How to improve your chart of accounts
/The Problem With a Large Chart of Accounts
The typical chart of accounts is in desperate need of improvement, because it is too large. Having a large chart of accounts leads to issues with incorrect account usage, immaterial account balances, extensive accountant training, higher audit costs, and incorrect financial statements. More specifically:
Incorrect account usage. It is quite common for an expense to be charged to the wrong account within a department, which is discovered when the financial statements are printed and reviewed. The result is that someone must create a journal entry to move the incorrect charge to a different account.
Immaterial balances. The majority of all accounts contain small balances that have little impact on the reader’s understanding of a business. Instead, they tend to focus on just a small number of accounts that contain the bulk of all transactions.
Training. New accountants may require extensive training before they are comfortable with recording transactions into the correct accounts.
Audit cost. It takes longer for outside auditors to audit a lengthy chart of accounts, which can increase the cost of an audit.
Financial statement links. If there are many account numbers, it can be difficult to map these accounts into a coherent set of financial statements. The result may be financial statements that incorrectly reflect the contents of the general ledger.
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Reducing the Chart of Accounts
It may be possible to drastically shrink the number of expense accounts in use. In particular, consider using just the following mega-accounts:
Direct costs. This account will probably contain the cost of materials and supplies used in the production process, as well as freight costs, and not a great deal more.
Allocated costs. The major accounting frameworks require that overhead costs be allocated. Therefore, have a single account that contains all factory overhead costs that are to be allocated. The account would include production labor, since this cost is not a direct cost of goods or services in most companies.
Employee compensation. This account contains an aggregation of hourly wages, salaries, payroll taxes, and employee benefits.
Business operations. This account contains all of the expenses required to operate the company on a day-to-day basis, such as non-factory rent, utilities, legal fees, and office supplies.
In addition, there may be a need for a small number of accounts in which information is aggregated for tax reporting or other specialized purposes, such as entertainment expenses.
When reducing the number of accounts, be aware that this makes it more difficult to compare a company’s financial statements to its historical financials. For example, an account may have been merged into another one that is now located in a different line item in the financial statements than was previously the case. This is a particular problem if accounts are being closed part way through a fiscal year, so that financial statement line items no longer show consistent results within the year. There is no easy workaround to this issue, other than only closing down accounts at the beginning of each fiscal year.
The concept of a massive reduction in the number of accounts might illicit cries of outrage from those accountants who are accustomed to breaking down expenses into a multitude of buckets, which makes expenses easier to analyze. However, consider these points:
Usage of account analysis. Once the accounting staff has provided a detailed variance analysis to management of the contents of each account, does anyone act on the information? Usually, they do not.
Help or hindrance. How much time is spent by the accounting staff in reviewing accounts and reporting variances to management, and how much time is spent by management in investigating these items without taking any significant remedial action? In other words, is account analysis really a continual cycle of uncovering “issues” and then explaining them away?
Requirements of accounting standards. Accounting standards do not require a full panoply of accounts. On the contrary, the standard-setting organizations have largely kept away from the business of requiring the use of certain accounts.
Even if these points are not sufficiently persuasive to result in a wholesale reduction in the number of accounts, at least use them as discussion points whenever anyone wants to increase the number of accounts – hopefully, these concepts will prevent the chart of accounts from becoming more bloated than its current state.