Every time you record a business transaction—a new bank loan, an invoice from one of your clients, a laptop for the office—you have to record it in the right account.
But how do you know which account to record it in? The chart of accounts will tell you.
Below, we’ll go over what the chart of accounts is, what it looks like, and why it’s so important for your business.
What is the chart of accounts?
A chart of accounts is a list of all your company’s “accounts,” together in one place. It provides you with a birds eye view of every area of your business that spends or makes money. The main account types include Revenue, Expenses, Assets, Liabilities, and Equity.
Companies in different lines of business will have different looking charts of accounts. The chart of accounts for a major airline will have a lot more references to “aircraft parts” than your local cat cafe.
The chart of accounts should give anyone who is looking at it a rough idea of the nature of your business by listing all the accounts involved in your company’s day-to-day operations.
Chart of accounts sample
Here’s what a chart of accounts looks like. This one is for a fictional business: Doris Orthodontics.
As you can see on the right, there are different financial statements that each account corresponds to: the balance sheet and the income statement. Here’s what that means.
The balance sheet accounts
We call these the “balance sheet” accounts because we need them to create a balance sheet for your business, which is one of the most commonly used financial statements. There are three kinds of balance sheet 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.
The income statement accounts
We use the income statement accounts to generate the other major kind of financial statement: the income statement.
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.
A note on reference numbers
You’ll notice that each account in the chart of accounts for Doris Orthodontics also has a five-digit reference number preceding it. 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.
Back when we did everything on paper, you used to have to pick and organize these numbers yourself. But because most accounting software these days will generate these for you automatically, you don’t have to worry about selecting reference numbers.
Why is it important?
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 exactly that: 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.
How to adjust your chart of accounts
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:
Note: Moving expenses for plaster from the Lab Supplies expenses account to the Plaster expenses account.