This is the fifth in a series of articles that will hopefully educate readers and illuminate the process of doing business in a simple to understand, nuts-and-bolts way.
To read all the articles in this series, click on any of the following:
In the previous articles, we have covered motivation, a Business Plan, the Organization Chart, and how to think about money as it goes in and out of a business. In this article, I will describe how to set up a rational and useable Chart of Accounts, focusing mainly on the Profit & Loss Statement (P&L). This will become essential when developing a Financial Plan for your business.
Chart of Accounts – A map of your business…
A properly constructed Chart of Accounts does many things. First, it simply keeps track of transactions, totals Assets of all kinds, Liabilities of all kinds, and your Equity in the business. Second, the Chart of Accounts is used to generate two essential reports, the Profit & Loss Statement and the Balance Sheet. Both of these reports are critical in understanding what is happening in your business. While I will primarily focus on the P&L because that report concerns itself with money in and money out to tell you whether you are profitable or not at any given time (hence the title of the report), I will address the Balance Sheet briefly.
The Balance Sheet
The Balance Sheet has three sections.
Assets are what you might think they are, stuff that is valuable that you own. Asset categories are typically:
Current Assets (current means having value within the next 12 month period starting today)
- Cash & cash equivalents (petty cash, checking and savings accounts, money market accounts, certificates of deposit, etc.)
- Accounts Receivable (money that’s owed to you through outstanding invoices)
- Inventory (raw materials, unsold finished goods, supplies)
- Prepaid expenses (some expenses, like insurance, are prepaid, and have a value to the company until the prepayment period is over)
- Notes receivable (loans owed to the company, employee loans)
- Other Current Assets (ask your CPA)
Fixed Assets (longer term assets, typically physical things)
- Furniture & fixtures
- Equipment (usually machines used to make things)
- Leasehold improvements
- Building improvements
- Accumulated Depreciation(this is a complicated issue as there are at least 4 different ways to calculate Depreciations of various kinds, ask your CPA)
- Notes receivable non-current (loans owed to the company, employee loans)
On the Balance Sheet, the value of all these things are added up to become “Total Assets.”
Liabilities are generally money that the business owes or things work against the value of the business. Categories are typically:
- Accounts Payable(stuff you owe, usually unpaid vender and supplier invoices)
- Taxes payable (lots of subcategories here… sales tax, payroll taxes, income taxes)
- Employee benefits payable (employees accumulate benefits over time and use them up in chunks and until they are used, its a debt)
- Current portion of Long Term debt (what you owe on loans over the next 12 months, starting today)
- Customer deposits (if you take money from customers for work done in the future, it’s not your money until the work is complete)
- Other Current Liabilities (ask your CPA)
Long-Term Liabilities (debt that is out in time past 12 months from now)
- Notes Payable
- Land Payable
- Equipment Payable
- Bank Loans Payable
On the Balance Sheet, the value of all these things are added up to become “Total Liabilities.”
Equity is the value you or shareholders have in the business. Accounts typically are:
- Owner’s equity (the money you put up)
- Capital (the money others put up, can vary in value based on circumstances)
- Retained Earnings (money that the business has accumulated over time, i.e., add up all the profits or losses at the end of every year you have been in business)
On the Balance Sheet, the value of all these things are added up to become “Equity.”
The reason that the Balance sheet is called the Balance Sheet is simple. Assets = Liabilities + Equity. In other words, if you look at a Balance Sheet, look at Total Assets, then look at the bottom of the report. Liabilities and Equity will be summed, and that number is exactly the same as Total Assets. It MUST be. Them’s the rules! There is a lot that goes on when any transaction occurs, and I recommend that you read a bit about Accounting and Bookkeeping to familiarize yourself with the principles of double-entry bookkeeping.
Whew! That’s a lot to absorb. Take a break, and come back, and we will discuss the structure of the Profit & Loss Statement.
The Profit & Loss Statement (P&L)
The Profit & Loss Statement (P&L) is much easier to understand than the Balance Sheet. It deals with the nuts and bolts of your business in a real and immediate way. As was discussed last time, there are three categories: Sales, Costs of Goods Sold (COGS), and General & Administrative (G&A) Expenses.
The trick to setting up the accounts in the P&L is to think about how your business operates. Every business is different. Do you sell one thing? Do you sell 3 types of things? For example, a residential construction company may build houses and also do renovations. A grocery store may want to section out meat, dairy, deli, bakery, etc. A manufacturer may also do design work.
You need to track each income stream and its associated costs (COGS) seperately in order to see what part of the business is more or less profitable, if one part has a different periodicity than another, if materials or labor costs are significantly different from one category of sales to another.
So, think about the business. Take a piece of paper and play with categorizing the income streams. Keep it simple, don’t get too complicated. Once done, your Revenue section of the P&L will look like this:
- Sales 1
- Sales 2
- Sales 3
- Other income (see the previous article for more details on other types of income you may want to track, like shipping charges to customers)
Now, Cost of Goods Sold (COGS)…
Think about each sales stream. Think about any and all costs for each stream… materials, labor, shipping into your business, etc. Again, see the previous article for a more detailed discussion. Then, list the COGS for each income stream seperately. Your COGS section should then look like this:
- Outside services
- Outside services
That’s it! Note that each COGS does not have to be and may not be the same. COGS 2 in this case is reselling something, for example. No labor or anything else. COGS 3 is maybe service of some kind your business does. The key here is to relate each COGS section directly to each sales stream.
We’re almost there…
Now we come to the General & Administrative Expenses (G&A). These are expenses that are not directly associated with creating what you sell. You will see what I mean shortly. The key in this section is to group expenses so you can look at them and manage them in a rational way, Again, see the previous article for details on what G&A is all about.
- Administrative labor
Then a General Category
- Facility expenses (usually repairs and maintenance to the physical property)
- Dues & Subscriptions
- Charitable Contributions
- Office supplies
- Postage & Delivery
- Professional fees
- Travel & Entertainment
There are other categories called Other Income, where things like gain/loss on sales of assets and interest income are listed. Other Expenses are where taxes, bad debt, and interest expense are listed. Both of these areas need input from your CPA to correctly assign these accounts.
And there you have it! A rational, organized and easily understood Chart of accounts!
This is critical to managing your business. Your CPA can help you set it up, but willnot know what is important to YOU. Popular software like Quickbooks doesn’t either. You have to take control of this very, very, very important part of your business.
Please contact me offline at [email protected] with anycomments, suggestions or ideas for future articles that you may not want to share here.
- Income Statement vs. Balance Sheet(brighthub.com)
- Glossary of Basic Accounting Terms: Balance Sheet Accounts & Transactions(brighthub.com)
- Putting Information on the Balance Sheet(readwriteweb.com)
- Should Information Be On The Balance Sheet? (chucksblog.emc.com)
- Explaining the Accounts Payable Process (brighthub.com)
- Help with Profit & Loss and Balance Sheets (ask.metafilter.com)
- Tax Basics for Startups: Setting Up Your Books (entrepreneur.com)
- What goes into a business plan? (e27.sg)