Chapter 3

Outlining Your Financial Road Map with a Chart of Accounts

In This Chapter

Introducing the Chart of Accounts

Reviewing the types of accounts that make up the chart

Creating your own Chart of Accounts

Can you imagine the mess your checkbook would be if you didn’t record each check you wrote? Like me, you’ve probably forgotten to record a check or two on occasion, but you certainly learn your lesson when you realize that an important payment bounces as a result. Yikes!

Keeping the books of a business can be a lot more difficult than maintaining a personal checkbook. You have to carefully record each business transaction to make sure that it goes into the right account. This careful bookkeeping gives you an effective tool for figuring out how well the business is doing financially.

As a bookkeeper, you need a road map to help you determine where to record all those transactions. This road map is called the Chart of Accounts. In this chapter, I tell you how to set up the Chart of Accounts, which includes many different accounts. I also review the types of transactions you enter into each type of account in order to track the key parts of any business — assets, liabilities, equity, revenue, and expenses.

Getting to Know the Chart of Accounts

The Chart of Accounts is the road map that a business creates to organize its financial transactions. After all, you can’t record a transaction until you know where to put it! Essentially, this chart is a list of all the accounts a business has, organized in a specific order; each account has a description that includes the type of account and the types of transactions that should be entered into that account. Every business creates its own Chart of Accounts based on how the business is operated, so you’re unlikely to find two businesses with the exact same chart.

However, some basic organizational and structural characteristics are common to all Charts of Accounts. The organization and structure are designed around two key financial reports: the balance sheet, which shows what your business owns and what it owes, and the income statement, which shows how much money your business took in from sales and how much money it spent to generate those sales. (You can find out more about balance sheets in Chapter 18 and income statements in Chapter 19.). The following lists show you a common order for these accounts within each of their groups, based on how they appear on the financial statements.

The Chart of Accounts starts first with the balance sheet accounts, which include

Current Assets: Includes all accounts that track things the company owns and expects to use in the next 12 months, such as cash, accounts receivable (money collected from customers), and inventory

Long-term Assets: Includes all accounts that track things the company owns that have a lifespan of more than 12 months, such as buildings, furniture, and equipment

Current Liabilities: Includes all accounts that track debts the company must pay over the next 12 months, such as accounts payable (bills from vendors, contractors, and consultants), interest payable, and credit cards payable

Long-term Liabilities: Includes all accounts that track debts the company must pay over a period of time longer than the next 12 months, such as mortgages payable and bonds payable

Equity: Includes all accounts that track the owners of the company and their claims against the company’s assets, which includes any money invested in the company, any money taken out of the company, and any earnings that have been reinvested in the company

The rest of the chart is filled with income statement accounts, which include

Revenue: Includes all accounts that track sales of goods and services as well as revenue generated for the company by other means

Cost of Goods Sold: Includes all accounts that track the direct costs involved in selling the company’s goods or services

Expenses: Includes all accounts that track expenses related to running the business that aren’t directly tied to the sale of individual products or services

When developing the Chart of Accounts, you start by listing all the Asset accounts, the Liability accounts, the Equity accounts, the Revenue accounts, and finally, the Expense accounts. All these accounts come from two places: the balance sheet and the income statement.

In this chapter, I review the key account types found in most businesses, but this list isn’t cast in stone. You should develop an account list that makes the most sense for how you’re operating your business and the financial information you want to track. As I explore the various accounts that make up the Chart of Accounts, I point out how the structure may differ for different types of businesses.

The Chart of Accounts is a money management tool that helps you track your business transactions, so set it up in a way that provides you with the financial information you need to make smart business decisions. You’ll probably tweak the accounts in your chart annually and, if necessary, you may add accounts during the year if you find something for which you want more detailed tracking. You can add accounts during the year, but it’s best not to delete accounts until the end of a 12-month reporting period. I discuss adding and deleting accounts from your books in Chapter 17.

Starting with the Balance Sheet Accounts

The first part of the Chart of Accounts is made up of balance sheet accounts, which break down into the following three categories:

Asset: These accounts are used to track what the business owns. Assets include cash on hand, furniture, buildings, vehicles, and so on.

Liability: These accounts track what the business owes, or, more specifically, claims that lenders have against the business’s assets. For example, mortgages on buildings and lines of credit are two common types of liabilities.

