Your chart of accounts (COA) is the list of all the accounts in your accounting software. The accounts that are all listed in your reports. And their totals allow you to evaluate how much has been spent, made, own or owe, depending on the type of account.
Create such a list of accounts will help you make better business decisions. You need to design your chart of accounts as per your requirements. Every time you record a business transaction—a new bank loan, an invoice from one of your clients, a laptop for the office—you have to record it in the right account.
But how do you know which account to record it in? The chart of accounts will tell you.
Below, we’ll go over what a chart of accounts is, how it looks, and why it’s so important for your business.
What is Chart of Accounts
Chart of Accounts (COA) is a list of all your organization’s accounts, together in one place, where its day to day operational expenses are recorded. Then these accounts are used to give you a birds-eye view of every area of your business that spends or makes money. The information is aggregated to help in the preparation of four basic financial statements and other reports.
For easier identification of accounts, these accounts are, further, assigned with a specific number and name in the software used by the business. All accounting software can be modified according to the company’s requirements. So, businesses operating in different industries may have different looking charts of accounts. The chart of accounts for a major airline will have references to “aircraft parts” than your graphic designing agency. The chart of accounts should give anyone who is going through the listing all the accounts involved in your company’s day-to-day operations will get a rough idea about the nature of your business.
The main types of accounts are Revenue, Expenses, Assets, Liabilities, and Equity.
Chart of accounts sample
Below’s a sample chart of accounts list. This one is quite small as it was for sample purposes only. There could be more accounts in your bookkeeping services, though.
Types of Chart of Accounts
There are three types of COA, viz
- Operating Chart of Accounts: They are used to post expenses (or income) done on a daily basis. The operating accounts in the Chart of Accounts could be either expense or revenue accounts, and the data is administered by Finance as well as Controlling modules.
- Group Chart of Accounts: The list of accounts used by an entire corporate group. They help in generating reports at the corporate level.
- Country-specific chart of accounts: This helps meet country-specific legal requirements.
Balance sheet accounts
These are named the “balance sheet” accounts because they are used to create a balance sheet for your business, which is one of the most common financial statements. And very useful too. There are three further types of balance sheet accounts:
- Asset accounts record all resources your company owns that add or are of value to your business. They can be physical assets like land, equipment, furniture, and cash, or intangible like patents, trademark registration, and software.
- Liability accounts are a record of all the debts the company owes. They usually have the word “payable” in their name—accounts payable, wages payable, invoices payable. “Unearned revenues” are also a kind of liability account—usually cash payments that were received before services are delivered.
- Equity accounts are a little more complex. They represent what’s left of the business once the company’s liabilities are subtracted from its assets. They basically measure the company’s valuation and are of good use to its owner or shareholders.
Income statement accounts
The income statement accounts are used to generate the other significant financial statement: the income statement.
- Revenue accounts track all income that the business earns from the renting or sale of goods, services.
- Expense accounts are all of the resources and money spent in the process of generating revenues, i.e. wages, utilities, and rent.
The way that the balance sheet and income statement accounts affect each other is complex, but a general rule to remember is that all revenues develop your company’s equity and asset accounts, while expenses reduce your assets and equity.
How to make Chart of Accounts
There are three factors to hold when rebooting a chart of accounts:
- The number of “bins,” or accounts.
- Defining clearly what goes into each bin.
- The way the bins are organized.
Here are the steps to address each one of these points and boost your chart of accounts to clear gain the financial visibility your company needs.
1. GAAP and tax
Most small businesses initially set up their bookkeeping services to suit their taxation accounting. As the business grows, GAAP-based financial reports are needed for various associates, such as banks, investors, and agencies like bonding companies. Often, GAAP-based financial reports are the end of the progression.
But there is another step in between. That is managerial accounting. This is where you create financial reports with the information you want to and must-see. Tax and audit CPAs adjust the financial to fit their purposes anyway. While your goal, as the owner, is financial reports that provide the metrics you need to run the operation.
Some accountants recommend adhering to the GAAP-oriented chart of accounts and generating management-oriented financials through custom reports. These custom reports shuffle together numbers from different sections of the COA to get the financial statement layout that the management is looking for.
That approach works as long as there is a custom reporting capability. Without it, however, tax and audit CPAs would have much trouble in converting your management-oriented COA into their format.
It makes sense to ensure that they can conveniently incorporate any special accounts they need into your remodeled chart of accounts.
