4 Keys to the Best Chart of Accounts Structure for Growing Companies
A clean chart of accounts is crucial for proper analysis of your P&L statements and balance sheets. But it's not always easy to tell whether or not your general ledger is well organized. Learn 4 keys to building the best chart of accounts structure for a growing business.
Modern finance teams become strategic business partners by shifting from looking backward to looking forward. That means less time on financial reporting of historical data and more time analyzing the numbers to drive business decision-making.
But the only way you can focus on looking forward is if your foundation for financial reporting is rock solid. And that starts with building the best chart of accounts structure for your business.
Organizing your general ledger according to generally accepted accounting principles (GAAP) can only take you so far. Strategic finance functions go the extra mile to structure their chart of accounts (CoA) that enables deep analysis of profit and loss (P&L) statements and balance sheets. Follow these four keys to creating the best chart of accounts structure to maintain a clean general ledger that helps you do the same.
1. Don’t Stress Over a Parent-Child Account Structure
One of the keys to building a CoA structure that works for your business is to know which general ledger best practices to follow and which ones may not be necessary. Parent-child account setups are the perfect example.
From an accounting perspective, parent-child structure brings an additional layer of organization to the chart of accounts. It builds upon the four-digit numbering system for accounts, which generally matches the following:
- 1000s: Asset accounts including cash in checking accounts or saving accounts as well as accounts receivable, prepaids, and fixed assets.
- 2000s: Liabilities including anything in accounts payable, accrued expenses, and notes payable.
- 3000s: Equity accounts including common stock as well as preferred stock and any funding-related capital.
- 4000s: Income accounts from sales and revenue.
- 5000s: Cost of revenue accounts including things like support, hosting expenses, and third-party transaction fees.
- 6000s: Accounts for operating expenses from salaries, rent, etc.
- 7000s: Other income from interest, rent gains on the sale of assets, and gains from foreign exchange transactions.
- 8000s: Other expenses from taxes and interest.
A parent/child structure would nest similar accounts under broad segments within each of these ranges. For example, you might have accounts receivable set up as a parent account labeled 1100 with 1101 for subscription customers and 1102 for service customers.
The parent/child approach organizes your financial statements, but comes with limitations. As your company grows and you continue to add more accounts, it’ll become increasingly difficult to go back and slot new numbers into your CoA. Suddenly, you’re dealing with a mess of subsets under your parent account and unnecessarily complicating your general ledger.
You’re going to be rolling up your GL accounts to broader account categories no matter what. That’s why the time and effort it takes to create parent/child accounts isn’t worth the investment.
If you’re more comfortable with parent/child arrangements, that’s fine. But don’t get stuck thinking it’s necessary for a clean general ledger.
2. Align Your Chart of Accounts with How You Want to View the Business
The best chart of accounts structure is the one that perfectly aligns with how your business operates and how you want to analyze it. Following best practices for high-level account numbering is a good starting point. But you have to go a step further and decide what level of granularity is necessary in each account category.
There will always be more detail you could add to your CoA. But if you cross the line and go too granular, you’ll never be able to take a step back and track big picture trends.
How would you ever be able to track trends in your expense composition if you created a new GL account for every single new vendor? Your P&L would be so complex that you’d need to roll each vendor into a separate GL account before rolling that GL account into a new category just to analyze the business.
But there’s a fine line between too granular and too high level.
You don’t want to make your CoA so broad that you can’t get any actionable insights about the business. Having one GL account for sales when you have four different revenue streams would make it impossible to understand the performance of individual product lines without pulling apart your general ledger, creating pivot tables, and retagging transactional data.
Find the right balance of granularity for your own business. As an example, you should:
- Map your Facilities and Related category down to office expenses, rent, repairs, and utilities—but don’t make your gas and water bills separate accounts.
- Map your Sales and Marketing category down to things like advertising, swag, and conferences—but don’t create separate GL accounts for every conference your team attends. Instead, leverage project codes, or other fields within the GL string like the class field to tag expenses to more granular business units.
The right level of granularity comes down to how you answer the one main question—how do you want to view your business? As long as you’re consistent about how you book things to answer that question, you’ll be able to maintain a clean general ledger.
3. Make Department Tagging a Top Priority
Department tagging makes a significant difference in the effectiveness of financial reporting. It’s the only way you’re able to dig in and view your P&L at the department level. And without effective department tagging, any budget variance analysis process will be meaningless because your historicals won’t have any context.
Effective tagging starts with effectively structuring your company’s GL accounts based on departments. There are two ways you could approach it:
- Multiple GL Accounts: You could break broad accounts down in a more granular way. For example, you could have four different payroll accounts—one each for Sales & Marketing, Engineering, R&D, and G&A. Then, you’d book individual payroll transactions to their corresponding GL account.
- Single GL Account: You could have one main payroll account and tag individual financial transactions with corresponding departments rather than actually breaking payroll transactions into different GL accounts.
For an accountant, it might be easiest to create multiple GL accounts. That way, they can automate payroll allocations with an HRIS and then prepare journal entries in a tool like Quickbooks or Xero for the separate accounts.
But your goal isn’t necessary to follow the accounting status quo. You can clean up your general ledger by taking the single account approach to department tagging as long as you have a software solution that can automate the process and help you slice the data as needed.
4. Nail Down Cost of Revenue vs. Operating Expense
How you map cost of revenue and operating expenses in your chart of accounts impacts your gross margin and gross profit. Take the wrong approach and you might end up positioning your company poorly for investors or setting far-too-aggressive financial goals.
In most cases, you can map your GL accounts to a somewhat standard set of categories. Travel & Related, Sales & Marketing, Professional Services, Facilities & Related—these are all mainstays of the CoA and are fairly straightforward.
But cost of revenue is more complicated than most GL accounts. If you’re booking payroll entirely to OpEx, you might be understating your cost of revenue and boosting your reported margins in the process. That’s why you have to think carefully about what exactly to include in cost of revenue compared to OpEx when building your CoA structure.
For a SaaS company, hosting fees are a clear candidate for the cost of revenue account. But something like payroll for the support team is more complicated. This is where department tagging is so important. With proper department tagging, you can reclass a portion of payroll from OpEx to cost of revenue to more accurately report margins. You could say 40% of support’s time goes to revenue-related tasks whereas the other 60% belongs in OpEx because it’s related to more administrative work.
Proper tagging makes it easy to book these allocations throughout the month or quarter. But you could also do bulk reclassing through journal entries when it comes time to close the books.
A Clean General Ledger Supports Strategic Finance
Cleaning up your general ledger may not seem like the most exciting task. But the cost-benefit of restructuring your chart of accounts can be massive. In most cases, it’s a low-lift project that sets the stage for significantly improved financial reporting. And that’s what gives you the foundation to make strategic finance a core part of your business.
Too often, general ledger disorganization goes unnoticed until it’s too late. An investor wants a certain slice of data and you have to go back and rework spreadsheets for a couple of days to get it to them. Or, your CEO wants a quick update on T&E for the sales team and you can’t generate an answer on the spot. Take these instances as signs that your chart of accounts could use some cleaning.
Want help restructuring your CoA and automating your financial reporting process? Reach out and learn how we’ve helped companies of all sizes organize their financial data.
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