In the case that your company needs to retrieve a specific dollar amount from a 12-month-old invoice, what would you do? There might be a moment of panic before you begin sorting through paperwork. And to find the exact number, you might have to sift through months’ worth of invoices. In the worst-case scenario, discovering that your file system was disorganized will set you up for failure. Some documents may even be missing.
In other words, the process could be quite hectic in the absence of a chart of accounts. With the chart of accounts, you can categorize every transaction in your business. That will allow you to see how your business spends and makes money. It can be anything from a new bank loan to a client’s invoice or a company’s receipt for a new computer.
It doesn’t matter what type of business you operate ― a chart of accounts is necessary.
Let’s break down what a chart of accounts is, how it works and how it can help your business succeed.
What Is a Chart of Accounts?
A chart of accounts is a directory of all accounts in an accounting system’s general ledger. Basically, it’s a list of accounts with titles and numbers, and in it, you can see how every aspect of your business generates revenue.
The charts of accounts of different business types will look different. A major airline’s chart of accounts will contain a considerably higher number of references to aircraft parts than your local pizza place’s. Even though small businesses will have fewer accounts to track, the COA will still prove valuable for quick overviews of their finances.
Having a chart of accounts that lists all of the accounts involved in the day-to-day operations of your organization gives anybody who looks at it a good understanding of your business. Charts of accounts generally list the account type, balance, and identification code for each account, along with the description. Your chart of accounts shows how your business is performing financially by clearly separating earnings, expenditures, assets, and liabilities.
The following account numbering system is commonly used by most businesses:
- Assets: 1000 – 1900
- Liabilities: 2000 – 2900
- Equity: 3000 – 3900
- Revenue: 4000 – 4900
- Expenses: 5000 – 5900
While it’s not necessary to follow that format, most businesses use the same numbering system for their chart of accounts so that an accountant or bookkeeper can easily summarize the data.
Components of a COA
Charts of accounts usually have four columns in accounting:
1. Account Number
Account numbers are unique codes assigned to each account. It shows how the COA is numbered. Account numbers with 120 indicate that the account belongs to a certain asset class. Using this number, a person can find out more information about the account.
2. Account Type
Depending on the type of account, each account has its own characteristics. Assets, liabilities, equity, income, and expenses are the five primary types of accounts. However, it can be reduced to four in small companies and to more than five in large companies.
- Assets: Assets include fixed, intangible, and Inventory and current assets, such as cash and trade receivables. The account number for all assets accounts starts with 1.
- Liabilities: COA liabilities include short-term and long-term borrowings, trade payables, interest payables, and other current obligations. The account number for all liability accounts starts with 2.
- Equity: Share capital, preference shares, and reserve & surplus are all considered equity. The account number for all equity accounts starts with 3.
Equities, liabilities, and assets are all part of the balance sheet.
- Revenue: Revenue includes sales revenue, interest income, scrap income, and other earnings. Revenue accounts all begin with a 4 as the account number.
- Expenses: COA expenses include the cost of goods sold, electricity, rent, salaries, and wages. Each expense account has a number that starts with 5.
Revenues and expenses are related to the income statement.
3. Account Description
The account description identifies the account name. Ideally, account descriptions should be concise but allow for the inclusion of several relevant accounts. For example, “cash receivables” will be listed under the asset type.
4. Financial Statement
The financial statement affected by the accounts is listed in this column. Balance sheet changes are reflected in the assets-liabilities and equity accounts, while income statement changes are reflected in the income statement accounts.
How does a chart of accounts work?
Charts of accounts are based on double-entry accounting principles. Practically speaking, this means:
Let’s say you buy an employee a new PC for $500. The $500 would be debited from the appropriate Asset Account (Cash in this case) and credited to the appropriate Asset Account (Computers in this case). That keeps the chart of accounts balanced.
On your financial statements, accounts appear according to how they appear in a chart of accounts. A company’s assets, liabilities, and shareholders’ equity appear first on its balance sheet, followed by its revenue and expenses on its income statement.
