Setting up your chart of accounts to reflect business operations allows you to easily identify the performance of all areas. Let me give you an example. A customer asked me to review their profit and loss statement. On this statement, they had one single line for income: Consultancy, $2 million. Nice! Underneath the lonely income line were many lines of expenses — and expenses had been broken down to such detail I knew they had spent $300 on office flowers that year. Fortunately, the customer’s invoices were very detailed, so it was an easy exercise of defining different types of income accounts, reallocating them to invoices and — ta da! — the owners now had details of the different income streams generated by the business.
Knowing the different ways the business was making money highlighted which streams were the strongest — for example, the owners could now identify that a steady stream of income was being generated from a support contract with a customer who was guaranteed a 48-hour response time. They promoted this support-style contract to other customers and — you guessed it — a few took them up. This generated additional regular income for the business, with minimal extra effort on their behalf.
Working out how account types affect your reports
Each element of the chart of accounts, known as a general ledger account, is allocated an account type, and the account type that’s allocated affects how the information is grouped on financial reports. Figure 2-5 shows where the different account types are grouped on two popular reports: The Profit and Loss Statement, and the Balance Sheet.
Source: Xero 2022
FIGURE 2-5: How account types are grouped on your reports.
Depending on how you set up your accounts, not a lot of difference may exist between some of the account types. Fixed Assets and Non-Current Assets, for example, could be deemed the same. Or you could have Fixed Assets defined as representing an asset with a medium life span and Non-Current Assets as an asset with a long life span.
The following sections provide a guide to the different account types. Grab a pad and pencil and, as you read through the lists, jot down how they apply to your own business, decide your interpretation and stay consistent.
Assets
Assets cover the following:
Current Assets: Items owned by the business for fewer than 12 months — for example, accounts receivable, and inventory. If Xero is integrated with an inventory management solution, opt to set up the inventory against a current asset type rather than an inventory-type asset. This gives you more flexibility; for example, it allows you to create a manual journal against the account. Inventory may reflect the value of raw materials, work-in-process goods and completely finished goods.
Inventory: The value of tracked inventory items on hand.
Prepayments: Payments made in advance — for example, rent paid in advance.
Bank Accounts: Accounts held at financial institutions. This includes credit card accounts, which would typically be classified as a current liability; however, in order to activate a bank feed, a credit card account needs to be classified as a bank account in Xero. Using Report Layouts customisation, you can list the credit card account with the Current Liabilities on your balance sheet (see Chapter 9 for more on customising your reports).
Fixed Assets: Assets owned by the business for between one and five years — for example, computer equipment.
Non-Current Assets: Owned by the business for over a year — for example, motor vehicles, office equipment, furniture and fittings.
Liabilities
Liabilities cover the following:
Current Liabilities: Monies owed by the business, to be paid back within 12 months — for example, accounts payable.
Liabilities: Monies owed by the business, to be paid back within one to five years — for example, car loans.
Non-Current Liabilities: Monies owed by the business, to be paid back after a year — for example, a mortgage on the building premises.
Equity
Equity covers the net worth of the business to the owner. As seen on the Balance Sheet, this is the assets minus the liabilities.
Revenue
Revenue covers the following:
Revenue: Income other than sales.
Sales: Monies earned from business operations.
Other Income: Income not related to the operations of the income — for example, bank interest.
See the section ‘Developing your own chart of accounts’, later in this chapter, for more on how different income streams can be reflected in revenue accounts within your Xero Chart of Accounts.
Expenses
Expenses covers the following:
Direct costs: Costs incurred in providing goods or services, inclusive of freight — for example, purchase of stock.
Expenses: Costs associated with running the business — for example, telephone charges.
Depreciation: The allocation of the value of capital assets to expenses, over the life of the assets — for example, depreciation on cars owned by the business.
Overheads: Fixed costs associated with running the business — for example, rent.
See the following section for more on how direct costs relating to specific income streams can be reflected in expense accounts within your Chart of Accounts in Xero.
Creating a chart of accounts that works for you
By taking the time to define what you want to know, you can easily generate useful information. Account types, excluding bank, credit card and online payment methods, can be altered at any time. So if you have been working with a file and realise you should make some changes, you can!
This section covers some points you can take into consideration when developing a suitable chart of accounts for your business.
Measure what matters
Think about the kind of information you need to help you understand how the business is performing and so improve your decision-making process. Can you easily identify specific income streams and the direct costs of products or services you provide relating to these separate income streams? This information allows you to identify gross profit per product or service on the fly. Understanding what area of your business is more profitable (and perhaps what area isn’t bringing in the cash) makes it easier to decide where energies and such costs as advertising budgets should be focused.
Keep it simple
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