There are few sights as charming as a class of kindergarteners shuffling down the sidewalk, kept in line by a brightly colored rope that their teacher has (wisely) instructed each one to hold at a different point. That same group of children careening freely through the streets without a tether in sight is much more anxiety-producing—and it’s also a recipe for a game of “find the five-year-old.”
Your business accounts are, in this way, like kindergartners. They travel in groups, are easier to monitor when shaped by an organizing principle, and become a huge problem if lost. Think of your chart of accounts like a kindergarten teacher’s tether. Used properly, the chart of accounts keeps all of your information in order, making it easy to generate financial statements, assess your company’s financial health, and plan for growth.
What is a chart of accounts?
A chart of accounts is a list of all accounts included in a company’s general ledger. These accounts are grouped according to five main account types: asset accounts, liability accounts, expense accounts, equity accounts, and revenue accounts.
The chart of accounts includes the account name, the account type, and the account number. It also lists the financial statement on which the account appears. Assets accounts, liability accounts, and equity accounts are balance sheet accounts, while expense accounts and revenue accounts show up on your profit and loss statements.
Most charts of accounts contain multiple accounts under each category. Your company might have an account for cash on hand, a separate account for accounts receivable, and a third account for real estate holdings, all three of which are categorized as asset accounts.
Balance sheet accounts
Asset, liability, and equity accounts are listed on a company’s balance sheet, a statement that shows a company’s financial position at a given point in time. Here’s an overview of what might be included in each of your company’s balance sheet accounts.
- Asset accounts. Cash, securities, accounts receivable (AR), and inventory are all asset accounts.
- Liability accounts. Accounts payable, taxes payable, wages payable, and accrued liabilities are classified as liability accounts.
- Equity accounts. Common stock, retained stock, dividends, retained earnings, and owner capital are all examples of equity accounts.
Income statement accounts
Income statement accounts include expense accounts and revenue accounts. The income statement (or profit and loss statement) shows a company’s performance over a particular reporting period. These accounts track how much money has been gained or lost during the period of time in question.
- Expense accounts. Expense accounts include categories such as cost of goods sold, operating expenses, non-operating expenses, credit card expense accounts, and prepaid expense accounts.
- Revenue accounts. Revenue accounts include sales revenue, dividend revenue, and gains on the sale of an asset, as well as any other revenue sources your business claims (such as rent or royalty income).
How does a chart of accounts work?
One of the main functions of a chart of accounts is to facilitate the process of double-entry accounting, a system of recording transactions that enters both a debit and a credit for every transaction you make.
One key principle of double-entry accounting is that a credit to any account must be offset by a debit to another account. The system by which debits and credits either increase or decrease the balances of specific account types isn’t completely intuitive. Asset and expense accounts increase when debited and decrease when credited. Revenue, liability, and equity accounts increase when credited and decrease when debited.
This system of debits and credits functions to support the central equation of double-entry accounting (assets = liabilities + equities), where revenue and expenses eventually net and roll into equity. The logic by which debits and credits either increase or decrease account balances depending on account type keeps this equation in balance. A credit to accounts receivable resulting from a paid invoice, for example, would be offset by a debit to cash, decreasing your accounts receivable balance and increasing your cash balance. In other words, following the rule by which specific accounts types increase and decrease when credited (or debited) will help keep your chart of accounts in order.
For example, let’s say you own a bait shop, and you sell $75 worth of chum to a local fisherman. First, you would debit your cash account for $75. Asset accounts increase when they are debited, so the sum of your cash account would increase by $75. You would then credit your revenue account $75. Revenue accounts increase when they are credited and decrease when they are debited, so your revenue account would increase by $75 as well. Both account balances increase—you’ve made money!—and the double-entry accounting system is kept in balance by a debit offset with a credit.
Maintaining a chart of accounts allows you, your accountant, or your accounting software to generate key financial statements, including income statements (which show how much money you gained or lost over a period of time), balance sheets (which show your current financial position), and cash flow statements (which show how money moved through your business during a reporting period).
Best practices for managing a chart of accounts
Maintaining an organized, user-friendly chart of accounts is the crux of operating a double-entry accounting system, and following a few key principles can help set you up for success. Best practices include using a consistent naming system, consolidating accounts where possible, and strategically timing the removal of any accounts that are no longer needed.
Be consistent in labeling and naming accounts and subcategories
Establishing and following a naming and labeling system for your chart of accounts can help you identify the purposes of each account and prevent confusion across account types.
Using accounting software can simplify this by encouraging you to file individual accounts by account type. You might, for example, have an account labeled “Credit card—operating expenses” filed under “Liabilities.”
Accounting software platforms also frequently include a sample chart of accounts or a template demonstrating how commonly used accounts can be categorized and labeled. Following a template can take the guesswork out of establishing a naming system and make it easier for you to share your books with a third party like an accountant or a financial adviser.
Consolidate accounts where possible
One of the beauties of accounting software is that it allows you to have as many accounts as you need to gain an accurate picture of the way that money is moving through your business.
This freedom, however, requires sound judgment: just because you can have separate accounts for office supplies (analog), office supplies (digital), office supplies (snacks), and office supplies (drinks) doesn’t mean that you should. This level of detail is unlikely to provide you with useful information, and it increases the odds that you will enter a transaction in the wrong place.
It’s a good rule of thumb to look in on your chart of accounts at the end of every fiscal year and ask yourself whether any accounts can be consolidated or removed.
Wait until the end of the fiscal year to delete old accounts
If you’ve identified redundant or archaic accounts, it can be tempting to clean up your chart of accounts by quickly deleting them or by merging multiple accounts into one. Resist this urge—at least temporarily. Waiting until the end of the fiscal year to delete, rename, or merge existing accounts will simplify your tax filing process, preventing you from unwittingly concealing relevant information from yourself over the course of the year.
Wrapping your mind around double-entry accounting, the accounting system facilitated by a chart of accounts, can take some time. Once you have it down, however, maintaining a chart of accounts, with its redundant system of debits offset by credits, can help ensure that your records are accurate.An organized chart of accounts also keeps all of your financial information in one place, making it easy to generate financial statements and allowing small-business owners to monitor their immediate financial health and profits over time.