These broad categories will likely have a significant number of subcategories within your chart of accounts. As an example, assets can consist of the following subaccounts:
- Accumulated depreciation
- Accounts receivable
- Allowance for doubtful accounts
- Fixed assets
- Prepaid expenses
- Petty Cash
- Marketable securities
There are also sub-accounts for liabilities, such as
- Accounts payable
- Accrued Liabilities
- Notes payable
- Wages payable
- Taxes payable
The following subaccounts may make up shareholders’ equity:
- Common stock
- Preferred stock
- Retained earnings
Similarly, you may choose to categorize revenue and expenses according to business functions, product lines, or company divisions in your chart of accounts.
For very large companies, a chart of accounts can get very complex, making it difficult to locate specific accounts. There may be thousands of individual financial accounts in a chart of accounts for an international corporation with multiple divisions.
Example Chart of Accounts
The following chart of accounts represents the financial statements of a fictional SaaS company:
|Account Number||Account Type||Account Description||Account Statement|
|Accounts payable||Balance Sheet
|Liabilities||Credit cards||Balance Sheet
|Wages Expenses||Income Statement|
|Payroll Tax Expenses
Why Is a Chart of Accounts Important?
A chart of accounts organizes complex financial data and breaks it into simple, logical categories for your business. All the important financial reports for your business are based on this foundation. Despite its organizational purpose, a chart of accounts is more than just a tool for keeping track of finances. You can gain important insights into your business’s performance by seeing how all your financial data relates to one another. Your business can benefit from a chart of accounts in the following ways:
(1) Earnings Understanding
You can gain a great deal of insight into the revenue of your business from a chart of accounts. Not only does it tell you how much money you make, but it also shows you how many spikes there are in your income and how long your cash flow should last as a result of your monthly expenses.
(2) Debt Management
Having a chart of accounts makes it easy to see the amount owed, whether it’s short-term or long-term. You can develop longer-term debt repayment plans using your chart of accounts by determining the amount of monthly income you can budget for debt repayment.
(3) Spend Smarter
The chart of accounts can provide an important insight into your spending habits, although it may not always be fun to see where your money goes. With a budget, you can manage your recurring expenses, such as utilities, rent, and internet. It may be possible to reduce costs by looking at your other expenses as well.
(4) Make Your Reports Better
Using a chart of accounts, you can organize all of your finances in one place. In-depth financial reports, such as cash flow statements, balance sheets, and income statements, are easier to develop when your chart of accounts is accurate.
(5) File Taxes
Tax season is simplified when your chart of accounts is properly organized. Using a chart of accounts, you’ll be able to keep track of your business income and expenses to report them on your income tax return.
Should You Hire a Bookkeeper or Accountant to Create Your COA?
It is not difficult to create your COA by yourself. Initially, you need to decide how your COA will be structured, what type of accounts it will have, and how it will be numbered. The general ledger account’s name can provide you with this information. Customizing your firm’s COA will allow you to include all expenses so you can see where the money is going. But, the chart should adhere to standard accounting standards.
However, even if you are a small organization or a small business entity, it is impossible to take care of your bookkeeping and accounting on your own. And for a small business owner, every second counts. Later or sooner, you will need to hire a bookkeeper or accountant to take care of your accounts and financial ledgers. Rather than spending your time crunching numbers, try a solution that frees you up to do what you love instead.
It’s a Wrap
An organized, descriptive COA can help bookkeepers, accountants, and financial managers make informed business decisions based on relevant, accurate, and timely data.
Although most business processes are one-size-fits-all, the COA can be adjusted to enable a more accurate view of your organization’s revenues and expenses.
If you need help with your company’s chart of accounts, EcomBalance can help. At EcomBalance, we provide accounting and bookkeeping services and help your team chase invoice payments automatically, reducing the amount of paperwork they need to do.
Ready to manage your records better? Schedule a call with us today!
EcomBalance is a monthly bookkeeping service for eCommerce companies. EcomBalance handles your bookkeeping and sends you a Profit and Loss Statement, Balance Sheet, and Cash Flow Statement by the 15th of each month. EcomBalance also has a sister company, AccountsBalance, that caters to agencies, software companies, coaches, and other online companies.