What is the chart of accounts?
A chart of accounts is a list of accounts available for recording transactions in a company’s general ledger. Think of it as the filing cabinet for your small business’s accounting system. It is used to organize transactions into groups. This helps keep track of the money coming in and going out of the business, especially when it’s time to file taxes.
More QuickBooks Online plans, for example, support up to 250 accounts. The average small business shouldn’t have to exceed this limit if they set up their accounts effectively. For example, if you buy a ladder for your roofing business, you can put it in the “equipment” account under assets, instead of dedicating an entire account to “ladders”.
Typical charts of accounts have five main accounts: assets, liabilities, equity, expenses, and income. These accounts are used to generate balance sheets and income statements:
Income statement = expense accounts + income.
Balance sheet = Assets + Liabilities + Equity accounts.
The expense and income accounts make up the income statement, which provides an overview of the overall profitability of a business. The remaining three accounts make up the balance sheet, which shows the financial health of the business at that time and whether it owes any money.
How a chart of accounts works
Every time you post something in the chart of accounts, you make two entries: a debit from one account and a credit from another. For example, if you own a local grocery store and sell $ 20 of fresh produce, you will debit the cash account with $ 20 and credit the income account with $ 20. This is known as Double entry accounting, and the sum of the two entries must equal zero each time. Traditionally, credits always go on the right side of the chart and debits on the left. If you can’t decide whether something should be credited or debited, remember this: Expenses and assets increase when debited, while liabilities, equity, and income decrease when debited. .
Accounting software can simplify the process and minimize manual data entry. Popular products, such as QuickBooks Online or Xero, will balance your credits and debits for you and establish a standard chart of accounts with categories relevant to your industry.
Each line of a typical chart of accounts will include an account number, title, description, and balance. Traditionally, accountants can determine which account a transaction belongs to based on the first digit of the account number; for example, asset accounts are usually numbered 100 to 199 and liabilities are usually numbered 200 to 299. This helps keep the books organized.
The accounts used to generate the balance sheet come first, followed by the accounts used to generate the income statements. Some companies also create categories based on department: one for sales, one for accounting, etc. In each department, there may be subcategory expense accounts for salaries, utilities, and more.
Assets: any resource your business has that provides value.
Liabilities: any debt your business owes.
Equity: what is left after subtracting your business’ liabilities from its assets.
Returned: the money your business makes from the sale of its goods or services.
Expenses: all types of money and resources that your business spends in order to generate income. To calculate net income, subtract expenses from income.
Examples of chart of accounts
The ladder you purchased for your roofing business was $ 300. You will credit $ 300 to the company’s bank account (which reports cash assets) and debit $ 300 to the equipment account (which reports fixed assets). Money comes out of your business, and in return you get new equipment.
Let’s say you pay rent in cash. In this case, you will credit the cash account, since the cash is leaving your business, and debit your expense account for the rent. Alternatively, if you are using accounting software, it will know which accounts to credit and which debit.
You receive a $ 15,000 small business loan and use QuickBooks Online. You click on the plus sign icon in the upper right corner and select Bank Deposit.
After that, you fill out the transaction information and tag it as “Small Business Loan”, which is nested under “Long Term Liabilities”. In this case, the liability account already exists in your books and the software automatically fills in its name for you. If you were to create a new account for the loan, you must click Add.
Once you are done filling out the information, you see a new transaction in your chart of accounts for a $ 15,000 small business loan. Your checking account is automatically updated and $ 15,000 is added to the balance. In this case, you credited $ 15,000 to your loan account (passive) and QuickBooks Online debited $ 15,000 from your checking account (active) to balance it.
Wait to delete the old accounts. In order not to spoil your books, it is better to wait until the end of the year to delete the old accounts. Merging or renaming accounts can create headaches during tax season. However, you can add new accounts at any time.
Don’t go overboard with your accounts. Create a chart of accounts that gives you important information. It does not mean recording every detail of every transaction. You don’t need a separate account for each product you sell, and you don’t need a separate account for each utility. Some elements can be grouped together.
Aim for consistency. Create a chart of accounts that doesn’t change much from year to year. This way, you can compare the performance of different accounts over time, giving you valuable insight into how you are managing your business finances.
Prune your accounts. At the end of the year, take a look at all of your accounts and see if there is a consolidation opportunity. This will make managing your accounts easier to manage.
Stacy Kildal, a former Fundera writer, contributed to this article.
A version of this article first appeared on Fundera, a subsidiary of NerdWallet.