A Chart of Account is a list of each account you’re going to use in your small business accounting system.
If you’ve found this web page I’m assuming you are just starting out in a small business, and need some accounting help. You’ve come to the right place. This website is all about small business. It’s not for accounting students, it’s for business owners or those trying to keep the books for one. So let’s start off with a simple question.
What is an account?
Assume you have a truckload of fruit. It’s all in one big crate. The trouble is, you don’t know how many oranges you have, or how many apples you have. So you divide them up into individual boxes.
Think of accounts like that. We have all kinds of business transactions. But they mean nothing when they’re all lumped together, so we separate them into accounts.
There are 5 types of accounts in your Chart of Accounts:
· Assets (things you own)
· Liabilities (things you owe)
· Owner’s Equity (owner’s net worth)
· Revenue (income)
· Expenses (costs of business)
Usually, accounts will have numbers and names. This is especially true in small business accounting software packages. For example: 1200 - Cash in Checking
Let’s divide up the Chart of Accounts and look at each type of account in depth.
Assets, put simply, are things you own. (you meaning your business)
In your Chart of Accounts there are Current Assets and Non-Current Assets.
Current Assets are accounts like Cash and things that are easily converted into cash, like Accounts Receivable (money owed to you from customers), Inventory, Savings Accounts, and some investments.
Non-Current Assets are things that are kept around longer. These can be:
Liabilities are things you owe.
Like Assets, they are divided into Current Liabilities and Non-Current Liabilities (more commonly called Long-Term Liabilities).
· Current Liabilities are obligations you will pay off within a year. These are things like vendor bills (Accounts Payable), payroll taxes due, and current portions of loans.
· Long-Term Liabilities are obligations that will take more than a year to pay, or loans that aren’t being paid for a while, like an owner loan. These are mortgages, vehicle loans, and any loans from you the owner, or other individuals that you won’t pay back right away.
Equity has a few other names…it also goes by Capital, or Net Worth. This is the accumulated worth of the business. In your Chart of Accounts, the accounts in this asset class differ depending on the legal structure of your business.
· If you are a sole proprietor, you will have Owner’s Equity. This account is sometimes subdivided into Owner Contributions and Owner Withdrawals.
· If you have a partnership, each partner will have his or her own Owner’s Equity account.
· If you have a Corporation, you will have accounts for Stock, Retained Earnings, and Dividends.
Revenue is income, which would be sales and any other miscellaneous monies coming into your business, like bank interest income, scrap income, or the like.
I suggest setting up a revenue account in your Chart of Accounts for each income stream you have. This makes sales analysis so much easier. You can set up revenue accounts for each product or type of product, for each method of sales (store, internet, direct mail, etc), or for each location. Take a little time and think about how you’d like to measure your sales later.
Expenses are the costs of doing business. Expenses are divided into 2 types:
· Cost of Goods Sold – these are the direct costs of making your product. Actually, this is a calculation on your Income Statement for most small businesses, not an actual account. But this designation covers the accounts of Materials (pieces used to make products), Direct Labor (employees directly making the products), Contracted Services (Subcontractors directly affecting the product), and Freight (getting the product to the customer).
Retailers and Service businesses would use the term ‘Cost of Sales’ instead. Retailers would use the account Purchases instead of Materials, and this would be for the products they buy to resell. Service businesses would include purchases directly used in providing their services.
· Selling & Administrative Expenses – these would be most of your ‘overhead’ costs, like rent, utilities, advertising, automobile costs, non-direct wages, interest expense, depreciation, etc.
When you list all of your accounts in your Chart of Accounts with their respective balances, this is called a Trial Balance. Just in case you wanted to know that. Impress your CPA.
Okay, so what do we do with all these accounts?
We use them in accounting journals, to designate like kind transactions. We can then summarize all like kind transactions together at the end of a month, quarter, or year, and use that information to help us make sound business decisions.
For example, if we’re using a manual accounting system, and a cash receipts journal, we use the account “Sales” to accumulate our revenue (income) received in our gift shop. By looking at the total sales each month in our cash receipts journals, we can compare month to month what our total sales were. We can see which months had higher or lower sales, to determine seasonality. We can use that information to determine which months to have a 10% off sale, or which month to take a vacation, etc.
That’s just a simple illustration, but tracking your business transactions and comparing month to month, quarter to quarter, and year to year gives you a lot of good information. And that’s what accounting is all about. And developing a good Chart of Accounts is one of the first steps in setting up a small business accounting system.
Learn more accounting basics here.