May 30, 2023
Every business transaction, such as a new bank loan, an invoice from a client, or a new laptop for the office, must be recorded in the appropriate account.
However, how can you determine which account to record it in? That’s where the Chart of Accounts comes in.
In the following sections, we will discuss the Chart of Accounts, its structure, and its importance for your company.
What does a “Chart of Accounts” entail?
An organized list of all the “accounts” for your business is called a Chart of Accounts. It gives you a great view of every part of your company that generates or spends money. Revenue, Expenditure, Assets, Liabilities, and Equity are the primary account types.
Depending on the industry, a company’s Chart of Accounts may appear somewhat different. There will be many more references to “auto parts” in the Chart of Accounts of a major automobile manufacturer than at your neighborhood little cafe.
The purpose of a Chart of Accounts is to provide an overview of your company’s activities by detailing all the accounts used in the daily operations of the company.
Example of a Chart of Accounts
Take a look at the list below as an example of a Chart of Accounts. This one is for a made-up company called Gina Dentistry.
Chart of Accounts
On the right of the above figure, you will see that each account corresponds to either one of the financial statements, either on a balance sheet or on the profit and loss statement. Let’s see what it means.
Accounts on the Balance Sheet
These are the accounts that define your “Balance Sheet,” since we need them in order to draft one of the most important financial statements for your company. The following are three basic categories of accounts in a balance sheet:
Assets accounts keep track of all of your business’s resources that add value. They can be tangible assets, such as cash, land, and equipment, while software, patents, and trademarks are examples of intangible assets.
Liability accounts are a list of all the debts owed by your business. Accounts payable, wages payable, and payables are all common names for liability accounts that contain the word “payable.” Another type of liability account, called “Unearned Revenues,” represents payments that your business has received in advance of providing services.
Equity accounts are somewhat more complex. They reflect what remains of the company after deducting all of its liabilities from its assets. In essence, they determine the company’s financial worth to its owner or shareholders.
Accounts on the profit and loss statement
The profit and loss statement is the second most important type of financial statement, and it is constructed using the data from profit and loss accounts.
Revenue accounts record all income your company receives from sales of services, rent, or products.
Expense accounts record all of the costs incurred in the production of income, such as rent, utilities, and payroll.
The relationship between the accounts on the balance sheet and the income statement is intricate, but a simple rule to keep in mind is that revenue will increase the equity and asset accounts while expenses will decrease them.
In reference to the account numbers
You can also see that a five-digit account number precedes each account in Gina Dentistry’s Chart of Accounts. Each account’s first digit indicates which of the five main account types it falls under; for example, an account with the number “1” is an asset account, “2” is a liability account, “3” is an equity account, and so on.
In the days of paper, you had to select and arrange these account numbers manually. These days, however, accounting software has dramatically simplified the process of automatically assigning them for you, so you won’t even need to worry about choosing account numbers.
Why the importance of a Chart of Accounts?
Without a clear overview of each account in front of you, you may struggle to stay on top of important information, so you must have a complete list of accounts visible. This way, you don’t have to try to remember each account by name. Having an organized, map-like overview of your accounts enables quick identification, tracking, and maintenance.
The purpose of the Chart of Accounts is to serve as a visual plan of your company’s financial structure.
A well-structured Chart of Accounts will categorize the company’s most crucial accounts and clearly identify where transactions should be posted.
It should help you comply with financial reporting standards, provide you with a clearer picture of the financial health of your business, and allow you to make more informed business decisions.
How to Make Changes to Your Chart of Accounts
It’s relatively easy to make changes to your Chart of Accounts, and you can add accounts at any time during the year. However, hold off on deleting the ones you no longer need until the end of the year. Your books could be messed up if accounts are deleted in the middle of the year.
Assume for a moment Gina, halfway through the year, discovers that her company is spending significantly more money on composites than necessary because her intern has been making mistakes by adding too much water to the resin.
Gina could choose to create a specific account for the composite rather than include it in the “Supplies” expense account.
The first step in this process would be to create a new expense account for “Composite” in the Chart of Accounts.
After creating the new “Composite” account, she would make a journal entry to transfer all of the composite charges from the “Supplies” account.
Assuming she had previously reached a total of $3,000 on composite spending, the corresponding journal entry would read as follows:
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