As a business owner, you have to record every transaction that your business is involved in, ranging from loans to a paid invoice from a customer. A chart of accounts will help you identify the correct account to record a transaction in. Keep reading our guide to what a chart of accounts is, how it works, its different parts, and why it is useful.
What is a chart of accounts?
Put simply, a chart of accounts refers to a list of your company's financial accounts in the general ledger. The chart is a helpful organizational tool, providing you with an overview of all the financial transactions undertaken by your business. It shows the effectiveness of different areas of your business and allows you to have a solid oversight of all areas in your business that make or spend money.
Depending on the sector your company operates in, your chart of accounts is likely to look different.
For example, if you are a theatre company, you may have one account for recording ticket sales, another for snack sales, and another for merchandise sales. By tracking revenue and expenses against these different accounts, you can montior the success of different business areas over time.
How do charts of accounts work?
Charts of accounts are a helpful way for a business to organize its finances. They can also be used to give shareholders or investors an insight into a company's financial health. The charts are broken up into different "accounts", for example, expenditures, revenue, assets, and liabilities.
When looking at a chart of accounts, the accounts will typically be shown in the same order they appear on a company's financial statements. Balance sheet accounts, including assets, liabilities, and shareholders' equity, are usually listed first. This is followed by income statements - revenues and expenses.
These broader categories can have several sub-categories. Assets, for example, can have subcategories like prepaid expenses, accounts receivable, inventory, marketable securities, and allowance for doubtful accounts. Liabilities can, for example, include accounts payable, notes payable, taxes payable, and accrued liabilities.
Structuring your chart of accounts
As a business, you can decide to structure your chart of accounts so that revenue and expenses are categorized according to business function, product line, or company division. How you do this is up to you as different strategies will be more useful for different business owners.
For identification purposes, every account is attributed with an identification code, description, and name. This is particularly relevant for larger companies, as their charts of accounts can get quite complicated. For a large company, a chart of accounts can include over 1,000 different accounts.
Why is a chart of accounts important?
- Provides you with an overview of your business and how the different financial parts are performing.
- Provides you with a clear picture of your company's financial health.
- Provides shareholders and potential investors with a good overview of your business finances.
- Provides you with input to make well-informed decisions on e.g. investment, hiring, or the development of a new product.
- Provides you with an easy tool to help follow financial reporting standards.
Different parts of a chart of accounts
- Assets: This refers to any resource your company owns that provides value. Assets include both tangible assets (e.g. land, equipment, cash) and intangible assets (e.g. patents, trademarks, software).
- Liabilities: This refers to all debt your company owes. Liability accounts are usually referred to as "payable" (e.g. invoices payable, accounts payable, or wages payable).
- Shareholder's equity: This refers to share capital plus retained earnings and represents the residual value of assets minus liabilities.
- Revenues: This refers to any income your company generates through goods and services or rent.
- Expenditure: This refers to all the money and resources and spent by your company in the process of creating revenue (e.g. utilities, salaries).
Assets - subcategories
- Prepaid expenses: This refers to any future expenses that have been paid in advance.
- Accounts receivable: This refers to any monies you are owed by clients for goods or services you have provided in the past.
- Inventory: This refers to the total amount of recorded value of your company's inventory.
- Marketable securities: This describes a company's financial assets to be sold or converted to cash within a year (e.g. bough or sold at an exchange).
- Allowance for doubtful accounts: This refers to an estimate of the amount of accounts receivable that will not be paid by customers.
Liabilities - subcategories
- Accounts payable: This refers to the funds your company owes to other entities. They are a short-term liability on your balance sheet.
- Notes payable: This refers to the face amount of the promissory notes (= a written promise to pay an amount of money by a specified date) that your company has issued.
- Taxes payable: This refers the total amount of tax payments a company owes.
- Accrued liabilities: This refers to expenses incurred by the end of an accounting period that have not been paid or recorded in a company's general ledger.
Example of chart of accounts
You will find a variety of charts of accounts examples online. This can provide you with a better feel for what a chart should look like. We have also included an example of a chart of accounts below:
Improving your chart of accounts
In order to use your chart of accounts efficiently, it is advisable to pick accounts that will not change for a couple of years. This allows you to compare results over time. You can also streamline your chart of accounts by taking out those that hold data of little importance. This stops your chart from becoming too large and unmanageable.