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The chart of accounts is the foundation upon which a business is built. Learn how to craft your chart before you start your small business. You'll be sorry if you don't.
No matter what product is to be sold or what service is to be offered, starting and operating a small business takes courage, fortitude, and lots and lots of planning. As an accountant catering to small business for 30 years or so, I can tell you that many entrepreneurs have the courage and the fortitude in abundance, but not nearly as many take the time to truly plan how their fledgling business is going to operate.
One of the first, and also one of the most serious, accounting mistakes small businesses make is not creating a cogent, coherent, and practical chart of accounts. In fact, some people start a business without even knowing what a chart of accounts is. To put it bluntly, if you don't know what a chart of accounts is and why it is so important, you might want to reconsider your plans to start a business.
What is the chart of accounts?
The chart of accounts is a numbered list of assets, liabilities, equity, revenues, and expenses that form the foundation for every transaction a business will make during its existence. It is the framework for all the bookkeeping, accounting, and tax reporting the company will be required to perform. Create a proper chart of accounts for your business before you transact any business—or you will regret that you didn't.
You can download our two sample charts of accounts to help you get started. One is a basic example for a corporation and one is a basic example for a sole proprietorship.
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Unfortunately, small business accounting and bookkeeping applications like QuickBooks do a poor job of explaining what a chart of accounts is and why it is so important. In fact, QuickBooks and the like seem to go out of their way to avoid any "accountant's lingo" in their setup process. This often leads to poorly constructed charts of accounts that must be corrected by a professional later.
Budding small businesses can avoid this costly outcome by learning and following a few basic rules.
The double entry accounting system on which the basic chart of accounts is founded was created by Luca Pacioli in the 13th century, and it is the tried-and-true method for tracking business transactions the world over. The system is based on this simple equation:
Assets = Liabilities + Equity
This is the basic accounting equation underlying the financial statement known as the balance sheet, which is part one of the chart of accounts.
Part two of the chart of accounts is the income statement (or profit-and-loss statement, if you prefer). This simple equation is:
Profit (Loss) = Revenues - Expenses
The basic chart of accounts
Of course, your business is unique and may require modifications to the basic chart of accounts, but the general outline will remain the same. I am purposely avoiding some of the more complicated tenets laid out by generally accepted accounting principles (GAAP) regarding the chart of accounts and financial statements because it is too complicated for this article, but if you want to see the full details, I suggest you visit the Financial Accounting Standards Board (FASB) web page.
The first two sections in a standard chart of accounts are for assets. The first section, usually represented by accounts numbered in the 100s, are cash and cash equivalent assets, like accounts receivables. Section two is for longer lasting and depreciable assets, like equipment, vehicles, and fixtures. These accounts are generally numbered in the 200s.
Liabilities come next in the chart and include accounts payable, lines of credit, loans, mortgages, and payroll tax withholdings. (Yes, that is correct—part of what the company takes out of an employee's paycheck is a liability and not an expense.) These accounts are generally numbered in the 300s.
The accounts in the 400s are reserved for the equity section of the balance sheet. Depending on how the business was created, accounts in this section could include owners' equity, retained earnings, accumulated adjustments, capital stock, and the current fiscal year's profit or loss.
The income statement starts with accounts numbered in the 500s and includes sales, service income, or other forms of revenue generated by the operation of the business.
The 600s are generally reserved for accounts that fall into the cost of goods sold category. This might include accounts for the materials, supplies, and labor needed to manufacture or produce the product a business is selling. It is important to note that this section may not be necessary if the business is selling a service that does not require materials, etc.
The next section is for general operating expenses, which range from advertising to workers' compensation insurance to everything in between. This section, usually numbered in the 700s, is the most variable section of any chart of accounts and will differ greatly depending on the business.
The last two sections are optional and may not apply to all businesses. The 800s are where you list non-business related income. This section is for things like interest, dividends, and rebates. On the flip side, the 900s are for non-business related expenses, like charitable donations.
Follow the plan
From a record-keeping perspective, the chart of accounts is the most important planning opportunity for any new small businesses. A proper chart of accounts will set the tone for success as the business goes forward. Conversely, a poorly executed chart of accounts will hinder success, create stress, require professional help to fix, and could ultimately lead to the downfall of the entire operation.
Before you start any business, plan and codify your chart of accounts—you will never regret that you did, but you will always regret that you didn't.