The Massively Important Key to Accounting Most Companies Miss
A great majority of small to medium-sized companies struggle with accounting and finance. Why?
The answer goes something like this:
The business isn’t big enough to justify a finance department led by a competent CFO or controller.
No one else in the company has the time or expertise to deal with accounting complexities and issues.
Which means, when the owner opens the profit and loss statement at 3pm Friday afternoon, it's a mess.
The balance sheet looks even worse.
The owner helplessly clicks into a few of the worst numbers, gets discouraged, and goes home.
Many entrepreneurs can identify, at least in part, with these points. Financial frustration is common.
Does it have to be this way? Is a business simply doomed if it cannot afford a $400,000 finance department?
No. It’s not doomed any more than it would be with a $400,000 finance department.
There is a little-known key to finding the middle-ground between frustration and a $400,000 finance team.
That key is:
A Well-Designed Chart of Accounts
Wait, what? I don’t even know what that is!
Don’t be embarrassed. You’re right there with 90% of the business universe. I continue to be amazed by how little attention is given to this absolutely foundational concept.
Understanding the power of the chart of accounts is the first key to leaving financial frustration behind.
Have you ever been to a repair shop that had a large organizer full of tiny drawers for different types of nuts and bolts? The chart of accounts is like that organizer, except the drawers hold transactions, not bolts.
If the repair shop simply threw all their nuts and bolts together in a mad, disorganized drawer, it would be a disaster. The mechanics would spend most of their working hours trying to find parts.
The same is true in accounting. Highly effective financial management derives from a well-organized and well-thought-out chart of accounts that reflects the company’s goals and strategy. A great chart of accounts isn't just a list, it's a vibrant manifesto of what's important to the company.
I cannot over-emphasize how the chart of accounts really is the foundation of financial management. It drives pretty much everything, including these three major pillars:
Clarity of financial reports.
Success of budgeting.
Accuracy of pricing.
Since this is such a massively important key, how much time do business leaders spend getting their chart of accounts right?
In my experience? Usually zero.
A Superior Chart of Accounts
While the fine details of developing a superior chart of accounts are well beyond the scope of a 900-word article, here are a few tips to point in you in the right direction.
Tip #1: Carefully divide your expenses between variable and fixed.
Variable expenses go up every time you produce one more product or provide one more hour of service. Examples include: production labor, job materials, and shipping expense. Examples of fixed costs include rent, insurance and property taxes.
This tip sounds easy until you sit down and actually try it. What about utilities? Sales commissions? Shop supervisor wages? Waste removal? Small tools and equipment?
For guidance on these, go to the next tip.
Tip #2: Match your variable expense accounts to your quoting/pricing process.
Let's say you quote jobs to customers by adding up materials, labor and delivery and applying a 40% markup. In that case, the cost of goods sold (variable expense) section of your chart of accounts should only have materials, labor and delivery.
That way you can see at a glance when you look at your income statement if you are achieving your desired quoting margin. This is a foundational principle almost 100% of small (and even big) companies get wrong.
Tip #3: Match your chart of accounts to your budget/projections. If your budget divides Travel expense into Travel-Boston, Travel-Miami and Travel-Seattle, then your chart of accounts should too. Otherwise it will be virtually impossible to track actual results against projections.
In fact, working backwards by first developing a budget (or projection) can be a great way to build the framework for a chart of accounts. It helps you realize which accounts you’d like to track, as well as which expenses are actually fixed.
Real Life Example
A few years ago, I met with a contractor in the Midwest whose chart of accounts and accounting records were a complete disaster. It was so bad they were considering starting fresh with a brand-new QuickBooks file.
To their credit, they had already developed a budget with the help of a coach. Those budget categories served as the base for the new chart of accounts. We added in a few of the hard-to-understand accounts that weren't on the budget, and before long, a shiny streamlined chart of accounts was ready for use.
Today this contractor has highly accurate financial information at their fingertips. The elegant income statement aligns with budget categories. Gross profit % on the income statement corresponds to target quoting margin.
In a relatively short amount of time they've moved from financial reporting chaos to the upper echelons of small business financial management.
They found the massively important key!
Be Your Own
The Massively Important Key to Accounting Most Companies Miss
A great majority of small to medium-sized companies struggle with accounting and finance. Why?
The answer goes something like this:
The business isn’t big enough to justify a finance department led by a competent CFO or controller.
