While installing your new accounting software you have most likely been asked whether you would like to use one of the default charts of accounts included with the program or develop your own. Unless you are very familiar with setting up a set of financial books you will want to choose from one of the selections offered. And even if you have the experience choosing one of the defaults will save you a great deal of time. But you may ask what if I don’t need all these accounts and how do I know which accounts I should keep. And should I use a numbering system or not? Let me help you by explaining just what a Chart of Accounts is and how to adjust the default list to your needs.

First of all a Chart of Accounts in its simplest definition is a list of accounts used to track all financial transactions that flow through a business. This list is typically broken in to eight segments: Assets, Liabilities, Equity, Income, Cost of Goods Sold, General and Administrative Expenses, Other Income and Other Expenses. You might see Equity referred to as Capital, Cost of Goods Sold referred to as Direct Costs, and General and Administrative Expenses referred to as Expenses. Companies that wish to track Sales Expenses such as commissions, salaries and related expenses of sales personnel and other costs related directly to sales activity might also add a Sales Expense segment.

The first three segments represent the accounts you will find on a Balance Sheet and they will be broken down into sub-segments. Under Assets you will find sub-segments for Current Assets, Fixed Assets and sometimes Other Assets. Current Assets accounts are used for assets that can be readily liquidated into cash, such as cash, investments, accounts and notes receivables, and deposits. You may choose when setting up more than one cash account or receivable account to create a further segment. This will allow you to summarize all your cash accounts, for example, on your balance sheet while keeping a separate recording account for each bank account. Fixed Assets accounts are used to record the cost of items purchased that have a useful life that extends beyond one year. The Fixed Assets segment also includes contra-accounts (reduction of the value of an asset) that are used to record the depreciation of your fixed assets. These contra-accounts are typically named “Allowance for Depreciation – (name of type of fixed asset)”. You should have a fixed asset account and corresponding depreciation account for each type of fixed asset you purchase. Some examples are vehicles, office equipment and furniture, building or leasehold improvements. The Other Assets segment is used for all other types of assets.

Likewise the Liabilities segment is broken into Current Liabilities and Long-Term Liabilities. Current liabilities represent the company’s liabilities that are to be paid in less than one year. Examples are Accounts Payable, Payroll Tax Liabilities, and Note Payables. Long Term Liabilities represent liabilities that are to be paid over a longer term than one year such as mortgages, vehicles loans and other long term debt.

The third segment of the balance sheet is the Equity, or Capital, segment. This segment consists of accounts that record the owner’s, partners or shareholders investments, draws of profits taken from the company by the investors and the net earnings of the company. For each owner or partner within a business entity there should be an individual investment account and draw account. When a company is incorporated than the capital investment by the shareholders is recorded into capital stock accounts. These accounts may be broken down further if different types of stock are issued. The Retained Earnings account is used to record the profit, or loss, the company has earned from the beginning of its existence. Usually you will not be posting to this account, as this is the account your software program will use to close out your end of year income statement accounts.

Moving on to the Income Statement segments, you will want to have in the Income segment accounts to record each type of income you earn in the course of your business. You may want to break out your sales income into more than one account if you have more than one type of service or product. For example if you are a general contractor you may want to track how sales compare between remodeling and new homes.

Cost of Goods Sold or Direct Costs are those expenses that relate directly to the sale of a product or service. Again if you are a contractor these typically would include payroll and payroll expenses of your workers, materials, subcontractors, permits, general liability and workman’s compensation insurance, equipment rentals, etc. They would not include rent or office supplies.

General and Administrative Expenses are business expenses incurred that are not dependent on the sale of a product or service. They include rent, phone, office payroll and payroll expenses, employee benefits, office supplies, utilities, etc.

Other Income typically includes non-sales income such as interest income. Federal and State Income Taxes and any related interest and penalty expenses are what you will find in the Other Expense segment.

