Key Takeaways
- A chart of accounts lists all the general ledger accounts that entries can be classified under in an accounting system, and it helps to ensure accurate financial statements.
- Property and fund accounting software is typically shipped with a standard chart of accounts, but users are encouraged to tailor the chart of accounts to reflect the nature of the business and portfolio.
- Customizing the chart of accounts to meet the needs of your private equity real estate or property management business can mitigate key risks, improve the quality of financial reporting, reduce stress leading up to tax filings, and accommodate future growth.
Among middle market private equity commercial real estate firms and property management companies, it is common to use specialized accounting software to maintain property and operating company records. While purchasing this software is a step in the right direction, users often overlook the importance of customizing the chart of accounts included with the accounting software to address their specific business and reporting needs.
Why the Chart of Accounts Matters in Commercial Real Estate
A chart of accounts is a list of all the general ledger accounts that are available to book entries against in an accounting system. In many respects, it’s the most important component of the accounting system because it helps to ensure financial reporting accuracy and it governs how financial statements are displayed to readers.
Many of our middle market private equity commercial real estate clients rely on specialized accounting software to maintain property and operating company records, and these software products are shipped with a standard chart of accounts. This means the general ledger accounts available to the software user are limited to basic and generic options. This presents a problem because every property, portfolio, and operating company is unique, and the essence of the business or asset can’t be captured by relying on an out-of-the-box chart of accounts.
The Risks of Relying on an Out-of-the-Box Chart of Accounts
When we partner with a new client, we usually find that they have been relying on the default chart of accounts included with the software, and we discover that transactions have been classified under GL accounts that don’t accurately reflect the nature of the transactions. To further muddy the situation, many users of property accounting software make one-off additions and adjustments to the chart of accounts without considering future ramifications. Over time, this leaves many real estate investment firms and property management companies with disorganized and difficult to read financial statements.
A poorly designed chart of accounts poses some of the most underappreciated risks in real estate fund and syndication operations. The primary risk is inaccurate financial reporting. An example of this is when the chart of accounts results in non-operating expenses displaying “above the line,” which results in an artificially low net operating income (NOI).
Another common risk relates to the incorrect classification of operating expenses as capital expenditures, or vice versa. This becomes especially problematic during tax season when the syndication or fund sponsor must present accurate figures to the accountant responsible for preparing K-1s. Delivering K-1s with inaccurate information is a serious liability, and taking on a reclassification project in the weeks leading up to a filing deadline is resource intensive, costly, and exposes the sponsor to additional risks.
How We Tailor the Chart of Accounts to Fit Your Business and Portfolio
When we partner with a new client, one of the first steps we take is to review the existing charts of accounts across all the client’s accounting systems. We evaluate where each one meets the client’s needs, where it falls short, and we consider how the client’s business, portfolio, and reporting requirements might evolve in the future. Based on this assessment, we redesign the chart of accounts to meet the client’s needs.
We focus on adding general ledger accounts that allow for accurate transaction classifications, which ensures that financial statements present the right level of detail. Additionally, we design the chart of accounts with future growth in mind, allowing for the addition of new accounts as the business expands.
The Benefits of a Customized Chart of Accounts
Designing and implementing a customized chart of accounts is a significant undertaking, but the benefits can be substantial.
First, a well-designed chart of accounts helps to ensure that our private equity and property management clients can share accurate and easy-to-read financials with external stakeholders. In the world of private equity commercial real estate, sponsors may be contractually obligated to produce monthly, quarterly, or annual reporting for investors or lenders. Failing to produce financial statements on time or issuing inaccurate figures can pose serious risks to the business. A tailored chart of accounts, combined with proper controller oversight, can ensure that transactions are classified accurately and that financial statements can be compiled and shared in a timely manner.
Second, classifying transactions using a thoughtfully designed chart of accounts can be very helpful when tax season rolls around. Producing K-1s with inaccurate information and delivering them late in the year are two issues that many funds, syndications, and property managers struggle with. A thoughtfully-designed chart of accounts helps to mitigate the risk of reporting incorrect figures, and it can reduce the time required to gather financial information for the tax preparer.
The Risks Involved in Redesigning a Chart of Accounts
Several of our clients have reported previous failed attempts to design and implement tailored charts of accounts. In most cases, they took on the project without consulting with a fund administrator or an accountant, and in some cases, they hired a generalist bookkeeper to undertake the redesign project. Unfortunately, these sponsors were left in challenging situations where an incomplete or inadequate chart of accounts made it exceedingly difficult to accurately classify transactions and produce financial reporting.
These approaches tend to fail because designing a chart of accounts for a commercial real estate investment firm or property management company requires experience with private equity deals as well as accounting concepts. Our firm brings a unique advantage because our team possesses a strong accounting background and a deep understanding of private equity commercial real estate deal structures and transactions. Taken together, this allows us to design charts of accounts that meet the needs of our clients.
Final Thoughts
While the chart of accounts may seem like a minor component, it has a significant impact on financial reporting, tax filings, and portfolio expansion. By taking the time to customize and optimize the chart of accounts, sponsors and property managers can mitigate key risks and gain the trust of investors, lenders, and other stakeholders.
Lexcraft Advisors is a fund administration provider that serves middle market real estate investment funds and syndications, typically with equity under management between $15 million and $100 million. Our team takes pride in providing general partners with reliable fund administration solutions often reserved for large, global investment firms. To learn more about our services, schedule a complimentary meeting with one of our Managing Partners.