Equity: These accounts track what the owners put into the business and the claims the owners have against the business’s assets. For example, stockholders are company owners that have claims against the business’s assets.

The balance sheet accounts, and the financial report they make up, are so-called because they have to balance out. The value of the assets must be equal to the claims made against those assets. (Remember, these claims are liabilities made by lenders and equity made by owners.)

I discuss the balance sheet in greater detail in Chapter 18, including how to prepare and use it. This section, however, examines the basic components of the balance sheet, as reflected in the Chart of Accounts.

Tackling assets

The first accounts on the chart are always the ones that track what the company owns — its assets. The two types of asset accounts are current assets and long-term assets.

Current assets

Current assets are the key assets that your business uses up during a 12-month period and that likely won’t be there the next year. Here are the accounts that reflect current assets on the Chart of Accounts, starting with the cash accounts:

Cash in Checking: Any company’s primary account is the checking account used for operating activities. This account is for depositing revenues and paying expenses. Some companies have more than one operating account in this category; for example, a company with many divisions may have an operating account for each division.

Cash in Savings: This account is used for surplus cash. Any cash for which the company has no immediate plan is deposited in an interest-earning savings account so that it can at least earn interest while the company decides what to do with it.

Cash on Hand: This account is used to track any cash kept at retail stores or in the office. In retail stores, cash must be kept in registers in order to provide change to customers. In the office, petty cash is often kept around for immediate cash needs that pop up from time to time. This account helps you keep track of the cash held outside a financial institution.

Accounts Receivable: If you offer your products or services to customers on store credit (meaning your store credit system), you need this account to track the customers who buy on your dime.

Accounts Receivable isn’t used to track purchases made on other types of credit cards because your business gets paid directly by banks, not customers, when other credit cards are used. Head to Chapter 9 to read more about this scenario and the corresponding type of account.

Inventory: This account tracks the products you have on hand to sell to your customers. The value of the assets in this account varies depending on the way you decide to track the flow of inventory into and out of the business. I discuss inventory valuation and tracking in greater detail in Chapter 8.

Prepaid Insurance: This account tracks insurance you pay in advance that’s credited as it’s used up each month. For example, if you own a building and prepay the insurance one year in advance, each month you reduce the amount that you prepaid by 1⁄12 as the prepayment is used up.

Depending upon the type of business you’re setting up, you may have other current asset accounts that you decide to track. For example, if you’re starting a service business in consulting, you’re likely to have a Consulting account for tracking cash collected for those services. If you run a business in which you barter assets (such as trading your services for paper goods from a paper goods company), you may add a Barter account for business-to-business barter.

Try It

Exercise 3-1: Think about the current assets you’ll need to track for your business and write down the accounts on a separate piece of paper.

Long-term assets

Long-term assets are assets that you anticipate your business will use for more than 12 months. This section lists some of the most common long-term assets, starting with the key accounts related to buildings and factories owned by the company:

Land: This account tracks the land owned by the company. The value of the land is based on the cost of purchasing it. Land value is tracked separately from the value of any buildings standing on that land because land isn’t depreciated in value, but buildings must be depreciated. (Depreciation is an accounting method that shows an asset is being used up. I talk more about depreciation, including how to calculate it, in Chapter 12.)

Buildings: This account tracks the value of any buildings a business owns. As with land, the value of the building is based on the cost of purchasing it, but the building’s value is depreciated, as discussed in the preceding bullet.

Accumulated Depreciation – Buildings: This account tracks the cumulative amount a building is depreciated over its useful lifespan.

Leasehold Improvements: This account tracks the value of improvements to buildings or other facilities that a business leases rather than purchases. Frequently, a business that leases a property must pay for any improvements necessary to use that property the way it’s needed. For example, if a business leases a store in a strip mall, the space leased is likely an empty shell or filled with shelving and other items that may not match the particular needs of the business. As with buildings, leasehold improvements are depreciated as the value of the asset ages.

Accumulated Depreciation – Leasehold Improvements: This account tracks the cumulative amount depreciated for leasehold improvements.

