1.07 – Outlining Your Financial Road Map Using a Chart of Accounts
The Chart of Accounts is like a financial road map for organizing business transactions. Before you can record any transaction, you need to know where to place it, and this chart helps you do just that. It’s a list of all the accounts a business uses, each with a description detailing the type of account and the transactions to be entered. Each business tailors its Chart of Accounts to fit its operations, so no two are exactly alike.
Basic Structure and Organization
Despite the differences, some common characteristics are shared by all Charts of Accounts. They are structured around two main financial reports: the balance sheet, which shows what the business owns and owes, and the income statement, which shows the revenue and expenses of the business.
The Chart of Accounts starts with balance sheet accounts, which include:
- Current Assets: Accounts for items the company owns and expects to use within the next 12 months, such as cash, accounts receivable, and inventory.
- Long-term Assets: Accounts for items the company owns with a lifespan longer than 12 months, like buildings, furniture, and equipment.
- Current Liabilities: Accounts for debts the company needs to pay within the next 12 months, such as accounts payable, interest payable, and credit cards payable.
- Long-term Liabilities: Accounts for debts due after more than 12 months, such as mortgages payable and bonds payable.
- Equity: Accounts for tracking the owners’ claims against the company’s assets, including investments, withdrawals, and reinvested earnings.
The income statement accounts come next and include:
- Revenue: Accounts for tracking sales of goods and services and other sources of revenue.
- Cost of Goods Sold: Accounts for tracking the direct costs of selling goods or services.
- Expenses: Accounts for tracking operating expenses that are not directly tied to sales.
Developing Your Chart of Accounts
When setting up the Chart of Accounts, start by listing all the asset accounts, followed by liability accounts, equity accounts, revenue accounts, and finally, expense accounts. These accounts form the basis of the balance sheet and the income statement.
Here’s an example structure:
Balance Sheet Accounts:
- Current Assets: Cash, Accounts Receivable, Inventory
- Long-term Assets: Buildings, Furniture, Equipment
- Current Liabilities: Accounts Payable, Interest Payable, Credit Cards Payable
- Long-term Liabilities: Mortgages Payable, Bonds Payable
- Equity: Owner's Investment, Retained Earnings
Income Statement Accounts:
- Revenue: Sales Revenue, Service Revenue
- Cost of Goods Sold: Direct Materials, Direct Labor
- Expenses: Rent, Utilities, Salaries, Marketing
Customizing Your Chart of Accounts
The Chart of Accounts should be customized to fit the specific needs of your business. It serves as a crucial money-management tool, helping you track transactions and make informed business decisions. It’s common to tweak the accounts annually and add new ones as needed for more detailed tracking. However, it’s best to avoid deleting accounts until the end of the 12-month reporting period.
Practical Tips
- Regular Updates: Review and update your Chart of Accounts periodically to ensure it meets your business needs.
- Detailed Descriptions: Provide clear descriptions for each account to avoid confusion.
- Consistency: Maintain consistency in naming conventions and account categorization.
By organizing your financial transactions with a well-structured Chart of Accounts, you can gain valuable insights into your business’s financial health and make smarter financial decisions.
