The chart of accounts structure is the skeleton of your accounting system. It’s the way you organize your finances and categorize transactions, and it’s a key component of your accounting software.
While not every business has the same chart of accounts, some best practices can help your accounting processes run more smoothly.
If you haven’t set up your chart of accounts yet, or if you’re looking to streamline an existing one, here are some guidelines to follow.
What Is the Chart of Accounts, and Why Is It Important?
A chart of accounts lists all the reports that make up your business’s financial records. It groups them into categories, like assets and liabilities, to see what you own (assets) and what you owe (liabilities). It also lists your income and expenses in separate categories to help you track how much money your business is making or losing.
Your chart of accounts helps keep your accounting books in order by tracking specific transactions, such as payroll, expenses, inventory costs, and other transactions.
These accounts are then used to prepare your business’s financial statements. You can use accounting software to automatically generate a chart of funds based on your business type.
Accountants commonly use the chart of accounts to prepare financial statements. These financial statements are then used by various stakeholders, such as investors and creditors, to analyze a company’s finances and make business decisions about whether or not to invest or extend credit to it.
The chart of accounts is important because it is the foundation for all your other financial reports. It drives what shows up on your income statement, balance sheet, and cash flow statement. You’ll want to ensure that you have all the accounts that apply to your business set up in the correct order.
How should you use the Chart of Accounts?
- To categorize every transaction in your business.
- As a tool for analyzing past performance and planning future strategies
- To identify where you are making money and where you are losing money
Use Chart of Accounts Best Practices
A well-designed chart of accounts allows management to make decisions based on accurate reports. Inaccurate or poorly categorized statements can lead to reporting issues and may indicate that management needs to change its bookkeeping procedures.
A “numeric” structure is a “numeric” structure, meaning each account has a unique number assigned to it. These are often three to five digits long, with different categories posted with varying ranges of numbers. Anyone looking through the general ledger can find every transaction for a specific account.
A good chart of accounts has a numbering system that allows new account numbers to be added easily between existing ones without renouncing all subsequent account numbers. This makes it easy to add unique or detailed account numbers without disrupting existing reporting processes.
Which type is right for your small business depends on your industry and business model, but there are some common patterns you can use to set up your chart of accounts. A typical accounting system uses the following:
1000’s: Current asset accounts, including all cash accounts (savings/checking accounts) and accounts receivable, prepaid, and fixed assets.
2000’s: Liabilities including anything in accounts payable, accrued expenses, notes payable, and other liability accounts.
3000’s: Owner’s equity accounts, including common stock and preferred stock and any funding-related capital.
4000’s: Income statement accounts that cover sales and revenue.
5000’s: Cost of revenue accounts, including support, hosting expenses, and third-party transaction fees.
6000’s: Accounts for operating expenses from salaries, rent, etc.
7000’s: Other income from interest, rent gains on the sale of assets, and gains from foreign exchange transactions.
8000’s: Other expenses from income taxes and interest.
A number like 1000 could represent an asset account. Subaccounts under 1000 might start with 1001 (a checking account), 1002 (a savings account), or 1003 (a second savings account). You can create subaccounts under 1001-01 for a checking account for business expenses or 1002-02 for your savings account where you save money for taxes.
Align Your Chart of Accounts With How You Want to View the Business
Every business is different, and your chart of accounts must reflect how you want to view your business. If you’re unsure what the best structure for your chart of accounts is, consider how you want to see your business. You’ll probably have one income account if you wish to view your business by location. If you’re interested in seeing expenses by department, you might have one expense account.
It’s also a good idea to consider how many different reports you’ll be running. Having just a few categories might be acceptable if you only need a few standard reports like a balance sheet and an income statement. On the other hand, if you need more complex information or if the nature of your business requires a systematic analysis of different segments, then breaking up your chart of accounts into more subcategories will be helpful.
It’s essential to align your chart of accounts with how you want to view the business. When you know what metrics are critical to your business, you’ll better understand how to categorize expenses in your accounting system. This will give you better data and improved reporting.
If you’re not sure where to start, here’s an example chart of accounts for a small company:
1000 Cash Assets
1100 Accounts Receivable Assets
1200 Inventory Assets
1400 Investment Accounts
1500 Fixed Asset/Depreciation
2000 Accounts Payable
2100 Credit Card
2300 Sales Tax Payable
2400 Accrued Expenses
2500 Current Portion of Long-Term Liability Liabilities
2700 Long-Term Liabilities Liabilities
Follow GAAP but Focus on the Business
You know that it is essential to follow the Generally Accepted Accounting Principles (GAAP) when creating your chart of accounts. But it’s also true that your chart of account structure has to be tailored to your business.