Now that you have an idea of how a Chart of Accounts if typically set up, how do you pick and choose what accounts to keep and which to delete? Print out the default list and go through it choosing the accounts you think you will need. You will need at least one cash account, an account receivable and accounts payable account. If you do not have employees and don’t ever expect to have any than by all means delete all accounts with payroll in the name. If your company will not be making investments than delete all accounts having to do with investments under Current Assets. You get the picture – however it is easier to keep what you think might be needed sometime in the future. Your program may not let you delete some accounts because they are being used in conjunction with another account or accounts. Let them be. You can also edit account names – as long as the new account name belongs in the same segment as the one you are replacing.

Now, to number or not number. Numbers are used in a Chart of Accounts to sort the accounts correctly. Also, between you and me, accountants are much better at remembering numbers than they are at names so they prefer numbers. When using numbers, each segment is assigned a specific group of numbers. Typically these are as follows:

• Assets – 1,000’s

• Liabilities -  2,000’s

• Equity  - 3,000’s

• Income  - 4,000’s

• Cost of Goods Sold - 5,000’s

• Marketing & Promotion Expenses – 6,000’s

• General & Administrative  – 7,000’s

• Other Income -  8,000’s

• Other Expense - 9,000’s

When a Sales Expense segment is used it is assigned the 6000 range and each of the remaining segments move up a range. Leave room between sub-segments so you will be able to add if needed. And when setting up numbers within a segment make sure you leave some room between each account as you may also want to add accounts.

And when in doubt ask a professional. Your software advisor or accountant can get you started in the right direction from the start which may save you a lot of time and aggravation down the road. As with most endeavors, doing it right the first time is always best.

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Workman’s compensation and part of your general liability insurance premiums are based on wages paid. These rates vary from state to state as well as job classification and these costs are part of your payroll burden. You can find out the cost of the premium per wage dollar paid from your insurance agent.

The cost of paid vacation, sick, personal and holidays should also be included in the cost of payroll. To do this, determine the number of paid days off an employee is entitled to and multiply that number by the employee’s average daily wage. Then divide by the number of working days in a year (for example – 52 weeks less 2 weeks vacation equals 50 working weeks). And then divide by the average number of hours worked in a week resulting in an average hourly cost of paid time off. For example an employee paid $800.00 per a 40 hour week with two weeks paid vacation, 1 week of paid sick leave and eight paid holidays computation would be: 10 days vacation + 5 days sick + 8 holidays = 23 paid non-working days. $800/5 days = $160 per day paid wages. $160 x 23 non-working days = $3,680 (yearly cost of non-working days). There are 260 possible working days in the year (52 x 5) less the 23 non-working days = 237 working days. These 237 working days need to be burdened with the cost of the 23 non-working paid days. Divide the expense of the non-working days by the number of working days ($3,680/237) which is $15.53 per day. Divide the $15.53 by 8 hours and you have your hourly burden cost for paid days off. Depending on your company you may have employees working overtime or even less than a 40 hour week occasionally. Unless you think this may affect your burden substantially you can base your figures on the “usual order of business”.

Other expenses you should consider are health, dental, and/or disability insurance premiums paid by the company (net of employee contributions). And if you are providing a vehicle to your employee the cost of purchasing, financing and insuring that vehicle may be an expense to include. Also any other employee benefit cost that the company provides should be considered as part of the payroll burden charge.

When all is said is done, the wage you pay your employee for a day’s work is just the beginning of the cost of that employee. Not determining the cost of your payroll burden can shave profits from your bottom line. And without profits we can not continue to stay in business.

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First-In, First-Out Costing (FIFO) assumes that the first goods purchased are the first goods sold and therefore that the last goods purchased are the ones remaining in inventory. This system is used frequently because whenever the flow of inventory can be controlled it makes sense that the oldest items are sold first satisfying the accounting convention that inventory should be shown on the balance sheet at the most current cost possible. Also because this method has been used for such a long time, continued use assures consistency for income calculations comparability.

