Last updated by
Charles Hall
on
December 2, 2024
The foundation for accounting is the chart of accounts, the method an organization uses to group financial transactions into categories such as assets, liabilities, equity, revenue and expenses.
The foundation for accounting is the chart of accounts, the method an organization uses to group financial transactions into categories such as assets, liabilities, equity, revenue and expenses.
Every structure requires a solid foundation to prevent it from collapsing under pressure. Your business is no different and relies on accounting as the foundation for its support and stability.
Think of it like your personal budgeting system. When you buy food, the amount goes into the food category. When you buy gas for the car, the amount goes in the transportation category. An organization does the same thing, it tracks all monetary payments by recording them in specific categories.
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Table of contents
The chart of accounts is the detailed list of categories, defined by an organization, to track financial transactions. The chart of accounts can have as many categories as necessary and is unique to each organization.
There is a basic structure to the chart of accounts, which most organizations follow.
Categories start broad and are then broken down into subcategories defined by each organization.
You will notice that the broad categories and subcategories essentially match the categories of the balance sheet and income statement. Hence the chart of accounts is the foundation for accounting. All reports and financial information are derived from the chart of accounts.
The best way to understand a chart of accounts is to see an example. Below is an example of a small business chart of accounts. Some of the accounts have been deleted in an effort to shrink the size for demonstration. However, you can download a free chart of accounts template to see the full chart.
Click here to download an actual example that you can use and modify to fit your particular organization.
Keep scrolling and we will discuss each aspect of the chart of accounts so you can get a full understanding.
Most chart of accounts include an account number for each defined category.
Account 1001 is Cash – Bank Account
Account 1003 is Cash – PayPal
The number system is useful for several reasons. First, it is much easier to reference a category by number rather than by name. Second, it allows like categories to be grouped and sorted together and organized in a more logical manner.
The numbering scheme used in the chart of accounts example above is a very simple numbering scheme very effective for small business. Larger organizations often have more detailed numbers to break categories into divisions or geographical areas.
There is also meaning to the numbering scheme. Typically blocks of numbers are associated with the broad categories. You can go to any company and typically find the following breakdown of numbers
1xxx – Assets
2xxx – Liabilities
3xxx – Equity
4xxx – Sales
5xxx – Cost of Goods Sold
6xxx – 8xxx – Expenses
9xxx – Non operating type revenue or expense
The last thing to mention is inserting numbers. Let’s assume you have 2 bank accounts. Bank accounts are assets which fall under the 1xxx sequence. To keep the bank accounts together each account should be assigned a number sequentially. The primary bank account is 1001, so in this example you could insert another bank account as 1002 Cash – Secondary Bank Account.
Useful Tip: When setting up a chart of accounts it is helpful to leave gaps between account numbers in the event you have to add a similar account down the road.
This is the account name or description which is important as it really tells you what is contained in that category.
The description should be brief and concise as they will be used on reports. The descriptions used above are fairly standard descriptions and work for most organizations.
Column 3 lists the broad category the account fits into. So, in essence this is showing what broader categories the detailed accounts will be grouped in as the numbers are consolidated on say the balance sheet or the income statement.
For example, look at accounts:
1530 Furniture and Fixtures
1540 Office Equipment
1560 Leasehold Improvements
1599 Accumulated Depreciation
Each of these accounts relate to fixed assets and therefore get grouped together with all fixed asset accounts.
When reporting it doesn’t make sense to show all the details, so by creating broad categories reports can be condensed. It is also important because the 5 broad categories of financial statements: Assets, Liabilities, Equity, Revenue, Expenses are all different and unique and need to be handled as such.
Column 4 is just another level of classification. It is more classified than the account number level, but less classified than the broad level. Looking at the expenses is a good way to understand this detailed type classification.
5805 Travel – Air/Auto
5807 Travel – Gas Receipts
5810 Travel – Lodging
All of these accounts relate to travel. Their broad category is an expense, but within the expense category they are grouped as travel. If you were to look at the income statement you would see a line item for travel. So, the Detail Type classification is the breakdown you will see on the financial statements.
Establishing a chart of accounts is the first thing you need to do when establishing an accounting system. As a new business, it may seem a little daunting. It really isn’t. The best approach is to use a template and then customize it for your business. You can add, delete or change any number, description, type or type detail to arrive at your chart of accounts. Download a FREE chart of accounts template here.
The chart of accounts builds the foundation for all accounting records and reports. It organizes the financial information into a basic form that can then be used to provide usable financial information.
Without the chart of accounts, financial data becomes meaningless and unusable because it is unorganized.
The chart of accounts groups all financial information into one of 5 categories: Assets, Liabilities, Equity, Revenue and Expense.
Yes, you can adjust the chart of accounts anytime you need.
You may find as your business starts growing that you need a second bank account, just add it. You may find you are spending money on contract labor rather than payroll and you need to keep track of the amounts, just add a contract labor account.
Useful Tip: While you can change the chart of accounts at any time, it is recommended you keep it as consistent as possible. Consistency in the categories creates consistency in reporting. If categories are always changing it becomes hard to compare and analyze to prior periods.
If you need help setting up your chart of accounts don’t hesitate to reach out to one of our expert accountants who can guide you through the process.
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