Understanding how money moves within a business can be a challenge, but it’s an essential part of ensuring a company is healthy and headed toward its financial goals.
Today, with only 40% of American small businesses making money, focusing on profitability is vital, and without a chart of accounts, your business will almost certainly struggle to find success.
What is a Chart of Accounts?
A chart of accounts is a list of financial accounts in the general ledger of an organization. Because a chart of accounts collectively represents the organization’s entire financial activity, it can contain thousands of different versions.
What Does a Chart of Accounts Look Like?
In a chart of accounts, accounts are first placed into one of five categories: Assets, liabilities, equity, revenue, and expense. From there, accounts can be assigned to subcategories.
For example, Liabilities may also be broken down into Notes Payable, Accounts Payable, and Accrued Liabilities, while Notes Payable can be broken down even further into Mortgage, Line of Credit, and Car Loan.
Generally, each account within the chart has two unique identifiers: account number and account name. This is what a simplified chart of accounts for a small business might look like:
1. ASSET ACCOUNTS
101 – Cash
101.01 – Checking
101.02 – Savings
120 – Accounts Receivable
140 – Inventory
170 – Land
175 – Buildings
176 – Office Building
177 – Warehouse
185 – A/D Buildings
186 – A/D Office Building
187 – A/D Warehouse
180 – Equipment
183 – A/D Equipment
2. LIABILITY ACCOUNTS
200 – Accounts Payable
210 – Unearned Revenue
230 – Payroll Tax Liability
3. EQUITY ACCOUNTS
300 – Owners Equity
300.01 – Casey Smith
300.02 – Jessie Rosen
310 – Common Stock
4. REVENUE ACCOUNTS
400 – Service Revenues
405 – Product Sales
5. EXPENSE ACCOUNTS
500 – Wages Expense
501.01 – Employee Salaries
510.01 – Contractor Wages
520 – Rent Expense
550 – Supplies
600 – Utilities
600.01 – Gas
600.02 – Electric
750 – Depreciation
Why is a Chart of Accounts Important?
A chart of accounts is the backbone of your entire financial system. Without it, you would have no general ledger and no finances to speak of; you would be operating blindly. The chart of accounts and general ledger are necessities in tracking your financial activity. If your chart of accounts is organized well, it can help ensure that every transaction is accounted for and recorded in a standardized fashion.
If you’re still not convinced of the need for a chart of accounts, here are a few more reasons why charts of accounts are so important.
1. They Help Businesses Track Financial Progress Over Time
A chart of accounts and general ledger are essential because together, they offer businesses insight into how their numbers are trending over time.
For example, if you notice that your expenses are increasing while your revenue isn’t, this may indicate the management may need to re-evaluate operations and implement policies to increase efficiency.
In other words, this information allows critical decision-makers to determine what works and what doesn’t work.
2. They Ensure Managers Can Track Down Financial Issues
According to a U.S. Bank study, 82% of businesses have poor cash flow management. This often stems from inadequately tracking the company’s financial activity. With a chart of accounts, a manager can more easily drill down into transactions they find concerning. Managers will be given a chance to solve problems like late payments, employee mismanagement of funds, and other internal issues that can damage a company in the long run, even if they are of little consequence now.
3. They Are Customizable to the Business or Industry
Your chart of accounts is customizable to fit your particular business or industry. For example, a food distribution business may want to create an account for Deli Purchases or Refrigeration Costs, which are accounts that an advertising business or daycare would not need. Charts of accounts provide this flexibility. They can also be customized to track activity at multiple business locations.
For example, if a company has a headquarters and two satellite offices, they can have separate accounts for each site. These accounts will get consolidated when it’s time to run reports, but having this level of detail available allows you to drill down to see patterns in your finances.
What Else Do You Need to Know About Charts of Accounts?
- Charts of accounts should stay the same every year.
If accounts change or are consolidated each year differently, management will have difficulty identifying patterns. There may be instances where you’ll be required to change your chart of accounts (e.g., mergers), but the goal should be for your chart of accounts to be flexible enough to grow as our organization grows.
2. Accounts can be grouped differently for different purposes.
Most accounting software allows you to consolidate and group accounts in more than one way. For example, accounts are often consolidated differently for financial reporting purposes than for tax preparation purposes. Leverage this technology when you can.
3. Your chart of accounts is only as good as the information you supply it with.
Take care when crafting your chart of accounts. Taking the time to organize your chart of accounts and implementing a process for adding new accounts will ensure your financial information is just as well organized in the future as it is today.
An Accounting Essential: Using a Chart of Accounts
A chart of accounts is a critical aspect of accounting. It ensures that your financial information is communicated effectively and is accurately portrayed. A good chart of accounts is flexible enough to suit different industries, locations, and managers with what they need to make the right business decisions.
So, whether you’re a lead accountant or have just started handling a new account, you’ll want to ensure that finding and displaying information is as easy as possible by using a chart of accounts.