The Chart of Accounts (#163)
/In this podcast episode, we discuss ways to fine-tune the chart of accounts. Key points made are noted below.
Characteristics of the Chart of Accounts
The chart of accounts is the listing of all the accounts you use in the general ledger. If you use accounting software, which is most everyone, it’s quite likely that the software suggests a standard account structure for you. When new types of transactions come up, you probably add an account in which to store the related information. For a lot of accountants, that’s it – the chart of accounts is pretty much a non-issue.
But maybe it should be an issue. If the chart of accounts is structured incorrectly, it can require a lot of extra work. For example, let’s say the company controller likes to track expenses at a really detailed level, and so creates an amazing number of accounts. So instead of just having an office supplies account, there’re now accounts specifically for the copier machine, and another one for paper supplies, and so on. That’s what I call a deep chart of accounts – there’re a lot of accounts.
And also, what if the controller decides to have a longer account code structure, just in case? For example, a small company may only accumulate expenses for the company as a whole, in which case you can get by with a three-digit code. But if you add a department code, then the account code expands to five digits. And if you add divisions, then the account code becomes seven digits. That’s what I call a wide chart of accounts – each account has a lot of digits.
The worst possible case, of course, is when the chart of accounts is both deep and wide, because the accounting staff has to remember so much more information in order to record transactions. This difficulty shows up in several ways.
For example, the accounts payable staff has trouble remembering which accounts to charge expenses to, which means that they end up in one account this month, and in another account the next month. And that makes it impossible to track accounting balances on a trend line, since the numbers are constantly moving around among different accounts, and departments, and even divisions.
An issue with having a deep chart of accounts is that it’s more difficult to create financial statements. Whenever you create a new account, there’s a risk that the report writer in the accounting software won’t include the new account in the financials. And that means the financial statements will be wrong, and you’ll have to access the report writer and figure out what happened.
And yet another issue with both a wide and deep chart of accounts is setting up suppliers with a default account. The standard approach to dealing with suppliers is setting up a default account to which all purchases from that supplier are charged. This is a good idea. But if you get it wrong, which is way more likely with a complex chart of accounts – then every subsequent transaction with that supplier will also be wrong – at least until someone figures out the problem and fixes the default code.
Here’s another issue with a deep chart of accounts. The company’s outside auditors will be buried with accounts that they have to audit. And if they have to conduct more audit work, then the audit fee is going to increase.
Chart of Accounts Best Practices
So what can we do about this? Obviously, simplicity is crucial. First of all, the shortest possible account code structure is always best, since the accounting staff has fewer numbers to potentially enter incorrectly.
Second, and speaking of numbers, think about setting up the departments and divisions with an alphanumeric code instead of a numeric code. For example, department 01 becomes department AC, for the accounting department. This is much more obvious for the accounting staff to remember.
Third, shut down the minor accounts. There tend to be a lot of accounts that just don’t contain much information. For example, there may be a property taxes account that only gets used a couple of times a year. Or, you may have something like an office supplies account that gets used a lot, but the total balance is really small in comparison to the major accounts.
In this case, consider shutting down some accounts. The main criterion for doing so that you’re not using the information. In other words, if you see a variance in an account and yet you still don’t take action to eliminate the variance, then there’s not much point in having the account.
This concept can be taken to an extreme. To cover all of the expenses, you could have just one account for the variable cost of goods sold, one account for allocated overhead, one account for compensation of all kinds, and one account to accumulate every other type of business expense. That’s four expense accounts. Now, I point this out just to get you thinking. Very few organizations will really shrink their chart of accounts down that far. It isn’t really possible, since some accounts are needed to accumulate information for tax returns. And some managers have a hot button expense that they like to track, so by God there’s going be an account for that item. Whatever.
Nonetheless, you can see how far you could scale things back. A more realistic approach is to do an annual review of the chart of accounts that’s pretty harsh. Make the staff give you good reasons to keep accounts. Otherwise, they’re gone. The accounts, not the staff.
I only suggest doing this at the beginning of the fiscal year, for a couple of reasons. First, it’s no longer possible to compare periods. For example, the old financials might have a separate line item for payroll taxes, while this information is consolidated into a single compensation line item in the new financials. If so, the report writer has to match up the accounts properly, so that the financial statements show payroll taxes in the compensation line item both for the old year and the new year – that’s assuming that you issue comparative financials that cover more than one year.
Another problem is the comparability of information for the auditors. They like to compare expense account balances from last year with this year, to see if anything unusual occurred that needs to be investigated. But if you changed the account structure, this is kind of hard to do. So you need to warn the auditors about changes in accounts.
Because of these issues, it could be better to only make a modest number of account reductions in each year, so this becomes a pretty long-term project.
And there’s one more issue, which is keeping tight control over the chart of accounts going forward. There’s always somebody in the organization that wants to create another account, so they can store information, usually for an analysis or reporting project. If so, your initial reaction should be to turn them down. Once a new account is in the chart of accounts, it’s tough to get rid of it. Instead, tell the person to store the information separately, maybe in a spreadsheet.
Usually, the information being requested will end up being for a really short period of time, and then they don’t need the information any more. And you just saved yourself from setting up another account.
The same advice goes for subsidiaries. Everyone gets the same chart of accounts. The only waiver should be if a subsidiary operates in a different industry, and so really does need to accumulate information in a different way. Otherwise, subsidiaries tend to go wild with new accounts, and before you know it, there’s a massive tangle of accounts. This also means that acquired companies need to shift to the chart of accounts of the parent. This is a hard conversion, but it’s a good idea in the long run.
So in short, reduce the number of accounts, and don’t use many numbers in the account structure. That means the chart of accounts is narrow and shallow.