Last-In, First-Out Costing (LIFO) assumes that the most recent purchases are the first to be sold leaving the older items remaining in inventory. One argument for using this method is that it matches the most current cost of items purchased against the current sales revenue. Also when prices are rising net income calculated by this method is smaller than the amount determined from using other methods resulting in a smaller income tax. This would be reversed if pricing were falling.

One other, however uncommon, method is specific identification costing which requires that each item that is sold and each item remaining in inventory is separately identified in respect to it’s purchase cost. This method is not practical for most businesses. Only those businesses that sell items where the cost is relatively high, and sales volume is low and it is easy to identify the cost and sale price of each item separately would find this method useful.

When choosing a method consider the practical issues of how the valuation can be accomplished accurately and with the least amount of effort, and be sure to consult your tax preparer for tax return considerations.

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I am often asked by business owners why the market value of an asset is not listed on their balance sheet. This is because in the bookkeeping and accounting professions we are traditionally reluctant to accept market value as the basis of asset measurement. Although assets such as cash or accounts
receivable are usually measured by their value, most other assets are measured at cost. The reason is that it is difficult to verify the forecasts upon which a generalized value measurement system would have to be based. For example, should you purchase a building today at a certain cost, is it likely its value would increase or decrease as time goes by? The answer may depend upon several
unknowns; the real estate market, the location and the changes in the value of the location, for example. As a result, the balance sheet does not pretend to show how much the company’s assets are worth; it shows how much the company has invested in them.

The historical cost of an asset is the sum of all the expenditures the company made to acquire it. This amount is not always easily measurable. If, for example, a company has built a special-purpose machine in one of its own factories for use in manufacturing other products, and the project required
logistical support from all parts of the factory organization, from purchasing to quality control, then a good deal of judgment must be reflected in any estimate of how much of the costs of these logistical activities should be capitalized (i.e., placed on the balance sheet) as part of the cost of the machine. Most commonly the determination is made by identifying all the costs of the components that make an asset a useful item. A computer is not very useful without a monitor; keyboard and operating system, therefore the cost of all of these items would be included in the cost of the computer. In summary the cost of a fixed asset (an item purchased that is expected to have a useful life exceeding one year) is the actual cost plus any required expenses to put that asset to work.

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Bank reconciliation is one of the most common examples of this approach. Your bank reconciliation should agree with your computer records and your manual checkbook. All cash accounts should be reconciled monthly including your petty cash fund.

The next two accounts to be reconciled are Accounts Receivable and Accounts Payable. The ending balances in these accounts should correspond to the balances shown on your aging reports.
Accounts that often get overlooked when preparing an internal financial statement are the Note Receivables or Note Payables. Do the general balances match the statements provided by the bank?
If not, it is easier to locate the problem within the month the discrepancy happened instead of waiting for year end. And of course if there is a variance, either your books are wrong or the bank has made a mistake. Either way now is the time to correct the problem.

Payroll reconciliation will ensure that your payroll and payroll taxes are posted correctly. Ascertain that your payroll tax liability accounts are showing the correct balance (the amounts withheld from employee paychecks plus the companies share of payroll taxes that remain undeposited at the end of the month). Also check the amounts posted to your labor accounts and payroll tax expense accounts. Do you break out your labor costs to departments? Do you break out vacation, sick, holiday, etc to separate general ledger accounts? Reconcile your payroll records to those accounts using your outside payroll service reports or your internal reports should your payroll be done in house.

And lastly, take a look for reasonableness. Does it make sense that you spent $10,000 on office supplies in one month? Depending on the size of your company, that might make perfect sense, but then again maybe there is a posting error. It is better to take a few minutes to review the financial statements before you hand them to your boss, then to be questioned after the fact.

Taking these extra steps will build trust in your ability to produce accurate financial statements which is after all, what we all strive for.

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