The goal of accounting is to record the economic activity of the business. This is achieved by entering each economic transaction into a set of books. The books are formatted to reflect the balance sheet and income statement items. The chart of accounts is designed to present the information in the prescribed format. So the layout of the chart of accounts is essential in the final outcome of reports for the entrepreneur.
To fully understand the chart of accounts, the reader must first understand what an account is used for in accounting. Next, the reader should understand the five major groupings (layout) of accounts for compiling data. Finally, the reader is introduced to variances in achieving a great chart to meet the business needs.
What is an Account?
Every business owner wants to know how his money is being spent. So accountants track this information in a register. Similar to the old fashion check registers – a list of activity – registers in accounting relate to a narrowly focused area of activity. In accounting, we keep a ledger of this activity in chronological order by date. This ledger is based on an account.
As an example, suppose you wanted to know how much money was spent on office supplies. Well, in almost all businesses, accountants create an account called ‘Office Supplies’. In this account, we record in chronological order the cost associated with office supplies purchased. The following is an illustration:
Account Identification: Office Supplies Group: Expenses
Date Source Document Description $ Amount Balance
11/02/13 Ck # 3304 Office Depot: Printer Cartridge $76.22 $76.22
11/07/13 American Express File Folder Packs/Erasers 83.11 159.33
11/15/13 A/P Tri-City Paper 7 cases of copier paper 117.40 276.73
When the information is presented with the details as illustrated above, we refer to this as a ledger. Most ledgers cover an accounting period (typically one month). The ledger sums the total for the month and will also report the Year To Date (YTD) activity balance (not illustrated above).
In our financial reports, this account will display the activity associated with the period request. Since this account is an expense account. The dollar amount will be reported on the Profit and Loss Statement in the expense section. If the reader of the report wants to know how much has been spent for the month to date for November 2013, the result will be $276.73. If requesting the YTD information, it would tally the entire amount for office supplies for the additional 10 months prior to November.
The reviewer may desire the details of the account and request a ledger report which is illustrated above. This information comes from the account information as entered for each economic transaction related to office supplies.
Six Major Groupings of Accounts
There are six major groups of accounts. The first two groups relate to the balance sheet. The first group is assets and the second and third group are liabilities and equity for the business.
Groups four through six relate to the profit and loss statement (income statement). They are respectively the revenue group, the cost of goods sold group and finally the expenses. Note the example for office supplies above is grouped in expenses.
The following are the respective five groups and many of their typical accounts:
Balance Sheet – Assets
- Accounts Receivable
- Fixed Assets
- Accumulated Depreciation
- Other Assets
Balance Sheet – Liabilities & Equity (Groups Two and Three)
- Accounts Payable
- Accrued Payroll & Payroll Taxes
- Short Term Notes Due Within One Year
- Long Term Notes
- Capital Paid In Excess
- Retained Earnings
- Current Earnings
Profit & Loss – Revenue
Profit & Loss – Cost of Goods Sold
- Payroll Benefits
Profit & Loss – Expenses
- Taxes & Licenses
- Office Supplies
- Depreciation & Amortization
The above accounts are the core accounts. But often as businesses grow and expand; the chart of accounts begin to grow into more details. As an example, a retail store may have two sites and each has their own cash, and cash awaiting deposit to the bank. There may be several checking accounts associated with functions. Below is a more detailed format of just the cash and bank accounts:
Balance Sheet Assets
Cash – summation of the subsidiary accounts
- Cash in the drawer at Store A
- Cash in the drawer at Store B
- Cash/Checks Awaiting Deposit (Held in Safe) – summation of the subsidiary accounts
- Store A
- Store B
Checking – summation of the subsidiary accounts
- Bank of the World – Acct # 1000001111 (General Operating)
- Bank of the World – Acct # 1000001112 (Payroll)
- Bank of the World – Acct # 1000001113 (Vendor/Suppliers)
Variances in the Chart of Accounts
Not every business is going to follow the basic model of a chart of accounts to the format as shown above. Often the industry or form of operations dictates a better or more useful set of accounts. Some industries are driven by the need to have more information related to the cost of goods sold, e.g. manufacturing and construction. Therefore, the cost of goods sold section in the chart of accounts would be expanded to meet the need for better information. Examples include adding ‘Equipment Rental’; instead of purchases, a contractor would have ‘Materials’, ‘Land’, ‘Supplies’ and ‘Contract Adjustments’. In manufacturing, we have direct and indirect costs to produce the product. Here accounts such as ‘Overhead Application’ and ‘Waste Disposal’ are included.
Other businesses have divisions of operations based on geographical location or customer types. In this case, the chart of accounts can have a divisional code added to their name or number identifying the correlating division.
The key is that the chart of accounts is laid out in the five basic groups as identified above. From this point the business owner can have the system expanded as he grows or changes his format of operations. Remember, you control your chart of accounts; there is no MANDATORY requirement to layout the chart of accounts in any particular pattern. There are however, customs and guidelines to make it easy for the owner of the business to expand the chart of accounts and/or gather information in an easy to retrieve format.
In many situations, the accounting software includes the basic core accounts in a preloaded chart of accounts associated with your type of business. When you start the software; it asks about the industry and then loads the basic set of accounts automatically for you.
Summary – Chart of Accounts
The chart of accounts layout is relatively straight forward. There are six basic groupings of accounts related to the two basic financial reports – the balance sheet and income statement (profit and loss). The chart of accounts can be modified to suit your particular business and there is no mandatory requirement to have them in a specialized order. There are customs and guidelines to make it easier to work with them, but overall, as the owner, you control the chart of accounts layout. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.