Chart of Accounts Explained
Definition
In accounting, bookkeepers organize transactions by collecting them together in similar groups called accounts. These accounts, in turn, have names assigned to them, which can be unique to the business or can be common names.
Since these names are often unique and are based on the needs of a particular business, it is helpful to have a list of accounts that a company uses. This way, all the employees know which accounts can be used to record the transactions. This listing of accounts is known as a chart of accounts.
It should be noted that although giving the accounts respective names is more commonly practiced, some companies choose to use numbers instead. The numbering is more common among larger organizations and makes it easier for accountants to provide and share information. For example, you will see numbers such as 115, 240, and 450.
Although there are no specific rules for account numbers, most bookkeepers create them following a similar pattern. Usually, the accounts from one category start with the same number. The categories themselves, which we are going to discuss next, are numbered from 1 to 5, with Assets being 1 and Expenses being 5. Since the Expense category typically consists of many accounts, it can have more numbers assigned to it.
Structure
A chart of account is simply a list of all account used in an organization that is organized in a very specific way. First of all, the accounts are grouped by the category within the accounting equation that they belong in. Assets are first, then Liabilities, then Shareholder’s Equity. Since Revenues and Expenses are part of the Owner’s Equity, these come after the other Shareholder’s Equity accounts. Note that for a non-profit organization, the Chart of Accounts will look slightly different.
Assets
Within each category of accounts, there are also specific orders that are used in each category. For instance, assets are always recorded in the order of their liquidity, with the most liquid assets being listed first. Accordingly, you will always see Cash being the first item on the Chart of Accounts.
The next item is usually Accounts Receivable and followed by any assets that a business plans to use or sell quickly. A good example would be Supplies because for most businesses this is something that is used by the businesses within one year of the purchase. Next, they list the accounts that are harder to trade or convert into cash, such as equipment, machinery, and vehicles since companies usually keep these for many years.
Liabilities
In the Liabilities category, short-term debts are added first and the other accounts are going in alphabetical order. For example, you can see the following accounts:
- Accounts Payable
- Payroll Liabilities
- Income Tax Payable
- Bank Loan.
Owner’s Equity
The accounts listed in this category will depend on the type of business you are looking at. For a Sole Proprietorship, for example, you will only see two accounts: Capital and Draws. The Draws always follow the Capital account. For other business types, they might also need to add accounts such as Retained Earnings or Common Stock.
Revenues
Revenue accounts are always presented in alphabetical order. Common accounts in this category include Sales, which can be divided into Product 1 Sales, Product 2 Sales, and so on, Bank Account Interest, and other income.
Expenses
Just like Revenue accounts, Expense accounts are also placed in alphabetical order. When it comes to Expense accounts, the list can be endless and greatly depends on the specific business you are looking at. At the same time, there are expenses that most businesses have to pay no matter what they are doing. These would be recorded in accounts known as Advertising, Insurance, Rent, Depreciation, Sales Salaries, Office Supplies, and Miscellaneous.