What is a Chart of Accounts?

Bookkeeping is often one of the most troublesome aspects of self-employment. Many business owners would rather spend their time doing anything else, so it often gets put on the back burner - until tax time arrives and you realize it’s been on fire for months.

To avoid annual bookkeeping regrets each April, it’s best to establish solid systems and practices from the start. One critical step in that direction is to set up and dial in your chart of accounts.

Let’s explore what you should know about the document, including what it is, how it works, and how it can benefit your business.

What is a Chart of Accounts?

A chart of accounts (COA) is a comprehensive list of the accounts in your bookkeeping system. It includes every account you’ve ever used in your business’s financial statements, such as your balance sheet and profit and loss (P&L) statement.

In practice, the COA is a tool that helps you keep your financial records organized. For example, it’s often helpful to reference when recording recent business activities and can streamline the data entry process.

With a COA, you can look up your previously used accounts and use them to categorize new transactions. Not only is that easier than constantly coming up with new categories, but it also gives your financial records some much-needed consistency.

For example, say you purchase $500 of paper, folders, and printer ink, but you’re not sure how to classify each expense. You consult your COA and learn you’ve used a single office supplies expense account for all three in the past, so you record them as such.

Without a COA, you might unnecessarily create a new expense account for printer ink. Later, if you want to figure out how much you’ve spent on printer ink, you’d have to pull the information from two different accounts - if you even noticed the issue.

Without a chart of accounts, these problems accumulate over time, eventually resulting in messy financial statements that are so challenging to read that they’re no longer useful.

How Does a Chart of Accounts Work?

Traditionally, a chart of accounts separates your financial accounts into five primary categories, which are the fundamental building blocks of all balance sheets and P&L statements. They include the following:

• Assets: These are your company's economically valuable resources. Examples include cash, equipment, and goodwill. They are on the top half of the balance sheet.

• Liabilities: These are all the debts your business owes to third parties, such as accounts payable, business loans, and credit card balances. They go on the bottom half of the balance sheet.

• Equity: These represent the difference between your assets and liabilities, and include accounts like retained earnings and owner contributions. They go on the bottom half of the balance sheet with your liabilities.

• Revenues: These accounts refer to your company’s gross income from various sources, such as your proceeds from selling goods or services. They go at the top of the profit and loss statement.

• Expenses: Lastly, these are the various costs your company incurs, such as the cost of goods sold, direct labor, or professional service fees. They go below revenue on the profit and loss statement.

The chart of accounts typically presents accounts in the same order as the list above, with balance sheet accounts first and P&L accounts afterward. Traditionally, they’re also numbered in a way that makes it easy to identify each account’s type at a glance.

For example, you might assign all asset accounts a four-digit identifier that starts with 1. Meanwhile, all liabilities get one that starts with 2, and so forth.

Chart of Accounts Example

The format of a chart of accounts can vary between businesses, as there’s no one way to structure the document. Most accounting solutions let you add more or less detail to each line item according to your preferences.

That said, you should at least include each account’s number, name, and type. Many also opt to include which financial statement it belongs to, though that’s optional.

Here’s an example:

Who Needs a Chart of Accounts?

While a chart of accounts is never a bad thing to have, they're most helpful for businesses with complex financial statements. The more diverse your transactions and the more accounts you need to track, the more beneficial a COA becomes.

Meanwhile, business owners who run relatively straightforward operations and have little need for complex accounting systems can often get by without a chart of accounts. In such cases, creating one might not be worth the effort.

For example, a manufacturer who needs to keep track of every nut, bolt, and screw that goes into their products might set up a detailed chart of accounts that breaks down their cost of goods sold into many sub-accounts.

Meanwhile, a hairstylist whose only expenses are salon rent, styling supplies, and payment processing fees can probably get away without having one at all.

How to Set Up a Chart of Accounts

As we mentioned above, a chart of accounts might not be strictly necessary during the early stages of your business’s growth. Not only are your financial statements likely to have few moving parts, but you may also be on a tight budget.

In that case, Excel is an affordable, tried-and-true bookkeeping solution that works well for many small businesses. Creating a chart of accounts in Excel is as simple as completing the following steps:

• Open a new blank spreadsheet

• Create a table with a column for each detail you want to track (name, type, financial statement, etc.)

• Add a row for each account you want to include in your accounting system

Consider including a “Description” column that explains what each account is and what it contains in a little more detail. That’s particularly helpful in a spreadsheet-based system where you can’t drill down into an account’s history by clicking on it.

As your business’s finances become more complex, it often makes sense to invest in automated accounting software, especially since the cost is tax-deductible. Most modern tools can generate a COA for you, though they’ll only include generic accounts that are common among most businesses.

You or your bookkeeper will need to tailor your chart of accounts to your industry, company, and preferences. That process may look a little different depending on the software you use, but it should be intuitive.

Most tools work just like an Excel spreadsheet, letting you add, delete, or modify rows and columns the same way. However, changes automatically flow through to the rest of your accounting system, updating your financial statements and general ledger.

Chart of Accounts Best Practices

While you’re always free to make adjustments after setting up your chart of accounts, it’s not something you want to do carelessly. When you change things, it becomes harder to analyze your financial results over time.

Comparing your current balance sheet and P&L statement to those of previous years is an essential part of financial planning, and the more you mess with your chart of accounts, the more difficult that becomes.

In addition to maintaining consistency when possible, another good practice is to limit unnecessary detail and only document what’s significant. When there’s no reason to have multiple accounts, combine them and err on the side of simplicity.

For example, you might want sub-accounts for every advertising strategy you use to help determine which provides the greatest return on investment. However, you might lump water, gas, and electric costs into one utility expense account because there’s no benefit to tracking them separately.

Combine Accounting Software With Found

Accounting software is so convenient and affordable that it’s all but required for sophisticated businesses. However, you need a separate business bank account to make the most of it. Using the same bank account for personal and business activities is a sure-fire recipe for cluttered and confusing financial records.

If you’re in the market for a business bank account, Found can help. Our all-in-one business banking platform is built with one goal in mind: making self-employment easier. In fact, it can also double as accounting software, boasting a suite of tools designed to lessen the burden of bookkeeping and accounting.

For example, Found can automatically categorize your expenses, generate a P&L statement, and estimate your tax liability, then set aside the funds you need to cover your quarterly estimated tax payments.

Found can also transfer your activities to Schedule C and grant your accountant access to your data, making it easy to collaborate with a Certified Public Accountant or tax expert. Get started with Found for free today!

Disclaimer: The information on this website is not intended to provide, and should not be relied on, for tax advice.

FAQ

What is a Chart of Accounts?

A chart of accounts is a comprehensive list of the accounts used in your financial statements. Its primary function is to help keep your financial records organized and consistent from year to year.

Chart of Accounts vs General Ledger: What’s the Difference? 

The chart of accounts is closely related to the general ledger (GL), but they’re separate documents. The COA merely lists all of your accounts, while the GL details every transaction that’s impacted them in the selected date range and the subsequent balance.

What is the Standard Chart of Accounts Numbering?

The standard chart of accounts numbering uses the same first digit for all accounts of the same type. For example, asset accounts might start with 1, liability accounts with 2, equity accounts with 3, and so on.

In addition, they’re generally presented in the same order they appear on the financial statements: asset, liability, equity, revenue, and then expense accounts.

Why Create the Chart of Accounts?

If your financial situation is complex enough that there are too many accounts to track in your head, you should create a chart of accounts to help keep your financial statements organized and consistent.

However, if your operation’s finances are relatively simple, there may not be a need. Ultimately, only you or your accountant can determine when it makes sense.