2. Gross margin
Gross margin is the gross profit arrived at after subtracting direct costs from sales. What are “direct costs” now? Direct labor and direct materials are always direct costs. Beyond that, the definition becomes vague.
For instance, under GAAP, a fixed cost like Depreciation of equipment would be a direct cost for a manufacturer. However, for an entity operating as a service provider, such fixed costs should ideally be kept out of gross margin, and stick to the changes in sales volume only.
Say the depreciation is $50 per month and sales are $500 per month, depreciation is 10% of sales. If sales rise to $1,000 one month, depreciation is still $50 and is now only 5% of sales. In such a case, sales—not production efficiency or better estimating—have changed gross margin. This can be misleading, especially if production supervisors are compensated based on margin metrics.
So how to avoid it? Direct costs on the managerial financial statements should remain the same as the costs to be considered while quoting or pricing calculations. If you tend to only consider direct labor and direct materials when tendering for a new project or setting prices, then those should be the only direct costs shown on your financials. You’ll know at a glance if the targeted gross margin is being achieved.
Otherwise, if indirect items like depreciation and supplies are to be included in your quotes, then these should be also be included while calculating gross margin on your financial reports.
Not every business employs gross margin. Certain industries, such as advertising or consulting, run most of the costs together, under the broad category of operating expenses. In such entities, you won’t need to separate costs between direct/indirect and operating, and there will be no gross margin on the financials.
3. Indirect Costs
Indirect costs are overhead expenses that relate directly to business yet cannot be traced directly to a specific sale, product, or job. Examples may be machinery repairs, factory supervisor wages, incidental supplies (e.g., tape, glue, screws), shop building insurance, etc. Expenses such as tax preparation fees, marketing, and legal expenses are generally not included in indirect costs but are considered operating or general/admin expenses.
Mostly metrics such as labor hours and estimate a rate per labor hour that “uses up” these indirect costs over a month or a year, are chosen by the businesses. We take a simple manufacturer for example, who in a month had $1,000 of manufacturing supplies and $1,000 of shop repairs, so a total of $2,000 of indirect expenses. The production department operated for 200 hours during that month. So, the company decides to allocate indirect costs to future projects at a rate of $10 per hour ($2,000 total costs/200 shop labor hours).
As each hour of labor cost is posted to the operations, this budgeted indirect cost of $10 per hour is also automatically considered. Now, if the productions operated for 300 hours, $3,000 (300 x $10 per hour) of the indirect expense will be posted in the project module and the financial statements.
Unlike direct costs, the $3,000 is a project costing entry that did not get paid out in cash. Accordingly, the offset will not bring finances, just a -$3,000 entry to an Indirect Expenses-Applied account.
In a well-formatted chart of accounts, that offset account is typically arranged with the accounts that receive the actual supplies and repairs expense. This way as the actual supplies and repairs total $2,700 for the month, it shall also be visible that indirect cost was overapplied to projects ($3,000 applied, compared to the actual $2,700).
4. Operating expenses
There are many ways to organize data. For instance, Meals Expense might be a standalone account or spread across different departments the meals relate to, such as Marketing, Conferences, or Travel.
There isn’t a set way, but the chart of accounts must display what the end-users want to see. It will be a managerial decision on how they want to treat expenses like meals or technology subscriptions.
As an aside, for US companies subject to IRS tax regulations, meals are an example where you may want to provide an employee with a stand-alone total amount at year-end. If you choose to spread Meals across different departments, you’ll still want to keep them in discrete accounts within each department.
So, in the chart of accounts, the budget, and management preferences all must align in an efficient accounting system.
5. Account numbers
Account numbers are a kind of filing system. Five-digit base account numbers work well (four for a simple small setup). A good mode would be to use the 10000s for asset accounts, 20000s for liabilities, 29000s for equity, 30000s for sales, 40000s-50000s for direct and indirect costs, 60000-70000s for operating overheads, and 80000-90000s for non-operations accounts such as taxes and interest.
Thoughtfully spread out and leave room for growth. For instance, if the main Business Checking account is 10000, the Payroll Checking account may be kept 10100. 11000 for Accounts Receivable (commonly the next asset category). This skip leaves 10200, 10300, etc. for future cash and checking accounts, and you have the entire 11000 group for other receivable accounts (e.g., employee or intercompany receivables).
For income and expense accounts, major-minor arrangements are recommended to enable simultaneous summary and detailed reporting. For instance, imagine a technology company with three revenue streams. The major-level account for Sales would be 30000 Sales. But no transactions would be posted to that account. Under it would be the minor-accounts, say 31000 Sales-Web Design, 32000 Sales-Server Management, and 33000 Sales-Hardware.
