Standard Chart of Accounts Explained
Numbers provide a great way of summarizing information in a way that it can be quickly understood.
This is especially useful in the business world where all sorts of information are presented using numbers.
In fact, the whole profession of accounting revolves around summarizing company information into easy-to-understand numbers.
One of the tools that is commonly used by accountants to provide a summary of a company’s financial power is the chart of accounts.
Unfortunately, a lot of people do not understand this important accounting tool.
In this article, we will take an in-depth look at the chart of accounts to understand what it is, what it does and how to design one.
WHAT IS A CHART OF ACCOUNTS?
The term “chart of accounts” (COA) refers to a list that contains all the accounts that a company uses to record transactions in its general ledger.
An account in this case refers to a unique record for each type of the company’s revenue, expense, equity, assets, and liability.
The chart of accounts usually lists the account type, a brief description of the account, the account balance, and an identification code for the account. This information is typically represented in the order by which the accounts are represented in the company’s financial statements.
The purpose of a COA is to organize the company’s finances, segregating its expenditures, revenue, assets, and liabilities in order.
This orderly listing makes it easier for stakeholders and other interested parties to understand the company’s financial health.
It is also an important tool for analyzing a company’s past transactions and using historical data to forecast its future trends.
The standard chart of accounts usually contains two main categories – balance sheet accounts and income statement accounts – which are then further subdivided by account type.
The following are the various types of balance sheet accounts:
- Stockholders’ or owner’s equity.
The income statement, on the other hand, contains the following accounts:
- Operating revenues
- Operating expenses
- Non-operating revenues & gains
- Non-operating expenses & losses.
A well-designed COA achieves two things: it satisfies management’s information needs, and it enables the company to comply with financial reporting standards.
The format of a chart of accounts allows a business to tailor its chart of accounts to best suit its unique needs.
For instance, accounts in the categories of “operating revenues” and “operating expenses” can be further organized according to business function as well as company divisions.
Since it is a flexible financial organization tool, there is no standard length of a chart of accounts.
Its length will naturally depend on the company’s size, with larger companies having a larger and more complex chart of accounts compared to smaller companies.
For instance, a large, multinational company that has many divisions may need to list thousands of accounts whilst a local retailer may require as few as one hundred accounts.
Depending on the sophistication of the company, the COA may either be paper-based or computer-based.
STRUCTURE OF A CHART OF ACCOUNTS
Like I mentioned above, the chart of accounts is a flexible financial organization tool, so you will seldom find a company that has the exact same charts of accounts as another company.
Each company will develop its own COA based on its own unique factors, such as the volume of business, the nature of the business, the need for external parties to go through the company’s financial information, and so on.
That said, there is still a common structure that you will find on most charts of accounts.
Accounts in a COA are typically listed in the order by which they appear in the financial statements.
For that reason, balance sheet accounts are typically listed first, with the income statement accounts following.
The typical structure of a Chart of Accounts is, therefore, something that looks like this:
|Balance Sheet Accounts||Assets|
Owner’s (Stockholders’) Equity
|Income Statement Accounts||The Various Types of Revenues|
The Various Types of Expenses
Some organizations may also structure their COAs such that various expenses are separately listed by department, with each department having its own set of expense accounts.
DIFFERENT ACCOUNT TYPES REPRESENTED IN A CHART OF ACCOUNTS
Some of the different accounts that will typically be found on a standard chart of accounts include:
An asset is a resource that contains economic value and is owned by the organization. Put simply, the term “assets” refers to what a company owns.
Part of the value of assets stems from the expectation that they will provide future benefits. A company reports its assets in the balance sheet.
When a company buys or creates an asset, this results in either an increase of the company’s value or a benefit to its operations.
The best way to think of an asset is as something that might in future generate cash flow for the company, reduce its expenses, or increase sales.
Examples of assets include land/property, machinery & equipment, patents, cash, inventory, investments, buildings, furniture, vehicles, stock, and so on.
There are two types of assets: current assets and fixed assets.
Current assets are those you can easily convert into cash – they include cash, money in the bank, short-term deposits, stock, and marketable securities.
Fixed assets are those you cannot readily convert into cash or cash equivalents. They are typically long-term/hard assets. Examples include buildings, patents, land, equipment, machinery, and trademarks.
A liability is, to put it simply, what the company owes to some other party (a bank, a person, another company).
In other words, liabilities are the company’s legal financial obligations or debts that present themselves in the course of conducting business operations.
To settle liabilities, the company has to transfer economic benefits such as money, goods or services to the other party.
Basically, liabilities are the opposite of assets: while assets add value, liabilities reduce the company’s value.
Liabilities are recorded on the right side of the balance sheet whilst assets are recorded on the left. Examples of liabilities include bank loans, mortgages, accounts payable, deferred revenues, accrued expenses, and so on.
There are three main types of liabilities: current liabilities, non-current liabilities, and contingent liabilities.
