One of the first things any company needs to do when starting to lay the groundwork for its business finances is to set up a chart of accounts. It’s the backbone of every sound accounting system because it records every single account that your company uses to keep track of cash inflows and outflows.
This article will walk you through the fundamentals of setting up a customized chart of accounts that fits your business structure.
What is the Chart of Accounts?
For ease of understanding, let's think about it in terms of individual financial planning. It is common practice for online banking platforms to provide a dashboard that shows data for each one of your accounts, including checking, savings, and credit card numbers and balances. A company’s chart of accounts works similarly. The only difference is that companies typically have more types of accounts compared to individuals, which makes it appear more complex. Nevertheless, the premise and purpose remain the same, in that it provides an overview of all accounts involved in the firm's daily activities.
Types of Chart of Accounts
A chart of accounts will often have several accounts listed on it, each with its own specific function. These are the most common types:
● Asset Accounts: These funds reflect the company's ownership or management of resources that can provide future financial gains. Money, receivables, inventories, prepaid costs, and physical assets like buildings and machinery are a few examples.
● Liability Accounts: Anything you owe is considered a liability. Liability accounts reflect the debts and obligations that the company has to other parties. Some examples are receivables, payables, accumulated costs, and deferred income.
● Equity Accounts: Equity accounts represent the interest in a company’s assets that remains after removing liabilities from them. Examples include contributed capital for corporations, retained earnings for partnerships and sole proprietorships, and owner's equity for partnerships.
● Revenue Accounts: These accounts record earnings from the company's main activities or operations, such as income from rentals, interest, sales, and services.
● Expenses Accounts: The expenditures that a business incurs in pursuit of its revenue-generating activities are logged in the expense accounts. Wages and salaries, rent, utilities, cost of goods sold, depreciation, and marketing are some examples of expenses.
Five Steps to Making a Chart of Accounts
Follow these steps to set up a chart of accounts for your business.
1. Calculate the required number of accounts.
The first and most important step in creating a chart of accounts for your company is to determine how many accounts will be required. You should start by taking stock of the variety and intricacy of your financial dealings. Think about the assets, liabilities, sales, and expenses that make up your company. That said, keep in mind that too much information on a chart can be difficult to interpret and manage, so it's important to find a fair balance.
2. Organize financial records by assets, liabilities, equity, income, and expenses.
The second critical step, after deciding on the required number of accounts, is to classify them according to the various financial components: assets, liabilities, equity, income, and expenditures. This way of organizing accounts is both standard practice and helps with financial reporting and analysis. Moreover, it helps you make educated business decisions by providing a comprehensive picture of your company's financial health.
3. Create standard procedures for naming and numbering accounts.
Establishing rules for account numbering and naming is the next crucial step. This will make your chart of accounts more organized and consistent, and consequently, make it easier to understand and use for everyone involved.
The best practice is to list the assets first, followed by liabilities, equity, income, and costs. To make sure everyone can understand your accounts, choose names that are both short and descriptive. Also, use language that your team can understand and relate to instead of technical jargon. Before you allocate numbers, think about how important each subcategory's accounts are. Accounts that are vital or frequently used for financial analysis should receive lower numbers, while less critical accounts can receive higher numbers.
4. Create primary and secondary account groupings.
The fourth step in building a thorough chart of accounts is to develop primary account categories and subcategories, building upon the established account numbering and naming rules. By defining these primary and secondary categories, you can make your chart of accounts more applicable and useful by adapting it to your company’s specific structure.
5. Invest in good accounting software.
Many financial advisory firms, like Oblique Consult in the UAE, have now introduced specialized accounting softwares to simplify the chart of account management. If your budget allows, you should definitely invest in one and streamline your accounting and finance-related workflows. These systems also have pre-made templates for charts of accounts, which are both up-to-date with industry standards and give you a good starting point for making changes to fit your company's specific requirements.