A company's accounting system relies on a framework of accounts that keep revenue, expenses, and other data organized and ready to put into a financial statement.
This framework, called the chart of accounts, serves as an index of all the company's financial accounts. Accountants use this chart of accounts to identify transactions as they record them in the company's general ledger.
Setting Up the Chart of Accounts
When you start a new business, you set up your chart of accounts as a first step in establishing your company's accounting system. Small businesses don't all have the same chart of accounts. The accounts you include depends on the type of business. For example, if you have a service business, you won't have an inventory account.
When you set up your chart of accounts, think of the future. Don't just think about the accounts you need for your small business now. Think of the accounts you may need 5 or 10 years down the line and include those in your chart. You may not have employees now, but in a few years, you may add employees to your business, so plan for that with your chart. You still may have to add accounts to your chart as you go along.
You should create a numbering system for your chart of accounts. If you are going to use a computerized accounting system, use a four-digit numbering system. A block of numbers is usually assigned to each of the categories that make up the chart of accounts, and blank numbers are left at the end for additional accounts to be added in the future.
As a part of the accounting cycle, the chart of accounts is used in journal transactions, and there are five categories on the chart of accounts:
- Owner's Equity
The asset category is where you keep track of what your company owns. You may want your asset category to start with the number 1000. That is usually the number that computerized accounting programs use. Number each asset account in a sequence such as 1000, 1010, 1020, and so on, beginning with current assets and moving on to fixed assets.
Current assets will include accounts for cash on hand, such as cash in your checking and savings accounts. You may have customers to whom you extend credit, so you will need accounts receivable account. If you sell products, you will need an inventory account.
After your fixed asset account, put in an account for accumulated depreciation. It is always a negative number on the balance and is directly related to your fixed assets since that is what you are depreciating. Do not leave any space for any other accounts between fixed assets and the accumulated depreciation. You may have accumulated depreciation for more than one fixed asset. You can depreciate your buildings, vehicles, business equipment, and so on.
The liabilities category is where you keep track of your company's debt obligations or what your company owes or may owe in the future. You may want to start numbering the liabilities section with 2000. Just like with the assets category, you want to follow the traditional form of the balance sheet in developing the liabilities section of the chart of accounts. You will have a current liabilities section and a long-term liabilities section.
The current liabilities section will include short-term debt accounts like accounts payable, the account where you will record what you owe your suppliers. It also will include your accrual accounts, which include what you owe in payroll taxes and sales taxes. You also will have an account for accrued wages. You might also have a current liability account for credit cards payable and short-term loans payable.
In the future, you may incur some long-term debt such as a mortgage. You should include space in your chart of accounts for other long-term debt accounts.
The owner's equity accounts include your investment in the business. In case you decide to take on other investors somewhere along the line, you should include accounts for common stock and, perhaps, preferred stock. You will want an account for retained earnings for any profits you plow back into the company. You usually start the owner's equity accounts with 3000.
Sales revenue is the first account on the chart of accounts related to the income statement. Sales revenues are the primary source of income for your business, and this section of the chart of accounts usually starts with 4000. Along with the sales revenue account, you may want to include an account for sales discounts and sales returns and allowances. You also will want to include an account for interest income for any income you earn on your company's investments.
Sales costs or costs of goods sold is usually the next type of account to consider. Even service businesses have to consider sales costs. You also include accounts for discounts from suppliers, costs of shipping, and miscellaneous sales costs.
The last category listed on the chart of accounts is the expense category, which usually is numbered 5000. A handy way to list expenses in the chart of accounts is to look at IRS Tax Form Schedule C and follow the way expenses are listed on that form. That makes it easy for you and your accountant when tax time comes. Develop an account for each of the expenses listed on Schedule C plus any other expenses specific to your firm. Leave several blank accounts available in case you need them in the future. Assign a number in the 5000-5999 range to each.