Current liabilities are short-term and are typically due/payable within one year. Examples include interest payable, accounts payable, bills payable, income taxes payable, short-term loans, accrued expenses, and bank overdrafts.
Non-current/long-term liabilities are those that are due after a year or more. Examples include bonds payable, deferred tax liabilities, mortgage payable, long-term notes payable, and capital lease.
Contingent liabilities are those whose occurrence depends on a certain event. In other words, contingent liabilities are basically potential liabilities: they may or may not happen. For instance, if a company faces a lawsuit, it may or not be a liability – it depends on the outcome of the lawsuit.
Accounting standards dictate that a company should only record contingent liabilities if the liability is probable and if it’s possible to reasonably estimate the amount. Examples of contingent liabilities include lawsuits and product warranties.
Owner’s/Stockholders’ Equity Accounts
This is the third type of balance sheet account listed in the chart of accounts. It refers to financial capital which is sourced through investment by owners/shareholders.
Financial capital is one of the key factors of production.
Financial capital is absolutely necessary for any business to get off the ground. No business can operate without capital. Capital comes from two sources: debt and equity.
Equity capital, unlike debt capital, is not repaid to stockholders/investors in the normal course of business.
Equity capital is the risk capital staked by investors through purchasing a company’s common stock (ordinary shares).
Put simply, equity capital is the funds a company generates from the sale of its stock.
Owner’s equity is the funds owners inject into the business to finance its operations.
For a private limited company, the owners are an entity separate from the business.
In that case, the business is considered to owe the equity funds to its owners as a liability in form of share capital. Owner’s equity is also known as liable capital or risk capital.
In a case where shareholders are the owners (public limited companies), the equity is known as shareholders’ equity.
It refers to the ownership equity spread out amongst the company’s shareholders. Shareholders will vary in rank according to their use of share classes and options.
Should the company liquidate its assets, for instance due to bankruptcy, the first priority will be the creditors. The last to be paid will be the owners/shareholders.
The accounting equation for owner’s equity is, therefore, the difference between a company’s assets and debt liabilities.
The company can break down its shareholders’ equity into the following accounts: common stock, preferred stock, and retained earnings.
These accounts represent the company’s expenditures.
An expense may be defined as the amount by which an asset reduces in value when it is used to generate revenue for a business.
For instance, when the asset has been in use for an extended period of time, the expense that develops is known as depreciation.
Examples of common expenses include cost of goods sold, rent, utilities, insurance, depreciation, wages, and utilities.
Expenses are typically divided into two main types: operating expense and non-operating expenses. Operating expenses are those that involve the business’s main/core activities.
For instance, the operating expenses of a retailer include the cost of goods sold along with the selling, general, and administrative expenses.
In a large company, these are typically sorted according to product line, department, and so on.
Non-operating expenses are the expenses which do not involve the business’s main activities. They pertain to incidental/peripheral activities.
For instance, a common non-operating expense encountered by retailers is interest expense.
Other examples of non-operating expenses that will turn up on a retailer’s income statement include: commissions earned by the sales staff, rent, employee wages, advertising, and the cost of electricity.
Revenue accounts display the earnings/incomes the company accrues during a specific period. Common examples include sales, interest income, and service revenue.
Discounts and deductions for returned merchandise are also included as part of the business’s revenues.
A better definition of revenues is the income a business generates from selling goods or providing services, or from any other use of its capital or assets.
This is before the deduction of costs and expenses.
Revenue is typically represented as the top item in a profit and loss (income) statement.
Net income is determined by subtracting the costs from the gross income.
You calculate revenue by multiplying the price per unit by the number of units sold. Revenue may also be referred to as sales or (in the UK) turnover.
In a large company, revenue can be subdivided according to the various divisions that generate it.
Revenue may also be divided into operating revenue and non-operating revenue.
Operating revenue is the sales the company makes from its core business.
Non-operating revenue refers to the sales the company makes from other secondary sources.
Since non-operating revenues source are typically not predictable or recurring, they are termed one-time events or gains.
Examples include proceeds from selling an asset, money awarded for winning a lawsuit, a windfall from investments, and so on.
HOW TO NUMBER ACCOUNTS IN A CHART OF ACCOUNTS
Accounts in a standard chart of accounts are organized according to a numerical system.
The numbering sets up the structure of the accounts and assigns specific codes to the various general ledger accounts.
The account number typically involves three key components: the division code, the department code, and the account code.
This is usually a 2-digit code. It represents a specific division within the company.
For that reason, it is only used in multi-division companies.
Single-entity companies do not use this code. If the company is large and has very many divisions, this code is expanded to a 3-digit code, enabling the inclusion of more than 99 subsidiaries.
This is also typically a 2-digit code. It represents a specific department within the business; for instance, engineering, sales, accounting, or human resource departments.
This is typically a 3-digit code which describes the account itself. Accounts are divided into major categories and sub-categories.
Each major category starts with a particular number. Consequently, all the sub-categories that fall under a certain major category all start with the number of the major category.