Try to avoid more than 2 or 3 levels of child accounts. For instance, 31000 Sales-Web Design could further be broken into 33100 Sales-Digital marketing and 33200 Sales-Content. Content could be further broken out in 33210 Copyright and 33220 Blogs. Now any further detailing would make things get more complicated, it may be more harm than help. It is generally better to have too much detail and keep it short.
Also, keep numbers and descriptions consistent. Align direct cost account numbers with their corresponding sales account numbers. The consistency would also make sense to non-accountants.
6. Month-end entries
Good month-end financial reports are made accurate with large non-cash journal entries. For instance, say wages earned from February 18-28 are paid on March 7, a journal entry must be posted to move that March 7 cash expense to February 28, to make February financials accurate.
If the amount in the ledger entry is mixed in with the regular wage expense accounts, it’ll be difficult to see how much wage expense relates to cash payments and how much is accrued. Similar is true for complex book entries that adjust work in progress (WIP) values, or over/under billings entries at businesses that work on multi-month projects.
There must be separate accounts for such entries. You might have a parent account for Direct Labor and child accounts for, say, Production Labor, Change in Accrued Labor, & Change in WIP Labor.
7. Optimize Accounting Software
One of the benefits of the chart of accounts is that the useful life of even entry-level accounting software can be prolonged. Often issues in financial reporting can be fixed by modifying the chart of accounts, rather than going through the very painful process of installing a new one.
The chart of accounts should be structured in a way to maximize the ability of the software.
Since good financial reporting involves maintaining the chart of accounts well, it is also important to consider the financial reporting capability of the software when setting up or redoing the chart of accounts. So if the software does not allow a rearrangement of the order of the bookkeeping services on the financial statements, the order of chart of accounts would need a properly thought-out event.
Importance of Chart of Accounts
Unless you and your employees have a great memory and remember the name of every single account in the ledger, it’s good to have all of them laid out in a table like a sample. The chart of accounts is designed to map-out different financial parts of your business. The most important accounts of the business would stand out in a well-designed chart of accounts, ideally. So that it is convenient to review which transactions get recorded in which account. Easier reviews would enable you in making better decisions, give you an objective snapshot of your company’s financial health. Easier also to follow financial reporting standards.
The following practices can improve the chart of accounts concept for a company:
- Modifying: The rules for adjusting your chart of accounts are simple. You can add accounts at any time of the year, but it would be better to wait until the end of the year to delete old accounts. If an account is deleted in the middle of the year, it might plunder your books.
- Consistency: It is better to initially create a chart of accounts that is unlikely to change for several years, so that the results in the same account can be compared over a multi-year period. If you start with a smaller number of accounts and later expand the number of accounts with time, it would be difficult to get comparable information for more than the past year.
- Lock down: Don’t allow subsidiaries to change the standard chart of accounts without a sound reason because having different versions in use would make consolidation of the results of the business quite complex.
- Size reduction: Regularly review the list of accounts to check if any accounts have relatively insignificant amounts. If so, and if this information is not vital to special reports, shut down these accounts and roll the stored information into a single larger account. Doing this periodically would keep the number of accounts down to a manageable level.
If you acquire another business, shifting the acquiree’s chart of accounts into the parent company’s chart of accounts becomes a huge task. But necessary to be able to present consolidated financial results.
Chart of account has significant use for any organization because it is designed to systemically segregate all the Assets, Liabilities, and Income & Expenditure of the business. And makes the management of accounts easier. Investors and other stakeholders can understand and analyze the financial status that helps them to make better decisions.
Chart of account also helps for a quicker recording of all transactions in books of account because each account and its features are clearly mentioned in the chart. At the same time, the chart of account must be prepared in line with the requirements of the business. Accounts must be correctly linked with ledgers and financial statements else the results will be disastrous.
Small businesses, such as proprietorships may not have much requirement for a Charts of account, unless the business processes, etc. are too complex or have many stages. Because this requires the cost of accounting software and skilled manpower.
If you are running a small business and need skillful handling of accounts but can’t afford the costs of maintaining skilled accountants and software, get connected with AutoFilings. Get the services of expert professionals at the most affordable costs.
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Frequently Asked Questions
But if you want to track travel meals by water, drinks, foods, snacks, and a few more sub-categories, then that is stretching it. These are too many sub-categories, and not reasonable either. Too much detailing in the sub-accounts will just clutter up your Chart of Accounts and reports.