The Chart of Accounts is essentially the classification or coding system for each and every financial transaction in the books and is one of the first steps in the bookkeeping setup process. It is a list of all General Ledger accounts used by a business in its bookkeeping system. All of these accounts are grouped together by their classification:
Current Assets
Fixed Assets
Current Liabilities
Long Term Liabilities
Capital
Accrual
Income
Expenses
Costs
Take a look at the General Ledger page to see how the Asset, Liability, Capital and Accrual classifications above are the breakdown of Balance Sheet accounts. These accounts are used to create the balance sheet, while the Income, Expense and Costs accounts are used to create the income (profit & loss) statement.
Setting up the Chart of Accounts for your bookkeeping system is fairly easy once you understand the process. There are some accounts that are very common to most businesses. For example, under Current Assets even the smallest of businesses will have its bank account listed.
Putting the chart of accounts together takes a little bit of time but doesn’t have to be complicated. It’s good to ask yourself questions about the kinds of things your business will purchase, and the types of income it will receive. Here are some simple steps you can follow:
1. Name your Income accounts
2. Name your Cost of Goods Sold accounts
3. Name your Asset accounts
4. Name your Liability accounts
5. Name your Capital & Accrual accounts
6. Name your Expense accounts
1. Name your Income Accounts
The type of business you have will determine how many types of income you track. For example, if you have a window washing business you would probably only have one income account and you could name that account something like:
• SERVICES, or
• WINDOW WASHING INCOME, or simply
• INCOME or
• REVENUE
If you have a jewelry business, you might decide to have two different income accounts to track the kinds of sales you have. For example, you might have:
• JEWELRY SALES, and
• CONSIGNMENT SALES
If you did repairs of jewelry as well, you might add an additional income account such as:
• JEWELRY REPAIR, or just
• REPAIRS
2. Name Your Cost of Goods Sold Accounts
Cost of Goods Sold tracks how much it costs to produce a product or provide a service. These would be things such as the materials that go into a product or the labor to produce that product.
Costs differ from Expenses in that they are directly related to the production of your products and services and are used to help a company determine its gross profit.
Gross Sales – Cost of Goods Sold = Gross Profit
Let’s imagine you are bookkeeping for a widget company. You would track all costs that go into the production of their widgets. If they sell one of their widgets for $250 and it takes $50 in material and labor costs to produce that widget, then their Gross Profit is $200 per widget.
One thing many people miss is that it is very important for most companies to track their costs. If they don’t do this and they begin to see their profits shrinking, they won’t know for sure if it is the overhead expenses that are driving profits down or if it is costing them too much to produce their products or services.
The number of Cost of Goods Sold accounts a business keeps depends on how many products and services it provides. If it wants to track the costs of each of its products or services separately it will create an account for each one. The main reason for keeping a greater level of detail is to help a company determine its profitability with different product lines or to know which part of the process may be costing too much.
For example, a glass installation company will buy windows from a manufacturer to sell to their customers as part of their installation service. The windows and all materials that go into the installation are considered Costs of Goods Sold. The installer could even track the wages of their employees who install the windows as Costs of Goods Sold.
The window manufacturer in the above example tracks the cost of manufacturing its windows while the installation company tracks the cost of purchasing and installing the windows. The manufacturer is tracking the cost of product production while the installer is tracking the costs of installation.
The glass company might have only one Cost of Goods Sold account that would track its material costs, but it might also want to track the labor to install the windows as well since it is directly related to the cost of the service being provided. In this case you would name two Cost of Goods Sold accounts:
Materials
Labor, or
Installation Materials
Installation Labor
Those in the building industry will greatly benefit from tracking their costs per job. Unlike the widget company which produces the same products every day, the products and services a construction company provides vary from customer to customer. The information can be used at the completion of a job to determine how profitable it was and how the company can improve its profit on similar jobs.
3. Name Your Asset Accounts
Asset accounts keep track of what a business owns. Let’s start with fixed assets.
Fixed assets are tangible assets such as vehicles, tools, equipment or office furniture generally over $500. You can take something like office furniture such as a desk and chair and combine them if for example, the desk cost $400 and the chair cost $100, and put them together as one fixed asset. Here are some examples of fixed asset accounts:
• Vehicles
• Office Furniture
• Equipment
The next kind of Asset account would be current assets. Current assets are what a business owns that will most likely be turned into cash within a year and will not be depreciated. Examples of current assets would be inventory items that a retail shop owner may have for sale such as toys or books.
