating with numerous payment processors it may be a good idea to separate the fees for reporting purposes. This way you can see which processor is charging you a higher percentage.

Do you have multiple types of services or product groups?

If you are not tracking these with classes, etc you can create various revenue and expense accounts associated with these items.

Are you using multiple types of employees such as a sales staff, management staff, etc?

If so segmenting your payroll groups could be helpful in identifying which group of employees is providing the highest return on investment.

Are there assets that can be grouped in similar categories or should they be separated?

Having all vehicles in one category may work, until you need information on the book value of maintenance versus delivery vehicles you have, etc. Make sure your assets are grouped in a way that makes sense and in a way that does not make it overly complicated to track depreciation. If you need to make a sub account for each vehicle or each piece of equipment in order to help you see where the values are coming from than by all means do so. Just make sure it is in a way that does not clutter your financials.

How many owners are there?

How do you want your equity accounts to be set up? This is going to vary based on the structure of your business. If you have two owners than the chart of accounts won't be quite as daunting, but think about a partnership with 30 owners: it's going to take some planning.

What liabilities do you have?

We find that people often forget about that loan or credit card that they don't really use. But these should be on your chart of accounts! (hint: they should also be getting paid from business accounts if they are business loans/credit cards)

Final Thoughts

Creating a chart of accounts that really works for you is not a one and done situation. We often tweak the chart of accounts we create fairly extensively within the first few months. We may add accounts years down the road as the business model changes. A well thought out chart of accounts to start with certainly makes it easier from the get go, but don't be afraid to revisit your chart of accounts if needed.

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