But long-term assets aren’t always on the scale of land tracts and buildings. The following are the types of accounts for smaller long-term assets, such as vehicles and furniture:

Vehicles: This account tracks any cars, trucks, or other vehicles owned by the business. The initial value of any vehicle is listed in this account based on the total cost paid to put the vehicle in service. Sometimes this value is more than the purchase price if additions were needed to make the vehicle usable for the particular type of business. For example, if a business provides transportation for the handicapped and must add additional equipment (such as a wheelchair lift) to a vehicle to serve the needs of its customers, that additional equipment is added to the value of the vehicle. Vehicles also depreciate through their useful lifespan.

Accumulated Depreciation – Vehicles: This account tracks the depreciation of all vehicles owned by the company.

Furniture and Fixtures: This account tracks any furniture or fixtures purchased for use in the business. The account includes the value of all chairs, desks, store fixtures, and shelving needed to operate the business. The value of the furniture and fixtures in this account is based on the cost of purchasing these items. These items are depreciated during their useful lifespan.

Accumulated Depreciation – Furniture and Fixtures: This account tracks the accumulated depreciation of all furniture and fixtures.

Equipment: This account tracks equipment that was purchased for use for more than one year, such as computers, copiers, tools, and cash registers. The value of the equipment is based on the cost to purchase these items. Equipment is also depreciated to show that over time it gets used up and must be replaced.

Accumulated Depreciation – Equipment: This account tracks the accumulated depreciation of all the equipment.

You’re not done yet. Some long-term assets are intangible assets, assets that you can’t touch but that still represent things of value owned by the company, such as organization costs, patents, and copyrights. The accounts that track these assets include

Organization Costs: This account tracks initial start-up expenses to get the business off the ground. Many such expenses can’t be written off in the first year. For example, special licenses and legal fees must be written off over a number of years by using a method similar to depreciation, called amortization, which is also tracked. I discuss amortization in greater detail in Chapter 12.

Amortization – Organization Costs: This account tracks the accumulated amortization of organization costs during the period in which they’re being written-off.

Patents: This account tracks the costs associated with patents, grants made by governments that guarantee the inventor of a product or service the exclusive right to make, use, and sell that product or service over a set period of time. Like organization costs, patent costs are amortized. The value of this asset is based on the expenses the company incurs to get the right to patent the product.

Amortization – Patents: This account tracks the accumulated amortization of a business’s patents.

Copyrights: This account tracks the costs incurred to establish copyrights, the legal rights given to an author, playwright, publisher, or any other distributor of a publication or production for a unique work of literature, music, drama, or art. This legal right expires after a set number of years, so its value is amortized as the copyright gets used up.

Goodwill: This account is only needed if a company buys another company for more than the actual value of its tangible assets. Goodwill reflects the intangible value of this purchase for things like company reputation, store locations, customer base, and other items that increase the value of the business bought.

If you hold a lot of assets that aren’t of great value, you can also set up an “Other Assets” account to track those assets that don’t have significant business value. Any asset you track in the Other Assets account that you later want to track individually can be shifted to its own account. Flip to Chapter 18 for info on adjusting the Chart of Accounts.

Try It

Exercise 3-2: Think about the long-term asset accounts you’ll need to track for your business and write them down on a separate piece of paper.

Laying out your liabilities

After you cover assets, the next stop on the bookkeeping highway is the accounts that track what your business owes to others. These “others” can include vendors from which you buy products or supplies, financial institutions from which you borrow money, and anyone else who lends money to your business. Like assets, liabilities are lumped into two types: current liabilities and long-term liabilities.

Current liabilities

Current liabilities are debts due in the next 12 months. Some of the most common types of current liabilities accounts that appear on the Chart of Accounts are

Accounts Payable: This account tracks money the company owes to vendors, contractors, suppliers, and consultants that must be paid in less than a year. Most of these liabilities must be paid in 30 to 90 days from initial billing.

Sales Tax Collected: You may not think of sales tax as a liability, but because the business collects the tax from the customer and doesn’t pay it immediately to the government entity, the taxes collected become a liability tracked in this account. A business usually collects sales tax throughout the month and then pays it to the local, state, or federal government on a monthly basis. I cover paying sales taxes in greater detail in Chapter 20.

Accrued Payroll Taxes: This account tracks payroll taxes collected from employees to pay state, local, or federal income taxes as well as Social Security and Medicare taxes. Companies don’t have to pay these taxes to the government entities immediately, so depending on the size of the payroll, companies may pay payroll taxes on a monthly or quarterly basis. I discuss how to handle payroll taxes in Chapter 10.

