In today’s business world, every business needs to use accounting software, whether it be QuickBooks (the most common choice among small businesses) or any number of other off-the-shelf or web-based accounting systems. One of the very first steps a business takes when setting up and configuring accounting software is to create a chart of accounts.

What is a Chart of Accounts?

In accounting, a chart of accounts is the “system of accounting records developed by every organization to be compatible with its particular financial structure, and in agreement with the amount of detail required in its financial statements.” (Source: BusinessDictionary.com).

One key point this suggests is that different kinds of businesses should have a differently structured chart of accounts. The chart of accounts you create will serve as the basis for how both income and expenses are tracked and reported.

What Goes Into a Chart of Accounts?

Your chart of accounts is a critical tool that is used not only to track information and prepare your taxes, but as a central component in the accounting cycle, including journal transactions. There are five categories in a chart of accounts. They are:

1. Assets – This tracks what the company owns.
2. Liabilities – This tracks what the company owes today or may owe in the future.
3. Equity – This tracks your investment in the business.
4. Revenues – This tracks your company’s sales revenues, cost of goods sold and investment or other income.
5. Expenses – This tracks your company’s expenses.

How is a Chart of Accounts Structured?

Typically, a chart of accounts will consist of individual account records, and each record will include:

• Account Name – The name of the account
• Account Number – The number assigned to the account (see below for details).
• Account Type – The category assigned to this account (as noted above).
• Account Description – A description of the account and its intended uses, based on the type of transaction that should be recorded to the account.

Creating Your Chart of Accounts

There are two factors that should go into creating your chart of accounts. One is the legal requirements associated with state and federal tax law compliance. The second is the management needs and goals you have for your business.

A key component in creating your chart of accounts is to build out the expense categories effectively, since expense reporting is an essential element in tax strategy and reporting. In particular, for sole proprietorships, the IRS primarily relies on The Schedule C – Profit or Loss From Business to present this information. The form requires you to clearly state three things:

1. Income
2. Returns and Allowances
3. Cost of Goods Sold

It then requires you to specify expenses from your business in the following categories:

• Advertising
• Car and Truck Expenses
• Commissions and Fees
• Contract Labor
• Depletion
• Depreciation (including Section 179 Deductions)
• Employee Benefit Programs
• Insurance
• Interest: Mortgage
• Interest: Other
• Legal and Professional Services
• Office Expense
• Pension and Profit-Sharing Plans
• Rent or Lease: Vehicles, Machinery and Equipment
• Rent or Lease: Other Business Property
• Repairs and Maintenance
• Supplies
• Taxes and Licenses
• Travel, Meals and Entertainment: Travel
• Travel, Meals and Entertainment: Deductible Meals & Entertainment
• Utilities
• Wages
• Other Expenses

Note: IRS forms and regulations change regularly. Always consult with your CPA to verify current information regarding tax and legal compliance.

Many businesses will then make adjustments once this foundation is established. One of the most common modifications is to build additional accounts or sub-accounts. For example, some companies will create sub-accounts for things such as rent or lease, or divide supplies up into office supplies, shipping/receiving/mailing supplies and operational supplies.

The Schedule C structure provides a solid foundation for key expense accounts that every business should include in their chart of accounts. However, it is not the only format that a business can use as the foundation for creating their chart of accounts.

For example, your CPA firm can create a chart of accounts that facilitates IRS compliance but is not necessarily formally built around the Schedule C structure. In many cases, having your CPA create a more customized chart of accounts can empower you to better understand and manage the affairs of your business.

A great way to evaluate what to build into your chart of accounts is to consider what would be helpful when you review your balance sheet and profit and loss reports. Also, keep in mind that your chart of accounts serves as the foundation for your company’s accounting journals and general ledger.

Another factor to consider is future growth potential for the business. Many entrepreneurs make the mistake of assuming that their company will stay a sole proprietorship or solo practice in one location, and then two or three years down the road, the company has changed or evolved in new ways.

Structuring Your Chart of Accounts

The structure of a chart of accounts is typically built on a four-digit numbering system. Although nearly all accounting systems automate this process, you should be aware of this so that you can ensure that you activate the numbering function.

This is essential for two reasons. One is that it presents the chart of accounts in a ‘language’ and format that your CPA can quickly and efficiently utilize. The other is that this approach provides expansion space for the future, since it provides large blocks of unused numbers between active accounts.

One of the most common numbering system formats is based on the following top-level configuration:

• Assets – Account numbers 1,000 to 1,999
• Liabilities – Account numbers 2,000 to 2,999
• Equity – Account numbers 3,000 to 3,999
• Revenues – Account numbers 4,000 to 4,999
• Expenses – Account numbers 5,000 to 5,999

There are some common modifications used along with this model. For example, in some cases companies will create a separate, sixth category for Cost of Goods Sold and insert it between revenue and expenses.

We’ve just touched upon the basics of creating an effective chart of accounts for your business. The best way to develop the right chart of accounts for your business is to consult with your CPA.

For more information on how to create a chart of accounts that ideally works for your business, contact the team at Haines & Lagerquist CPAs by calling 301-249-0703 or via email to cpa@hainesandlagerquist.com.