A Startup’s Chart of Accounts

Building a business requires accounting for the funds flowing in and out of it. Honestly, it is one of those necessary evils that few entrepreneurs want to spend time on even though it is essential.

Startup Accounting Essentials

As a startup founder, if you plan to raise money from investors, banks, or other sources, it makes sense to set up your accounting system the right way from the beginning. What that means is:

1. Follow the GAAP (Generally Accepted Accounting Principles) accrual accounting standard. While there are other accounting methods (Cash, Modified Cash, etc.), this is what investors, banks, and vendors will expect to see. If you start with a different method, you will likely find that transitioning from one method to another can create rework or discontinuities in your records.
   
   
2. Use widely accepted accounting software such as Quickbooks Online. This makes it easy to get help since accounting experts will be familiar with it. Unlike tracking expenses in a spreadsheet or bank account, specialized accounting software follows many accounting conventions and produces commonly understood accounting records and reports.
   
   
3. Consider investing in expert assistance to set up your accounting system properly from the beginning. Mistakes made in the setup can cause real headaches later on. Often, it will only require a few hours from a contract accountant to get you started in the right direction. Plus, they can usually provide a cost-effective range of support in the early days, from providing bookkeeping services to just reviewing your bookkeeping entries to ensure you are applying the GAAP standards correctly and helping properly resolve any specialized issues that crop up.

Customizing Your Chart of Accounts

As part of setting up your startup’s accounting system, you will establish a “chart of accounts, ” essentially the “buckets” in which different transactions will be recorded. Examples would be balance sheet accounts like current assets such as bank accounts, liabilities such as loans, and equity accounts like common stock and preferred stock, as well as income statement accounts like various revenue and expense categories. A number of these accounts are standard for capturing the essential financial elements of a business. Such standard accounts will likely be generated as part of setting up your company in your accounting software – and this is where your contract accountant can help you tailor those accounts to fit.

However, in addition to the standard accounts, you should invest some time into thoughtful customization so that your accounting system can help provide meaningful reports to both your management team and your investors. Discuss the following with your expert accountant to find the right balance between standard and customized to fit. Here are some examples of areas that I have often found get customized:

• Revenue:  While all businesses will ultimately have revenue, often it is helpful to capture some sub-categories that reflect the nature of the business itself. For example, it might be useful to differentiate instrument revenue from consumable revenue. Similarly, it might be helpful to distinguish different major market segments, such as segment A revenue from segment B revenue from segment C revenue (insert appropriate segments for your business but do not go too crazy. Just enough to demonstrate how different major segments are growing year to year). Furthermore, you could distinguish SAAS recurring revenue from one-time implementation revenue. The key is to pick only the most critical dimensions for your business that you want to track over extended periods.
  
  
• Cost of Goods/Service Sold:  A critical and commonly used financial performance metric is gross margin, which indicates the portion of a company’s revenue that is left after direct costs of generating that revenue are subtracted, expressed as a percentage of revenue. While GAAP accounting standards have some rules about what needs to be included in the direct costs, it is often appropriate to have some accounts set up to capture the major components to enable an analysis of the relative proportion of the direct costs. For example, you might distinguish materials and labor. You might want to break out consumables, subcontractor work, product labeling and packaging, or other categories. You might also want to track direct costs by product type or category. This comes down to giving you some granularity so that you can identify areas to focus on for improvement. For your financial statements, you will likely summarize them at a higher level.
  
  
• Expenses: Indirect expenses associated with running the business, but not directly related to producing your product will fall below the gross profit and will be subdivided. Examples include office, payroll, research and development, travel, and other purchases. It is often helpful to take these broad categories and collect expenses within different business functions such as marketing and sales, product development, operations, and general/administrative. You can subdivide payroll, for example, by assigning different employees to different departments in your accounting system. Similarly, you can capture travel, computer, and training expenses by department. I prefer to do this because, as a business grows, you will have functional managers responsible for the work completed by their functional departments. By capturing functional breakdowns, your accounting system will be able to track expenses by function, which allows for the creation of function-based budgets and will highlight where you are investing company resources. A little up-front thoughtfulness about what the significant functions in your business will be as you grow can enable you to start capturing that information early, and that can empower your management efforts.   

The Big Picture

As you think about how to set up your chart of accounts, remember that your accounting system is only one of your management systems. You will have other systems for tracking physical assets, intellectual property, detailed inventory, software source code, regulatory approvals, and other aspects of your business. In addition, your accounting system tracks current transactions and provides historical reports. You will need a different method for developing forward-looking financial models like forecasts and budgets. However, there is undoubtedly value in ensuring alignment between your forward-looking financial systems and your historical accounting records and financial reports.

What all this means is that your accounting system should not be trying to be an all-singing, all-dancing, do-everything system. You need to strike a balance between capturing enough detail with some reasonable summaries while not over-burdening your system with too much granularity such that the costs outweigh the management benefits.

Hopefully, this post will give you some dimensions to consider as you get your startup’s accounting systems established – one of the earlier responsibilities of an aspiring entrepreneur.  

Congratulations! You made it through what my reviewer/editor said was my most boring blog post ever – although I would suggest that the subject is essential to startup management, even if it isn’t the most exciting topic to contemplate.