Credit Cards Payable: This account tracks all credit card accounts to which the business is liable. Most companies use credit cards as short-term debt and pay them off completely at the end of each month, but some smaller companies carry credit card balances over a longer period of time. Because credit cards often have a much higher interest rate than most lines of credit, most companies transfer any credit card debt they can’t pay entirely at the end of a month to a line of credit at a bank. When it comes to your Chart of Accounts, you can set up one Credit Cards Payable account, but you may want to set up a separate account for each card your company holds to improve your ability to track credit card usage.

How you set up your current liabilities and how many individual accounts you establish depend on how much detail you want to track for each type of liability. For example, you can set up separate current liability accounts for major vendors if you find that approach provides you with a better money management tool. Suppose that a small hardware retail store buys most of the tools it sells from Snap-on. To keep better control of its spending with Snap-on, the bookkeeper sets up a specific account called Accounts Payable – Snap-on, which is used only for tracking invoices and payments to that vendor. In this example, all other invoices and payments to other vendors and suppliers are tracked in the general Accounts Payable account.

Try It

Exercise 3-3: Think about the Current Liabilities accounts you’ll need to track for your business and write them down on a separate piece of paper.

Long-term liabilities

Long-term liabilities are debts due in more than 12 months. The number of long-term liability accounts you maintain on your Chart of Accounts depends on your debt structure. The two most common types of long-term liability accounts are

Loans Payable: This account tracks any long-term loans, such as a mortgage on your business building. Most businesses have separate loans payable accounts for each of their long-term loans. For example, you may have Loans Payable – Mortgage Bank for your building and Loans Payable – Car Bank for your vehicle loan.

Notes Payable: Some businesses borrow money from other businesses by using notes, a method of borrowing that doesn’t require the company to put up an asset, such as a mortgage on a building or a car loan, as collateral. This account tracks any notes due.

In addition to any separate long-term debt you may want to track in its own account, you may also want to set up an account called “Other Liabilities” that you can use to track types of debt that are so insignificant to the business that you don’t think they need their own accounts.

Try It

Exercise 3-4: Think about the Long-term Liabilities accounts you’ll need to track for your business and write them down on a separate piece of paper.

Eyeing the equity

Every business is owned by somebody. Equity accounts track owners’ contributions to the business as well as their share of ownership. For a corporation, ownership is tracked by the sale of individual shares of stock because each stockholder owns a portion of the business. In smaller companies that are owned by one person or a group of people, equity is tracked using Capital and Drawing Accounts. Here are the basic equity accounts that appear in the Chart of Accounts:

Common Stock: This account reflects the value of outstanding shares of stock sold to investors. A company calculates this value by multiplying the number of shares issued by the value of each share of stock. Note: Only corporations need to establish this account.

Retained Earnings: This account tracks the profits or losses accumulated since a business was opened. At the end of each year, the profit or loss calculated on the income statement is used to adjust the value of this account. For example, if a company made a $100,000 profit in the past year, the Retained Earnings account would be increased by that amount; if the company lost $100,000, that amount would be subtracted from this account.

Capital: This account is only necessary for small, unincorporated businesses. The Capital account reflects the amount of initial money the business owner contributed to the company as well as owner contributions made after initial start-up. The value of this account is based on cash contributions and other assets contributed by the business owner, such as equipment, vehicles, or buildings. If a small company has several different partners, each partner gets his or her own Capital account to track his or her contributions.

Drawing: This account is only necessary for businesses that aren’t incorporated. The Drawing account tracks any money that a business owner takes out of the business. If the business has several partners, each partner gets his or her own Drawing account to track what he or she takes out of the business.

Try It

Exercise 3-5: Think about the Equity accounts you’ll need to track for your business and write them down on a separate piece of paper.

Tracking the Income Statement Accounts

The income statement is made up of two types of accounts:

Revenue: These accounts track all money coming into the business, including sales, interest earned on savings, and any other methods used to generate income.

Expenses: These accounts track all money that a business spends in order to keep itself afloat.

The bottom line of the income statement shows whether your business made a profit or a loss for a specified period of time. I discuss how to prepare and use an income statement in greater detail in Chapter 19.

This section examines the various accounts that make up the income statement portion of the Chart of Accounts.

