Depending on what type of business you’re in – perhaps you sell jam, rope, or expertise (perhaps all three!) – your chart of accounts that Xero presents you with when you fire it up for the first time is vital to keeping your bookkeeping, tax accounting, payroll and other financial records organised properly – especially when tax season approaches.
The biggest mistake many businesses make with Xero cloud accounting is not setting up their chart of accounts properly. Getting this wrong can compound errors and take an accountant or bookkeeper many hours to fix – which costs you more in the long run.
What is a chart of accounts?
A chart of accounts is a list of financial accounts set up by an accountant so a bookkeeper can follow the transactions in a general ledger. In essence, it sets up a template so accountants, bookkeepers, and people inside the business can agree on what things are called so they can better interpret their profit and loss statements.
For example, a tradesperson may classify their Xero monthly subscription as a “subscription” whereas a bookkeeper may classify it as “software” or “digital services.” The chart of accounts is like an index of what expenditures (and income) go where which both the business owner and bookkeeper agree on right from the beginning.
Xero gives business owners or financial controllers a default chart of accounts. Some expenditure labels are useful, such as payroll or GST. However, when it comes to the more granular categories of expenses, having mismatches due to varying interpretations of what goes where can get confusing.
For example, “research and development” at an electronics business are completely different to the “research and development” at a PR company, which may involve staff training or purchasing trade magazines (again, a kind of subscription!)
Having this clearly labelled helps when interpreting your profit and loss statement.
How charts of accounts helps profit and loss statements
Your profit and loss statement gives you a snapshot of your business’s overall health – and having a robust and in-depth chart of accounts gives you more accurate and meaningful reporting.
An e-commerce business may need to split its postage and materials into separate account categories, to get a better understanding of how it can make inroads into increasing cost-efficiency. E-commerce businesses that send parcels overseas may want to split their postage and freight costs into domestic and international accounts.
Another mistake is getting too granular, and ending up with a chart of accounts for sub-sub-categories that doesn’t really help your business understand its income or expenses – and creates more headaches for you, your bookkeeper and your financial controller!
Fortunately, many charts of accounts are similar (if not boilerplate) for certain industries. A hair salon may have a similar (but not identical) chart of accounts to a nail salon; an electrician’s chart of accounts may overlap with a plumber, and so on.
The point of setting it up correctly is to avoid confusion and misunderstandings later as the business matures.