Chart of Accounts 101: What They Are & Why They’re Important
Whenever you record a business transaction whether it’s an incoming or an outgoing it’s imperative that you record it in the right account. That might sound simple but there are some accounting procedures you need to follow. That is where the Chart of Accounts comes in.
I think of the chart of accounts as buckets, it is buckets of allocation. Buckets of revenue types, expenses etc. You need to code your revenue and expenses into these buckets in a consistent manner each month as this helps with reviewing and identifying abnormal items which you can then drill into for further review. Consistent coding in buckets is vital for reporting purchases.
What is a chart of accounts?
A chart of accounts is a list that contains all the details of your company’s accounts in one place. It allows you to have a quick glance at what areas of your business spend or make money.
Generally, the chart of accounts will include:
Your chart of accounts will look different based on the industry that you operate in. For example, a major manufacturing firm will have more references to manufacturing equipment than a cafe which is likely to have coffee beans and machines. The chart of accounts should be simple for anyone looking at your business transactions to understand.
Balance Sheet accounts
The balance sheet accounts form part of commonly used financial reports. These are basically reports that summarise the financial position of the company. They give investors and other outsiders an idea of the company’s financial position – the assets and liabilities and how this relates to shareholder ownership.
The balance sheet accounts however are broken into three categories:
- Asset accounts– contain details of any physical property that your company owns. The assets can be tangible like land, furniture and property or intangible like trademarks, software and patents.
- Liability accounts– the debts that your company has. Each of the liability accounts will have the word “payable” in their name for example invoices payable, wages payable, accounts payable. Liabilities are not just debts though. They are also un-earned revenue which is payments that your company has not yet received. As the money is not guaranteed until it is in your account it cannot be treated as an asset.
- Equity accounts– these are a little bit more complicated. They contain what’s left from the business’s financial records after you have deducted all the company’s liabilities from its assets. Essentially they represent what the company is worth to its owners or shareholders.
Income Statement accounts
Income statements are another type of major accounts and are broken down into two categories.
- Revenue accounts which track any income that the business generates by selling goods, services or rent.
- Expense accounts which is a record of all the money that you spend to generate income. Wages and rent are a couple of things you might find in the expense accounts. Expense accounts include both direct and fixed expenses.
The general thing to note is that the income statements and balance sheets work together however the revenue increases your company’s asset and equity accounts whereas expenses decrease them.
Every account in the chart of accounts has a reference, being wither letters or numbers. However the key is that the chart of account needs a consistent logical format, designed in a user friendly format for business owners, accountants and bookkeepers.
For example – A 5 -digit reference number represents the category the account belongs to, for example “1” for asset accounts, “2” for liability accounts and “3” for equity accounts etc.
Most accounting software is capable of generating these numbers or letters, so you won’t have to worry about choosing them, however you may have to add others – which needs consideration for where they fit into the chart.
How to modify your chart of accounts
Modifying your chart of accounts is very simple. You can easily add accounts anytime during the year but you should wait until the end of the financial year to delete old accounts.
If you don’t wait until the end of the financial year, it could affect your books.
For example, Natalie who runs a salon notices that she’s spending more money on hair dye because the wrong quantity is being mixed. Instead of recording the hair dye in the “equipment” expenses account she might create a separate account for hair dye. That can simply be done by adding a new account “hair dye” to the chart of accounts.The expenses in the equipment account would then be adjusted and recorded into the new “hair dye” account.
Why is the chart of accounts important?
A chart of accounts is important because it gives you an understanding of how your business is performing. Knowing the financial performance of your business is important because it allows you to make decisions. Those decisions could be related to increasing revenue or decreasing expenditure.
It informs your financial position
A chart of accounts gives you an idea of the company’s financial position. It’s important to know your business’s financial position so you can determine whether you need to make cuts and what areas you should make cuts to.
Whether or not your business is listed on the ASX, knowing the financial position of the business can help investors make decisions whether to put their money in your company or pull money out.
It allows you to make better decisions
The chart of accounts is also important because it allows you to make informed business decisions. If there is an area of your business that is performing well then you might invest more funds. On the flipside if there is an area that is underperforming you may decide to reduce investment.
It makes life easier come audit time
The chart of accounts is also a very easy tool that you can use to meet financial reporting standards and regulations.
If your accounts are ever audited by ASIC, the ATO or another regulator, the chart of accounts makes it much easier to locate where everything is.
How to improve your chart of accounts
You can improve your chart of accounts in three simple steps.
Use account numbers
Account numbers will help you keep your chart of accounts organised. You can start each group of accounts by using the following:
100 series = assets
200 series = liabilities
300 series = equity
400 series = income
500 series = cost of goods/services sold
600 series = operating expenses
700 series = other items.
You don’t need to follow the above account numbering system. You can use your own system. The main thing is that you keep your accounts organised and structured.
Use a consistent naming convention
Your chart of accounts can be improved if you use a consistent naming convention across the board.
For example, start all bank accounts with the number 1, so if you have a transaction account that might be 100 and savings might be 101.
It is also important to add as much detail as possible so you can easily identify it. Some accounting software has limitations as to the amount of characters you can use, so check that before you create a naming convention.
Maintain the chart of accounts
The chart of accounts is only as good as the information that you enter into it, so to improve it you need to update it regularly.
If some of the accounts have been inactive or never used, then delete them.
There is no point keeping accounts in the chart that are just taking up space. It is also important to check that the accounts are grouped correctly – for example it will create major issues if you have an expense account classified as an income account.
Correct it as soon as you notice. As a general rule, you should review the accuracy of your chart of accounts at least twice a year. Doing so will help you create credible and accurate financial reports. It will also help when your accountant reviews your accounts at tax time.
What is the difference between a chart of accounts and a general ledger?
A general ledger contains account numbers that are used to sort financial transactions, and generally refers to revenue, expenses and transfers. A chart of accounts contains every account in your accounting records.
What happens if you don’t have a chart of accounts?
If you don’t have a chart of accounts, you won’t be able to simply identify the transactions that your business made in a specific period.
It will be harder to understand the financial position of your business, which will make your financial reporting duties much more difficult and that could affect how much tax you pay at the end of the financial year. It could also have an impact on your other financial reporting obligations.
Need help with your accounting?
If you need help building a chart of accounts or anything related to your business finance, contact our expert accountants here at 2account. We assist with everything related to month end reporting and income tax preparation to general corporate compliance and AFSL financial compliance.
The chart of accounts may seem a little overwhelming at first. The good news is our professional guidance will make it as easy and seamless as possible for you, so you can focus on growing your business without the burden of accounting taking up all of your time.
Book in a call with our Renee, the owner of 2account – and we’d love to see how we can help.