Recording the money you make: Revenue

First up in the income statement portion of the Chart of Accounts are accounts that track revenue coming into the business. If you choose to offer discounts or accept returns, those activities also fall within the revenue grouping. The most common income accounts are

Sales of Goods or Services: This account, which appears at the top of every income statement, tracks all the money that the company earns selling its products, services, or both.

Sales Discounts: Because most businesses offer discounts to encourage sales, this account tracks any reductions to the full price of merchandise.

Sales Returns: This account tracks transactions related to returns (when a customer returns a product because he or she is unhappy with it for some reason).

When you examine an income statement from a company other than the one you own or are working for, you usually see the following accounts summarized as one line item called Revenue or Net Revenue. Because not all income is generated by sales of products or services, other income accounts that may appear on a Chart of Accounts include

Other Income: If a company takes in income from a source other than its primary business activity, that income is recorded in this account. For example, a company that encourages recycling and earns income from the items recycled records that income in this account.

Interest Income: This account tracks any income earned by collecting interest on a company’s savings accounts. If the company loans money to employees or to another company and earns interest on that money, that interest is recorded in this account as well.

Sale of Fixed Assets: Any time a company sells a fixed asset, such as a car or furniture, any revenue made from the sale is recorded in this account. A company should only record revenue remaining after subtracting the accumulated depreciation from the original cost of the asset.

Try It

Exercise 3-6: Think about the Revenue accounts you’ll need to track for your business and write them down on a separate piece of paper.

Tracking the cost of sales

Of course, before you can sell a product, you must spend some money to either buy or make that product. The type of account used to track the money spent is called a Cost of Goods Sold account. The most common Cost of Goods Sold accounts are

Purchases: This account tracks the purchases of all items you plan to sell.

Purchase Discount: This account tracks the discounts you may receive from vendors if you pay for your purchase quickly. For example, a company may give you a 2-percent discount on your purchase if you pay the bill in 10 days rather than wait until the end of the 30-day payment allotment.

Purchase Returns: If you’re unhappy with a product you’ve bought, record the value of any returns in this account.

Freight Charges: Any charges related to shipping items you purchase for later sale are tracked in this account. You may or may not want to keep track of this detail.

Other Sales Costs: This catchall account is for anything that doesn’t fit into one of the other Cost of Goods Sold accounts.

Try It

Exercise 3-7: Think about the Cost of Goods Sold accounts you’ll need to track for your business and write them down on a separate piece of paper.

Acknowledging the money you spend: Expense accounts

Expense accounts take the cake for the longest list of individual accounts. Any money you spend on the business that can’t be tied directly to the sale of an individual product falls under the expense account category. For example, advertising a storewide sale isn’t directly tied to the sale of any one product, so the costs associated with advertising fall under the expense account category.

The Chart of Accounts mirrors your business operations, so it’s up to you to decide how much detail you want to keep in your expense accounts. Most businesses have expenses that are unique to their operations, so your list will probably be longer than the one I present here. However, you also may find that you don’t need some of these accounts.

On your Chart of Accounts, the expense accounts don’t have to appear in any specific order, so I list them here alphabetically. The most common expense accounts are

Advertising: This account tracks all expenses involved in promoting a business or its products. Money spent on newspaper, television, magazine, radio, and Internet-based advertising is recorded here, as well as any money spent to print flyers and mailings to customers. Also, when a company participates in community events such as cancer walks or craft fairs, associated costs are tracked in this account as well.

Bank Service Charges: This account tracks any charges made by a bank to service a company’s bank accounts.

Dues and Subscriptions: This account tracks expenses related to business club memberships or subscriptions to magazines for the business.

Equipment Rental: This account tracks expenses related to renting equipment for a short-term project. For example, a business that needs to rent a truck to pick up some new fixtures for its store records that truck rental in this account.

Insurance: This account tracks any money paid to buy insurance. Many businesses break this down into several accounts, such as Insurance – Employees Group, which tracks any expenses paid for employee insurance, or Insurance – Officers’ Life, which tracks money spent to buy insurance to protect the life of a key owner or officer of the company.

Companies often insure their key owners and executives because an unexpected death, especially for a small company, may mean facing many unexpected expenses in order to keep the company’s doors open. In such a case, the insurance proceeds can be used to cover those expenses.

