Chart of Accounts: Why is it Important?

Chart of Accounts: Why is it important?

What is a Chart of Accounts?

The chart of accounts (COA) is the foundation of the accounting system. It is a complete list of the accounts needed to organize all of a company’s activities. Simply put, think of it as a filing system for financial information. It helps to categorize transactions and group similar accounts together for reporting.

COAs are typically organized into five major categories. The first three categories represent the balance sheet: Assets, Liabilities, and Equity. The last two categories represent the profit & loss statement: Revenues and Expenses. Each category can be defined as follows:

Assets

Assets include the resources that a company holds or is owed in order to run its operations and generate cash flows, such as bank accounts, accounts receivable, software development and patent costs, equipment, inventory, deposits, and prepaid expenses.

Liabilities

Liabilities are the debts or obligations of a company that will result in future cash outflows, such as accounts payable, promissory and convertible notes payable, credit card payables, and accrued liabilities.

Equity

Equity is the owners’ value in the company after deducting all the liabilities from assets. It includes retained earnings, additional paid-in capital, common stock, preferred stock, and treasury stock.

Revenues

The income that a company earns through sales of goods and services. Depending on the nature of the company, they may also include grant income, interest and dividend income, and other gains such as realized and unrealized gains on investment holdings.

Expenses

The costs which a company incurs to generate revenue. It includes expenditures such as cost of goods sold, wages, research & development, rent, legal and professional services, contractor costs, and office expenses.

Under these five categories, a series of sub-categories and accounts are set up. Each account in the COA is assigned a unique name, number, and description which makes it easy to record transactions, track the flow of cash through a company, and report financial information.

Why is a Chart of Accounts important?

Consistency & Efficiency in Day-to-Day Operation

A well-developed COA serves as a directory when recording financial transactions and maintaining the general ledger. With similar accounts grouped together and each account neatly defined for its purpose, the COA provides uniformity and consistency in data input. Whether it is an owner, investor, a bookkeeper, or an accountant working on the books, a strong COA makes entering and tracking transactions in the accounting system more manageable and efficient. Additionally, the consistency in the system helps one find irregularities in the general ledger much faster.

Accurate Financial Statements

Each account in the COA is directly linked to line items on the company’s financial statements. A properly structured COA helps generate an accurate balance sheet and profit & loss statement, which provides company owners, investors, and other third parties with a clear picture of where the company stands financially and how it is performing. As an example of what could go wrong by not following the COA, incorrectly categorizing an expense transaction as an asset addition would cause both the balance sheet and the profit & loss statement to be inaccurate, thereby providing unreliable financial data.

Data Analysis Capabilities & Better Decision Making

A well-structured COA is the base for financial data analysis. Its consistency and regularity in nature enable more coherent analysis of the past, current, and the future. It makes it easier to generate comparative reports that evaluate performance over different periods or across departments and different locations. So to speak, it allows for apples-to-apples comparisons. This information can help more effectively detect trends and identify areas of improvement. It can also help manage resources, set goals, develop strategies, and forecast into the future.  In turn, owners and investors can make informed decisions such as hiring, purchasing, borrowing, and investing.

Compliance

The COA can help companies stay compliant with applicable regulations and financial reporting standards. Although the COA can be tailored to reflect a company’s unique operations, owners and managers should consider whether its accounting is subject to the standards and principles set by the Financial Accounting Standard Board (FASB) and Generally Accepted Accounting Principles (GAAP) that guide financial reporting in the United States. We highly recommend consulting with a qualified accountant or trusted advisor to create a COA that aligns with the applicable accounting standards.

Facilitates Auditing & Tax preparation

The COA will make the auditing and tax preparation processes much smoother. Reliable reports, including a detailed general ledger, are what auditors and tax professionals are looking for as they verify transactions against source documents.  When a disorganized set of reports are provided with transactions scattered in unclear categories, it may require additional time tracking down data, resolving discrepancies, and reconciling accounts. This could create delays and additional accounting fees.

Conclusion

The COA determines the input and output of a company’s financial data. By properly setting up and maintaining the COA, companies can ensure accurate financial tracking and reporting, gain valuable insights into their financial position and make informed decisions that promote growth and success.

For startups just getting ready to set up their accounting software, the first step should be customizing the COA in a way that conforms to the applicable regulatory standards. Completing the COA should be a priority before the company begins entering into a high volume of transactions, as adjusting the COA down the road and reclassifying old transactions can be a difficult and a time-consuming process.

For mature businesses, it is good practice for management to review the COA regularly to ensure that it reflects the current business operations and works to generate relevant reporting and analysis. As the company evolves and changes occur, there may be a need to add new accounts, remove accounts, or merge duplicate accounts. With that being said, the restructuring of the COA should be conducted with the advice of an accounting professional to help maintain consistency in periodic reporting.

Having a strong COA is vital for companies of all types and sizes. If you have any questions, please feel free to contact us. We can work as a team to build and uphold a solid foundation for your company!