The chart of accounts, or COA, is an accounting term that refers to the list of all the accounts used in the general ledger.
The accounts utilized in the income statement and balance sheet are primarily what dictates the accounts that get organized into a chart of accounts:
By setting up a chart of accounts, subgroups of accounts that belong to each of the above categories. By assigning categories, numbers, and number ranges to each category, it ensures that the accounts are properly labeled so that the bookkeeper can enter and check transactions with ease.
Why is a Chart of Accounts Important?
When financial statements must be prepared or information is looked up, it's crucial to be able to trace back to specific accounts outlined in the chart of accounts. Having accounts organized into proper subgroups helps provide business owners with a "bird's eye view" of their finances, and subsequently able to compute key ratios such as available working capital, debt-equity ratio, and determining liquidity and solvency. When information is easier to find, it improves efficiency across all departments and not just accounting functions. For instance, the human resources department may need to look up benefit costs and pay history for a specific employee, while also wanting to find out how much of an entire department or division is spending on payroll.
Having a well-organized chart of accounts also makes it faster and easier to file taxes and if required by the IRS, reconcile tax to books differences. While the smallest businesses only need to report income and expenses to the IRS and different considerations are made for tax purposes, larger businesses with a certain amount of assets also need to report the figures on their financial statements and reconcile the difference. No matter the size of the business, having a chart of accounts in place helps organize financial information and facilitate tax filing, and help business owners analyze their financial decision-making more closely.
Having information correctly conveyed in a properly set up chart of accounts, makes it easier for the end-users in an accounting information system to do their jobs and quickly find the information they need.
How Should a Chart of Accounts Be Organized?
Business functions are first broken down by groups of numbers. While there is no "hard and fast" rule for how the numbers in a chart of accounts should be labeled, they generally follow this convention throughout the accounting field:
- Assets: 1000–1999
- Liabilities: 2000–2999
- Equity accounts: 3000–3999
- Income: 4000–4999
- Expenses: 5000–9999
Every business has different needs, and thus different levels of complexity in their chart of accounts. The accounting specialist or bookkeeper then decides how granular the chart of accounts should be, but regardless of business type or size, they tend to utilize the above convention and modify it for their organization's specific needs.
The reason why this chart of accounts convention persists is that this numbering scheme makes it easier for users to memorize and key in account numbers if they don't know the name. It's common to expect that accounts starting with a 1 are going to be asset accounts. However, the chart of accounts can get more granular and use subgroup conventions differently than other companies. Depending on the accounting system in place and how the assets are labeled into subgroups, accounts beginning with 10 may only refer to cash assets like bank and merchant accounts while an 11 preface refers to receivables.
Expenses tend to get sorted in 5000-9999 because they are generally the largest and most diverse group of transactions that a business entity will have. Even if the business has many customers, their payments are generally tied to only a few different income accounts, like sales or service revenues. Even an incredibly small business is going to have many different kinds of expenses while large companies have more detailed expense reports that would require keying in several different expense accounts. These accounts may be generalized, such as Account #5500 for travel and lodging expenses, or they may be separated by an employee's rank or department, such as Account #5501 being for executives' expenses only.
Modifying a Chart of Accounts
Most accounting software has an option to manually set up a chart of accounts, or go with a template option based on the business type. However, they do not always account for business needs and realities.
For instance, a bakery would have multiple inventory accounts such as raw materials like flour and sugar, work in process for half-finished goods, and finished goods for completed products for sale. A software company that does not keep inventory would want to track service and subscription revenues separately but doesn't need inventory accounts. If a small business doesn't have employees, it does not need to set up expense and liability accounts for payroll and related taxes payable.
Charts of accounts also need to be modified as a business evolves and have new expense accounts created, or merged. Opening new bank accounts, taking out loans, and getting investors will also change the way that transactions are reported and grouped.