Legal and Accounting: This account tracks any money that’s paid for legal or accounting advice.

Miscellaneous Expenses: This catchall account is for expenses that don’t fit into one of a company’s established accounts. If certain miscellaneous expenses occur frequently, a company may choose to add an account to the Chart of Accounts and move related expenses into that new account by subtracting all related transactions from the Miscellaneous Expenses account and adding them to the new account.

With this shuffle, be sure to carefully balance out the adjusting transaction to avoid any errors or double counting.

Office Expense: This account tracks any items purchased in order to run an office. For example, office supplies such as paper and pens or business cards fit in this account. As with miscellaneous expenses, companies may choose to track some office expense items in their own separate accounts. For example, if you find your office is using a lot of copy paper and you want to track that separately, you set up a Copy Paper expense account. Just be sure you really need the detail, because the number of accounts can get unwieldy and hard to manage.

Payroll Taxes: This account tracks any taxes paid related to employee payroll, such as the employer’s share of Social Security and Medicare, unemployment compensation, and workers’ compensation.

Postage: This account tracks any money spent on stamps, express package shipping, and other shipping. If a company does a large amount of shipping through vendors such as UPS or FedEx, it may want to track that spending in separate accounts for each vendor. This option is particularly helpful for small companies that sell over the Internet or through catalog sales.

Rent Expense: This account tracks rental costs for a business’s office or retail space.

Salaries and Wages: This account tracks any money paid to employees as salary or wages.

Supplies: This account tracks any business supplies that don’t fit into the category of office supplies. For example, supplies needed for the operation of retail stores are tracked using this account.

Travel and Entertainment: This account tracks money spent for business purposes on travel or entertainment. Some businesses separate these expenses into several accounts, such as Travel and Entertainment – Meals, Travel and Entertainment – Travel, and Travel and Entertainment – Entertainment, to keep a close watch.

Telephone: This account tracks all business expenses related to the telephone and telephone calls.

Utilities: This account tracks money paid for utilities, such as electricity, gas, and water.

Vehicles: This account tracks expenses related to the operation of company vehicles.

Try It

Exercise 3-8: Think about the Expense accounts you’ll need to track for your business and write them down on a separate piece of paper.

Setting Up Your Chart of Accounts

You can use the lists upon lists of accounts provided in this chapter to get started setting up your business’s own Chart of Accounts. There’s really no secret to making your own chart; just make a list of the accounts that apply to your business.

When first setting up your Chart of Accounts, don’t panic if you can’t think of every type of account you may need for your business. Adding to the Chart of Accounts at any time is very easy. Just add the account to the list and distribute the revised list to any employees who use the Chart of Accounts for recording transactions into the bookkeeping system. (Even employees not involved in bookkeeping need a copy of your Chart of Accounts if they code invoices or other transactions and indicate to which account those transactions should be recorded.)

The Chart of Accounts usually includes at least three columns:

Account: Lists the account names

Type: Lists the type of account — asset, liability, equity, income, cost of goods sold, or expense

Description: Contains a description of the type of transaction that should be recorded in the account

Many companies also assign numbers to the accounts, to be used for coding charges. If your company is using a computerized system, the computer automatically assigns the account number. Otherwise, you need to plan out your own numbering system. The most common number system is

Asset accounts: 1,000 to 1,999

Liability accounts: 2,000 to 2,999

Equity accounts: 3,000 to 3,999

Sales and Cost of Goods Sold accounts: 4,000 to 4,999

Expense accounts: 5,000 to 6,999

This numbering system matches the one used by computerized accounting systems, making it easy for a company to transition to automated books at some future time.

If you choose a computerized accounting system, one major advantage is that a number of different Charts of Accounts have been developed for various types of businesses. When you get your computerized system, whichever accounting software you decide to use, all you need to do is review its list of chart options for the type of business you run, delete any accounts you don’t want, and add any new accounts that fit your business plan.

If you’re setting up your Chart of Accounts manually, be sure to leave a lot of room between accounts to add new accounts. For example, number your Cash in Checking account 1,000 and your Accounts Receivable account 1,100. That leaves you plenty of room to add other accounts to track cash.

On the CD, you can find a sample Chart of Accounts that you can customize for your business. If you are reading this text in an electronic format, please go to the table of contents for acess to the additional content.