The DNA of Your Accounting System

Tue, Feb 19, 2019 at 10:50AM

Lee Rust, Owner, Florida Corporate Finance

I would never recommend finding a comfortable chair, sitting down, and reading the white pages of the telephone book. There are, however, some business chores that approach the tedium of that exercise but are important nevertheless. One of those is a periodic review and revision, or perhaps even a complete rewrite, of your code of accounts. That code is the DNA of your accounting software. It determines how your financial statements will be presented, what line items are shown, what sub-accounts are used to create those line items, and how much underlying detail is available for each revenue, expense, asset, and liability line on your financial statements.

Because concise, timely, and accurate financial statements should be one of your principal corporate control tools, how your financial statements are compiled and presented is of vital importance. Your code of accounts is the foundation for that presentation. The format for those codes is established by your accounting software. Usually the codes are four to eight or more digits which can be either all numerical or alphanumeric. In any case, a single code is assigned to each accounting item you want to capture as a separate piece of financial information.

How the individual codes are handled, subtotaled, and totaled will also be established by your accounting software. Your software manual, another excruciatingly boring piece of reading, will determine how you compose the account codes to accumulate data that will total to a single line item on your statements. It will also tell you how to have a specific code become a line on your income statement or balance sheet. If your accounting software is adequate, it will also allow you to investigate any single line item, see the underlying codes and related dollar amounts that total to that line, and continue to drill down to individual invoices or other revenue, expense, or additional accounting data.

Start a review of your code of accounts with a review of your monthly financial statements in their current format. You should look at each line item to determine whether it is important enough to be shown separately. I’ve had clients managing companies with annual sales exceeding $20 million and found line items on their financial statements which totaled less than $75 per year. Those lines did not provide any valuable control information and should have been combined as one element of a more appropriate category or line item.

I’ve also had clients with fifty or more line items in their General & Administrative accounts but only a single line for revenues and another for direct cost or cost of goods sold. Ask yourself which is more important to track, understand, and control: the cost of postage or manufacturing labor and material costs. The answer should be obvious.

The first line or lines of your income statement show your company’s revenue. Those revenue items should be divided into appropriate control categories with a single account code and line item for each. If, for instance, you produce or sell several different product lines, you should have a revenue line item for each. If you sell similar products into several different markets, you should have a revenue line for each of those markets. Determine what revenue categories you should track over time and make sure each has a separate account code and is shown as a separate line on your income statement.

Next, consider your direct cost or cost of goods sold. If you are a manufacturer, those direct costs should include line items for production labor, raw material purchases, and factory overhead. If your company is only a distributor, your direct costs might include separate lines for each category of purchased goods for resale.

By the way, in regard to labor costs, either direct or G&A, I always like to show only a total that includes all payroll taxes, employee benefit costs, and workers’ compensation premiums. In regard to labor, your primary concern is the total cost of employing the staff necessary to perform each company function, not the amount of FUTA tax you incurred. If you need to study such underlying details, an appropriate code of accounts and accounting software should allow you to expand any labor cost line to show its individual components.

Of course, the difference between your total revenues and direct costs defines your company’s gross profits, perhaps your most important single accounting item and the one that most closely relates to your company’s ability to generate profits. A single revenue line and a single direct cost line are not sufficient to monitor, track, and control gross profits.

Some companies should have three direct cost line items, some should have six, and some should also capture various indirect production costs. You use your code of accounts to make those distinctions and format your financial statements for maximum utility.

In that regard, you should be careful to capture as individual line items only those G&A or operating expenses necessary for a summary presentation. For instance, I frequently recommend an “Occupancy Cost” line item that includes facility rent, all utility expense, janitorial expense, landscaping costs, and property taxes. If you need to see those subcategories, your code of accounts and accounting software should allow you to expand the Occupancy Costs line to show those items.

Once you determine what line items on your income statement and balance sheet are important, you can then review your code of accounts, usually with your accounting manager, to determine how the individual codes should be structured to produce the statements that will have the greatest utility. When establishing your individual codes, it’s a good idea to leave plenty of unused numbers. Over time, you may find that you need to add a code to a subtotal or even add a line item to your financial statements. If an appropriate code number is not available, that can be a difficult task.

In addition, changing code numbers can also be difficult depending upon your accounting software and how it both formats and uses the code of accounts. For that reason, it is often best to review your code of accounts near the end of your fiscal year and make all changes on the first day of the new year.

In addition to formatting your financial statements for ease of review, tracking, and control, your code of accounts review will also tell you whether your accounting software is appropriate. If that software will not show each line item as a percent of revenues, it is not adequate. Those percentages allow you to track changes in a way that dollar amounts only cannot.

I recently reviewed the financial statements for a product sales and distribution client and recommended format and line item changes for his income statement and balance sheet together with explanatory notes. If you would like to have a copy of that review, just let me know. I’ll be glad to e-mail it to you. Meanwhile, think about your financial statements and how they are used. Your code of accounts may need some adjustment.

FRM

Lee Rust, owner of Florida Corporate Finance, specializes in Mergers & Acquisitions, Corporate Sales, Strategic Planning, Financing and Operations Audits. He can be reached by phone at 407-841-5676 or by email at hleerust@att.net.


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