How to Choose Accounts for a Chart of Accounts
A chart of accounts is a system used to number, classify, and group related financial transactions. The chart of accounts typically includes asset, liability, equity, revenue, and expense accounts, to name a few.
When developing a chart of accounts for your organization, consider three factors:
The type of transactions that flow through the account
The number of transactions that flow through the account
How other firms in your industry set up their chart of accounts
Considering types of transactions
You may set up accounts based on your management team's preferences. In order to make management decisions, a manager may want to see activity in a specific account.
Take the cash section of your chart of accounts, for example. You may use multiple accounts for cash, including the following two:
Account 100 may be cash from normal operations, such as material purchases, payroll expense, and deposits from sales.
Account 110 may reflect interest and dividend payments from investments.
A manager may want cash activity from normal operations to be separated from investment cash flows. When the manager wants to see how cash flow from operations is performing, he or she pulls up account 100. To see interest and dividend payments from investments, the manager pulls up account 110.
Regulators or other stakeholders also may require you to set up certain accounts. Assume that you have a bond issue outstanding, which includes a sinking fund. A sinking fund requires the borrower to deposit funds into an account with the bond's trustee each year. Those funds are held to repay principal when the bond matures. To communicate the sinking fund activity to your statement readers, you specify an account called sinking fund deposits. This account reflects the dollars deposited to pay off the bond.
Assessing the number of transactions
If you process a large number of transactions in an area of your business, you probably need to set up multiple accounts to organize those transactions. Assume that you're in the construction business. You use dozens of expensive pieces of equipment, which are listed as fixed assets. Because each item is expensive, you'd probably want to set up an accumulated depreciation account for each asset. For example, your stump grinder equipment account (for the equipment's cost) would be paired with an accumulated depreciation- stump grinder line item.
With this account setup, you can scan the chart of accounts to see which fixed assets are nearing full depreciation. If the stump grinder cost $15,000 and has accumulated depreciation of $12,500, you know that the asset may need to be replaced soon. Imagine if you were considering selling the business. A potential buyer would review the fixed asset accounts to see which assets are close to full depreciation. Those represent assets that the potential buyer would have to replace sooner rather than later.
Making industry-specific considerations
Your industry also drives decisions about your chart of accounts. Stakeholders in your business need to be able to compare your business with others in the same industry. The comparisons allow shareholders and creditors to judge your financial performance against your peers in the industry. This type of apples-to-apples comparison is a reasonable way to judge management's performance.
Suppose you manufacture clothing for sale to large retailers. Returns and allowances are common in the retail industry. Retailers often return items or are given allowances (a discount on the sale price) based on goods that are damaged or manufactured with errors. Because competitors in your industry segregate returns and allowances into a specific account, you may want to do the same. Your organization's stakeholders will then be able to make better comparisons.
Take each of these factors into consideration when you set up your chart of accounts.