Charts of accounts is a list of all ledger accounts and has an identification number assigned to each account. It provides you with a bird’s eye view of every area of your business that spends or makes money. It allows you to break down all the transactions that your business made during a specific period into different subcategories. By separating out your revenue, liabilities, assets, and business expenditures, a chart of accounts enables you to gain insight into the effectiveness of different areas of your business.
In a chart of accounts, accounts are shown in the order that they appear on your financial statements. Consequently, assets, liabilities, and shareholders’ equity (balance sheet accounts) are shown first, followed by revenue and expenses (income statement accounts).
Charts of accounts breaks down your business’s transactions into five main accounts and as many sub-accounts as you need for budgeting and tax purposes.
Income (Revenue) accounts
First three relates with Balance sheets and last two relates with income statements accounts.
Asset accounts record any resources your company owns that provide value to your company. They can be physical assets like land, equipment and cash, or intangible things like patents, trademarks and software.
Liability accounts are a record of all the debts your company owes. Liability accounts usually have the word “payable” in their name—accounts payable, wages payable, invoices payable. “Unearned revenues” are another kind of liability account—usually cash payments that your company has received before services are delivered.
Equity accounts are a little more abstract. They represent what’s left of the business after you subtract all your company’s liabilities from its assets. They basically measure how valuable the company is to its owner or shareholders.
Revenue accounts keep track of any income your business brings in from the sale of goods, services or rent.
Expense accounts are all of the money and resources you spend in the process of generating revenues, i.e. utilities, wages and rent.
The way that the balance sheet and income statement accounts interact with each other is complex, but one general rule to remember is this: revenues increase your company’s equity and asset accounts, while expenses decrease your assets and equity.
Each account in the chart of accounts is typically assigned a name and a unique number by which it can be identified. (Software for some small businesses may not require account numbers.) Account numbers are often five or more digits in length with each digit representing a division of the company, the department, the type of account, etc.
The first digit in the account number refers to which of the five major account categories an individual account belongs to—“1” for asset accounts, “2” for liability accounts, “3” for equity accounts, etc.
Unless you have the name of every single account in your books memorized, you need to have all of them laid out in front of you, like a map.
The chart of accounts is designed to be a map of your business and its various financial parts.
A well-designed chart of accounts should separate out all the company’s most important accounts, and make it easy to figure out which transactions get recorded in which account.
It should let you make better decisions, give you an accurate snapshot of your company’s financial health, and make it easier to follow financial reporting standards.
The rules for making tweaks to your chart of accounts are simple: feel free to add accounts at any time of the year, but wait until the end of the year to delete old accounts. If you delete an account in the middle of the year, it might mess up your books.
Let’s say that in the middle of the year Doris realizes her orthodontics business is spending a lot more money on plaster, because her clumsy intern keeps getting the water to powder ratio wrong when mixing it.
Instead of recording it in the “Lab Supplies” expenses account, Doris might decide to create a new account for the plaster.
To do this, she would first add the new account—“Plaster”—to the chart of accounts.
She would then make an adjusting entry to move all of the plaster expenses she already had recorded in the “Lab Supplies” expenses account into the new “Plaster” expenses account.
If she had already spent $2,000 on plaster up to that point, the adjusting entry would look like this:
Account. Debit. Credit
Plaster . $2000
Lab Supplies. . . $2000
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