The GAAP-approved guidelines provide a framework for structuring a chart of accounts, but they shouldn’t be used as a checklist.
Your goal should be to create a structure that makes sense for your company and that you can use over the long term. Review your list regularly, make sure it is designed for long-term use, and don’t spend too much time tweaking an account that isn’t critical to your business’s goals.
Scalability and Flexibility Are Key
When you’re setting up your chart of accounts, it’s best to plan. You want to build something that will grow with you, so you want to make sure your structure is scalable and flexible. This will help you keep your records organized as you grow and expand.
You’ll also need to decide how detailed your chart of accounts will be. Some companies opt for a simple structure with fewer accounts, while others may have a highly complex system with hundreds of accounts.
The size and complexity of your business will help determine the best strategy for you.
Logical Account Numbering
Accounting is all about organization, so having a systematic way of numbering your accounts. One easy method to use is to give your accounts numbers based on the account type and its order in the Chart of Accounts.
For example, suppose you have three different types of revenue accounts (e.g., sales, service fees, and other revenue). You could number them 100, 200, and 300, respectively—and you’d number the individual accounts within these categories accordingly. So your sales accounts might be 101, 102, and 103; your service fee accounts 201 and 202; and so on.
Having your accounts ordered this way makes it easier to find things in reports because they’ll be grouped visually—for example, when you’re looking at an income statement.
Standardization Will Save the Day
One of the most important benefits of setting up your chart of accounts correctly is that it will be easier to pull accurate reports later. If you have a standard numbering system, you can sort your accounts by number and quickly find what you’re looking for.
This is especially helpful if you have multiple people working on your books since they’ll all know which account to look in when they need information. It makes things easier for everyone, and it’ll save you time and money down the road when you don’t have to hire someone who knows how to fix messed-up charts of accounts.
When you standardize your chart of accounts, you’re making your accounting and bookkeeping processes more straightforward, accurate, and stressful.
Your information will be more organized, which means everyone can access it. If a person leaves your organization, another is trained to step in seamlessly. If you switch software platforms, the transition will go much more smoothly.
Make Department Tagging a Top Priority
For most companies, having a helpful chart of accounts structure depends on being able to tag each transaction with the appropriate department. Many organizations have adopted a “tagging” system for transactions, which allows them to create reports that would otherwise be impossible or very difficult to make.
Unfortunately, this tagging is done manually and by different people in different ways for many companies – resulting in inconsistent reporting. Ensure you have a strategic and consistent approach for tagging.
To ensure that you’re getting the full benefit from your chart of accounts structure and your reporting capabilities, it’s best to prioritize department tagging. It might be helpful to start by creating a list of all the departments in your organization and then brainstorming how each type of transaction could be tagged based on its primary purpose.
Nail Down Cost of Revenue vs. Operating Expense
The first step in creating a chart of accounts is to nail down your cost of goods sold (COGS) or cost of revenue and separate it from operating expenses.
COGS includes all costs you incur to deliver your goods or services, including labor, materials, shipping, and overhead.
Operating expenses are everything else that’s not COGS. This includes rent, office supplies, marketing costs, accounting fees, travel, payroll for non-production employees, and professional development for non-production employees.
The more information you can track in your COGS account, the better. For example, if you make products and sell them to customers, you should follow the billable hours of your production team and the cost of materials used per product. You can also track shipping and overhead as line items in the COGS account.
Once you have your COGS sorted out, it’s time to start building out the rest of your chart of accounts. The best way to do this is to think about how you plan on using financial reports as part of your business management process.
A Clean General Ledger Helps Business Scale
There are many ways to organize your chart of accounts. The most important thing to remember is that the chart of accounts is a tool for you to use, so you should set it up in a way that helps you understand your business’s financial performance.
One thing to consider is whether to include account numbers and how long they should be. Account numbers are used in accounting software and can save time searching for specific accounts. They also help ensure the correct account is selected when entering transactions because the name alone might not be enough to tell the difference between similar accounts.
One of the best ways to successfully use a chart of accounts is to follow certain best practices established by similar businesses. These practices include:
- Funds should be in alphabetical order.
- Assets should be listed first, followed by liabilities and then equity.
- Accounts used more often should be assigned lower account numbers than those used less often.
- The use of subaccounts is encouraged.
- Account numbers should be able to accommodate future growth by including extra digits at the end of the number.
- Each new account added should have a unique account number; do not skip numbers when adding funds to an existing group.
A well-designed chart of accounts allows management to make decisions based on accurate reports. Inaccurate or poorly categorized statements can lead to reporting issues and may indicate that management needs to change its bookkeeping procedures.
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