No one else in the company has the time or expertise to deal with accounting complexities and issues.
Which means, when the owner opens the profit and loss statement at 3pm Friday afternoon, it's a mess.
The balance sheet looks even worse.
The owner helplessly clicks into a few of the worst numbers, gets discouraged, and goes home.
Many entrepreneurs can identify, at least in part, with these points. Financial frustration is common.
Does it have to be this way? Is a business simply doomed if it cannot afford a $400,000 finance department?
No. It’s not doomed any more than it would be with a $400,000 finance department.
There is a little-known key to finding the middle-ground between frustration and a $400,000 finance team.
That key is:
A Well-Designed Chart of Accounts
Wait, what? I don’t even know what that is!
Don’t be embarrassed. You’re right there with 90% of the business universe. I continue to be amazed by how little attention is given to this absolutely foundational concept.
Understanding the power of the chart of accounts is the first key to leaving financial frustration behind.
Have you ever been to a repair shop that had a large organizer full of tiny drawers for different types of nuts and bolts? The chart of accounts is like that organizer, except the drawers hold transactions, not bolts.
If the repair shop simply threw all their nuts and bolts together in a mad, disorganized drawer, it would be a disaster. The mechanics would spend most of their working hours trying to find parts.
The same is true in accounting. Highly effective financial management derives from a well-organized and well-thought-out chart of accounts that reflects the company’s goals and strategy. A great chart of accounts isn't just a list, it's a vibrant manifesto of what's important to the company.
I cannot over-emphasize how the chart of accounts really is the foundation of financial management. It drives pretty much everything, including these three major pillars:
Clarity of financial reports.
Success of budgeting.
Accuracy of pricing.
Since this is such a massively important key, how much time do business leaders spend getting their chart of accounts right?
In my experience? Usually zero.
A Superior Chart of Accounts
While the fine details of developing a superior chart of accounts are well beyond the scope of a 900-word article, here are a few tips to point in you in the right direction.
Tip #1: Carefully divide your expenses between variable and fixed.
Variable expenses go up every time you produce one more product or provide one more hour of service. Examples include: production labor, job materials, and shipping expense. Examples of fixed costs include rent, insurance and property taxes.
This tip sounds easy until you sit down and actually try it. What about utilities? Sales commissions? Shop supervisor wages? Waste removal? Small tools and equipment?
For guidance on these, go to the next tip.
Tip #2: Match your variable expense accounts to your quoting/pricing process.
Let's say you quote jobs to customers by adding up materials, labor and delivery and applying a 40% markup. In that case, the cost of goods sold (variable expense) section of your chart of accounts should only have materials, labor and delivery.
That way you can see at a glance when you look at your income statement if you are achieving your desired quoting margin. This is a foundational principle almost 100% of small (and even big) companies get wrong.
Tip #3: Match your chart of accounts to your budget/projections. If your budget divides Travel expense into Travel-Boston, Travel-Miami and Travel-Seattle, then your chart of accounts should too. Otherwise it will be virtually impossible to track actual results against projections.
In fact, working backwards by first developing a budget (or projection) can be a great way to build the framework for a chart of accounts. It helps you realize which accounts you’d like to track, as well as which expenses are actually fixed.
Real Life Example
A few years ago, I met with a contractor in the Midwest whose chart of accounts and accounting records were a complete disaster. It was so bad they were considering starting fresh with a brand-new QuickBooks file.
To their credit, they had already developed a budget with the help of a coach. Those budget categories served as the base for the new chart of accounts. We added in a few of the hard-to-understand accounts that weren't on the budget, and before long, a shiny streamlined chart of accounts was ready for use.
Today this contractor has highly accurate financial information at their fingertips. The elegant income statement aligns with budget categories. Gross profit % on the income statement corresponds to target quoting margin.
In a relatively short amount of time they've moved from financial reporting chaos to the upper echelons of small business financial management.
They found the massively important key!
Scott Hoover, CPA
About The Author:
Scott lives in Wisconsin with his wife Priscilla and their active family of eight children.
He has worked as a CPA and part-time CFO for over a decade, and draws on this experience to provide practical, down-to-earth guidance to his clients.
In addition to his CPA day job, he and his family have a small farm where they raise calves and produce. In his "spare" time, Scott enjoys writing articles on finance and faith.
Send any comments or feedback directly to scott@beyourowncfo.com.
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