What is a Chart of Accounts?
The Chart of Accounts is a listing of all accounts that form part of a company's accounting system.
Therefore, it forms the foundation of a company’s financial record keeping system.
Depending on the size of the company, the chart of accounts may include a few dozen accounts or a few thousand.
Understanding the Chart of Accounts
A well designed Chart of Accounts provides a logical structure that facilitates the addition of new accounts and deletion of old ones.
If you are a Bookkeeper or an accountant who has been assigned the task to prepare an initial Chart of Accounts you will need to determine the following information.
- The type of Business a company is in and the type of transactions that take place in the Business.
- The information that will be required to prepare Financial Statements and Tax Returns.
- The amount of detail that the company management would need to prepare internal reports.
A companies Organizational Chart can be of big help and provide an outline and a roadmap for the entire process.
The Chart of accounts is divided into two parts - The Balance Sheet Accounts followed by the Income Statement Accounts.
The Balance Sheet Accounts break down into the following three categories:
1. Assets - These accounts are used to track what the business owns. Assets include cash, furniture, buildings, vehicles etc.
2. Liabilities - These accounts are used to track what the business owes such as Suppliers to be paid and Outstanding Debt.
3. Equity- These accounts track what the owners put into the business and the claims the owners have against the assets.
After listing all the Balance Sheet accounts, the Chart of Accounts continues with the Income Statement accounts which are broadly divided into two categories
1. Revenue Accounts - Revenue Accounts keep track of the money coming into the Business.
2. Expense Accounts - In most organizations, the Expense accounts make up the longest list of individual accounts in the Chart of Accounts. They include all the accounts that track all money that a Business spends to keep running.
Each of the above Categories is then further broken down into sub categories.
An example of breaking down the above Categories into Sub Categories is given below
Current Assets, Long Term Assets, Intangible Assets
Current Liabilities, Long Term Liabilities
Common Stock, Retained Earnings, Capital, Drawings
Sales, Sales Discounts, Sales Returns
Cost of Sales
Purchases, Purchase Discounts, Purchase Returns, Freight Charges, Other Sales Costs.
Advertising, Rent, Bank Charges, Insurance, Legal Fees, Accounting Fees Salaries, Supplies, Travel, Taxes, Telephone Charges, Utilities, Vehicles.
Setting Up the Chart of Accounts
A Standard chart of accounts takes the above Main Categories and Sub Categories and breaks them down into a numerical system.
Each Main category begins with a certain number, and then the sub-categories within that Main category will all begin with the same number.
For example, if assets are classified by numbers starting with the digit 1, then all Current and Long Term Assets will start with the number 1.
Such as Cash might be labeled 101, accounts receivable might be labeled 102, Prepaid Rent might be labeled 103, and so on.
And if liabilities accounts are classified by numbers starting with the digit 2, then accounts payable might be labeled 201, Insurance Payable might be labeled 202 and so on.
Lets illustrate this with an Example
The following numbering system would be similar to that of a small to mid sized business.
The Sub Categories of the Main Categories would then be as follows -
Short Term Investments
Accumulated Depreciation- Automobiles
Legal Fees Payable
Long Term Lease Liability
Long Term Notes Payable
Paid in Capital in excess of par value, common stock
Unrealized Gains - Equity
Unrealized Loss - Equity
Revenue from Product 1
Revenue from Product 2
Revenue from Product 3
Service Revenue 1
Service Revenue 2
Service Revenue 3
Office Supplies Expense
Bad Debts Expense
Cleaning Services Expense
Travel and Entertainment Expense
General & Administrative Expense
Depreciation Expense - Furniture
Depreciation Expense - Automobiles
The numbering system is used to make organization and recordkeeping easier.
A Note to Accountants
In bigger companies, if you are setting up the chart of accounts manually, make sure to leave a lot of room between accounts to add new accounts. For Example, number your Cash in Checking account 1000 and your accounts Receivable account 1100. This leaves a lot of room to add other accounts to track cash.
The Account numbers can also be five or more digits in length as the size of the company grows with each digit representing a division of the company, the department, the type of account, etc.
For example, if a company has ten departments (production, marketing, human resources etc.) you may need more accounts for each department to track the revenue and expenses of each department and you may need more digits.
Adding and Removing Accounts from the Chart of Accounts
Accounts can be added or deleted by way of adjusting entries at anytime during the year.
If a new account is being created to track transactions separately that once appeared in another account, you must move the transactions already in the books to the new account.
Best Practices for creating and maintaining a Chart of Accounts
1. Planning is the key to success.
It is important to initially plan ahead and create a chart of accounts that is unlikely to change for several years, so that you can compare the results in the same account over a multi-year periods.
If you start with a small number of accounts and then exponentially expand the number of accounts over time, it becomes very difficult to obtain reliable comparable financial information from year after year.
Once set, be careful to only allow changes in the standard chart of accounts with a very good reason, since having many versions in use makes it more difficult to consolidate the results of the business.
2. Keep the Chart of Accounts Manageable
Bigger companies can have thousands of accounts.
Periodically review the account list to see if any accounts contain relatively immaterial amounts. If so, and if this information is not needed for special reports, shut down these accounts and roll the stored information into a larger account. Doing this periodically keeps the number of accounts down to a manageable level.
3. Keep the relevant people informed
After you are done with the list of accounts, make sure to distribute the list to any employees that may use it. Even employees that are not involved in the bookkeeping function my need a copy of the chart of accounts if they code invoices or other transactions.
If you acquire another company, a key task is shifting the acquiree's chart of accounts into the parent company's chart of accounts, so that you can present consolidated financial results. This process is known as mapping the acquiree's information into the parent's chart of accounts.
Technology and the Chart of Accounts
Based on the sophistication of the company, the chart of accounts can be paper-based or computer based.
In computerized accounting systems - many of the software companies provide a standard chart of accounts customized to suit different types of businesses.
Therefore, Accountants just have to build on these and do not have to start from scratch in these situations.
The chart of accounts lists the accounts that are available for recording transactions. In keeping with the double entry system of accounting, a minimum of two accounts is needed for every transaction with at least one account being debited and at least one account being credited.
When a transaction is entered into a company's accounting software, it is common for the software to prompt for only one account name—this is because the software is programmed to automatically assign one of the accounts. For example, when using accounting software to write a check, the software automatically reduces the asset account cash and prompts you to designate the other account(s) such as Rent Expense, Advertising Expense Etc.
If you are new to accounting the next thing I would read about would be an Introduction to Bookkeeping.
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