A chart of accounts is a lot like the game Jenga. If you take a block away from one section of your business, you have to add it back someplace else. This is because accounting systems are created in the hope that there will always be a balance between your total assets (what you own) and your liabilities (what you owe). While this is rarely the case in reality, as you may know, the difference between what you own and what you owe is your equity. The goal, of course, is to own more than you owe, so that your equity looks positive on the books and can provide for you later.
Let’s start with understanding your chart of accounts.
There are four main sections: assets, liabilities, income, and expenses. Equity is also a section, but it’s not one you will actively manage. Equity is what’s left over after all your business activities, plus and minus, have been properly recorded.
Assets and income are good. Liabilities and expenses are not great but not always bad. Many people think of expenses and loans as a necessary evil, but the idea is to incur only those liabilities and expenses that will serve the good. In other words, think of your liabilities and expenses as an investment — an investment whose purpose is to pump up your assets and income.
Many accounting systems come preset with a chart of accounts whose line items include numbered headers like 1430.2 and 530.8. While this may be great for your accountant in the same way that the Dewey Decimal System makes sense to librarians, for a small business it is unnecessary, cumbersome, and confusing. Just make sure that your line items have titles that make sense to you and your accountant. Use straightforward titles like “Bank Fees and Charges,” or “Bottling Equipment.”
When setting up your line items for the first time, keep it very, very simple. Over the course of time, don’t fall into the trap of creating a new line item for every single thing. You can create subaccounts for tracking certain things, like “PayPal Fees” under “Bank Fees,” or “Postage” under “Office Supplies.” But for the most part, keeping your chart of accounts simple will keep your business accounting simple and error free.
Your asset accounts will include anything you own that has value, like a building, land, equipment, vehicles, valuables, and inventory. Unfortunately, your assets may not look as pretty on your chart of accounts as they might on a real estate agent’s website. That’s because your accountant will be tracking what you actually paid for the property and its depreciation. If you want to show someone what your building, equipment, or inventory is really worth when it’s put up for sale, you’ll be using outside sources and reports for that — which is as it should be, because those values will change with the market.
Other asset accounts include accounts receivable and notes receivable. After all, you technically own that money. When someone owes you money, it’s your asset. It just hasn’t been delivered to you yet.
Liabilities include things like bank loans, mortgages, personal loans and promissory notes, income tax payments due, payroll taxes due, and, of course, your bills — otherwise known as accounts payable.
One important thing for the beginning business owner to keep in mind is that your notes payable entries should represent the amount of the loan only. Do not include interest in the amount owed. When you make each monthly payment and enter that payment in your accounting system, you will split the payment into an amount subtracted from what you owe, and an amount of interest paid, which will go to expenses. For example: Boardwalk bank loan $150, Boardwalk interest $3.57, total check = $153.57.
Income is pretty self-explanatory, but it’s also a category that is underutilized by many business owners. Most new owners start out with just one or two wide categories, like “sales” and “services.” But some types of income are easy and cheap to generate, and some require effort, time and expense, so it makes sense to create separate line items for different types of income.
Instead of lumping all your income into one account, consider what your various profitable activities may be and break them out into types of income. Don’t go wild and crazy of course, but by being able to see exactly which locations or activities are bringing in the most cash flow, you will be able to more wisely manage your business. For instance, if your store sells books, gifts, and food items, you will want to have an income line for each. Later you’ll be able to compare your cost of goods and profit levels for each category and know which type of goods are most profitable for you. The same is true for service businesses; if you sell a service, but also teach classes and do outside consulting, track your different types of income separately.
It’s also a good idea to break up expenses into separate accounts. Keep your categories as simple as possible, creating subcategories only when you truly see a need. For instance, if you ship a lot of products, you may want to track your costs from different shipping carriers separately. Or if you’re a cookbook author, you may want to track your food costs for recipe testing in different subcategories by book.
Remember that as your business grows, so will your need for accurate, fast, legible reporting. Your chart of accounts is your map of the past and present, and your treasure map to the future. Keep it clean and organized, and make sure that it makes sense to the most important person involved — you.