• Inventory, or
• Inventory – Books
• Inventory – Toys
Another kind of current assets would be money owed to the business for services performed or for goods sold. Once an invoice has been created for a customer, it becomes a current asset named accounts receivable. This account is normally used in accrual accounting.
Another asset account is Bad Debt Allowance. This is called a contra-asset account.
4. Name Your Liability Accounts
A Liability account keeps track of what a business owes at any give time. There are two kinds of liability accounts: Current Liabilities and Long-term liabilities.
Current liabilities keep track of things that a business owes that are payable within one year or less, such as money owed for sales tax collected or payroll taxes withheld. Long-term liabilities keep track of what a company owes that is payable over a period of more than one year. These would include such things as loans payable. So taking what we have discussed here, our liability accounts may look like this in the chart of accounts:
• Sales Tax Payable (current liability )
• Payroll Tax Payable (current liability)
• Bank Loan A (long term liability)
• Bank Loan B (long term liability)
• Vehicle Loan (long term liability)
Another current liability account is Accounts Payable. This is used in accrual accounting and tracks bills that are payable in less than a year.
5. Name Your Capital and Accrual Accounts
Capital accounts track money invested into or taken out of the business by owners, partners, or corporate shareholders. They are often referred to as Equity accounts. For a sole proprietorship they might look like this:
• Owner’s Investment
• Owner’s Draw
• Owner’s Equity (Investments minus Draws)
For a partnership they might look like this:
• Partner A Investment
• Partner A Draws
• Partner A Equity (Investments minus Draws)
• Partner B Investment
• Partner B Draws
• Partner B Equity (Investments minus Draws)
For a corporation they would look like this:
• Shareholder A Investment
• Shareholder A Distributions
• Shareholder A Capital Stock (Investments minus Distributions)
• Shareholder B Investment
• Shareholder B Distributions
• Shareholder B Capital Stock (Investments minus Distributions)
According to dictionary.com, accrue means to be added as a matter of periodic gain or advantage, as interest on money. Accrual accounts track the accrual or buildup of such things as depreciation and bad debt allowance. Accumulated depreciation accounts track the buildup of depreciation taken on assets. These accounts might look like this in your Chart of Accounts:
• Accumulated Depreciation – Equipment
• Accumulated Depreciation – Furniture
• Accumulated Depreciation – Vehicles
Bad Debt allowance is another kind of accrual account. It tracks the amount of the allowance that has been taken by a business over time, since the IRS sets a limit on the amount of bad debt that can be claimed each year.
6. Name Your Expense Accounts
Expense accounts are often referred to as overhead. These are different than costs in that they are not directly related to the product or service provided but are necessary for the business to function. Let’s consider some of the things that a small business owner may purchase for the business:
• Small Office Furniture (Not big enough to be classified as assets) – small chairs, bookcases or lighting
• Office Equipment (Not big enough to be classified as assets) – computers, printers copiers and coffee makers
• Office Supplies – pens, paper and ink for the printer
• Tools (Not big enough to be classified as assets) – for a remodeling or repair business such as hammers, saws, drills, screwdrivers and toolboxes
Taking the above ideas let’s name the Expense accounts in our Chart of Accounts:
• Office Supplies
• Office Equipment (All items under $500 each)*
• Office Furniture (All items under $500 each)
• Tools (All items under $500 each)
In your bookkeeping system it is possible to combine all of the above into one account called Office Expense if you aren’t looking for a lot of detail on your Profit & Loss Statement
With tools, furniture and equipment, only items under $500 should be included under expenses.* As a general rule, items such as these costing over $500 with a useful life of more than one year, should be treated as depreciable assets of the business. This means that you will not be allowed to take a full expense deduction for these items in the year that you purchased them. They will be depreciated over a period of time, such as 5 or 7 years. These items fall into a category in the chart of accounts called assets.
Other expenses might include:
• Bank Service Charge
• Advertising
• Auto Repair
• Fuel
• Equipment/Tool Repair
• Professional Fees – service, accounting, legal
• Telephone
• Internet Service
• Utilities (such as water and power)
• Business Insurance
• Office Rent
There are so many different kinds of businesses. Most have certain expense accounts in common such as office and telephone, but some have expenses that are unique to their own industry. Some businesses may choose to keep their expense accounts as general as possible in their bookkeeping while others may desire to keep a greater level of detail.
*Please check the IRS for rules concerning depreciation.