For instance, the first major category is “assets” and begins with the digit “1”. The first account could be “cash” and is labeled “100”. The next could be “savings account” and labeled “101”
The second major category “liabilities” starts with the digit “2”, then the liability accounts will be labeled in the 200 to 299 range. The next major category “Equity” will start with a “3”, occupying the 300-399 range, and so on.
The account code will not always be represented by 3 digits. In some cases, especially for bigger companies with a more complex chart of accounts, the account code might be represented by 4 digits.
As you might have realized so far, the account code breaks down two key pieces of information about an account: the type of major category account and the type of sub-category account.
For instance, if you find that an account code starts with 100, you can automatically conclude that this account belongs to the ‘assets’ category.
The subcategory account is usually represented by the second digit within the account code. For instance, let’s assume that the account code for a specific account is 109.
Since the first digit is 1, we already know that this is an assets account. However, there are different types of asset accounts.
Therefore, the second digit is used to show the subcategory in which the account belongs.
In our case, this might mean the account falls under the current assets subcategory within the assets category. The third digit denotes the actual identity of the account.
If the account number was 115, then this would mean that this particular account is account number 5 under the receivables sub category within the assets category.
Bringing It All Together
In a multi-division company which has several divisions and departments, the chart of accounts numbering would be as follows: xx-xx-xxx.
If it’s a single-entity company (that is just one division) that has multiple departments, the first two digits (the division code) would be left out. The numbering scheme would instead be as follows: xx-xxx.
If it’s a very small business that has no departments at all, only the account code would remain. In that case, the numbering would be simply as follows: xxx.
EXAMPLE OF A CHART OF ACCOUNTS
Below is a rough sample COA to help you understand how it looks.
|Current Assets||100 Checking Account|
101 Savings Account
|Receivables||110 Accounts Receivable – Clients|
113 Travel Advances
116 Notes Receivable
|Unbilled Services||120 Unbilled Services|
|Fixed Assets||150 Accumulated Depreciation|
152 Furniture and Fixtures
153 Leasehold Improvements
|Payables (Short-Term)||200 Notes Payable Short-Term|
|Accounts Payable||210 Accounts Payable – Trade|
211 Accounts Payable – Consultants
212 Accounts Payable – Other
|Net Worth (300-399)|
311 Previous Year’s Retained Earnings
312 Current Year’s Profit and Loss
|400 Commercial Sales|
410 Interest Income
422 Grant Revenue
|Direct Costs||500 Direct Labor|
503 Materials and Supplies
|Fringe Benefit Costs||510 Vacation|
511 Sick Leave
513 Payroll Taxes
|Overhead Costs||520 Overhead Labor|
525 Depreciation – Office Equipment
|General & Administrative Costs||530 General & Administrative Labor|
536 Equipment Rental
|Unallowable Costs||540 Interest Expense|
BEST PRACTICES FOR CHART OF ACCOUNTS DESIGN
The following are the criteria/principles a company should follow when designing a chart of accounts:
Do the Mystery Accountant Test
A good COA provides structure for the business, uniformity, and enhances communication across the company.
It should also be possible for a concerned third party to understand the information provided in the COA without difficulty.
To accomplish this, test to see if your chart of accounts passes the Mystery Accountant Test.
This is a thought experiment where you try to see if competent accountants unfamiliar with the details of your business can successfully close the book.
Can they successfully perform the close or do they get confused because of poor chart design?
Can they use the provided code combinations to figure out the nature of each transaction, who is responsible for it, and where the transaction is occurring?
The chart should contain only one type of information in each segment; otherwise, there will be overlapping of information across segments, which can lead to potential inaccuracies during reporting.
For instance, if a company defines two of its segments as “Location” and “Department”, then the location segment should only contain location information and the department information should only contain departmental information.
Leave Room for Expansion
Small companies may tailor the design of their COA to the current size of their business.
This is not necessarily a problem.
However, if this is a company that is likely to experience growth in future and greater success, it is important to design a COA that leaves room for expansion.
Otherwise, when the company grows, there will be risk of some of the segments filling up.
This can pose a problem, particularly for a publicly traded company where accuracy of information is legally crucial.
Use Logical Ranges
While leaving room for expansion is good, it is possible to get carried away and go to the other extreme where you have ridiculously large ranges.
For instance, if a company is small and unlikely to expand, but insists on having a range of values such as 20000-29999.
This leaves room for up to 9,999 accounts.
The trends in your business should inform your decision when determining the most appropriate range.
Don’t Rely on Spreadsheets
While spreadsheets are great tools for organizing simple data, they are not the best choice for transforming data from your financial systems to report results.
Not relying on spreadsheets to get financial information is a key best-practices consideration when designing a COA.
WRAPPING IT UP
The chart of accounts is one of the most important accounting tools.
The COA is essentially a summary of the company’s financial power. It contains both balance sheet information and income statement information.
A good chart of accounts reveals the size or financial might of a company.
Any interested party can then figure out how large the company is (from the division code and department code or their absence), and see the range and number of its transactions (based on the number of recorded accounts).
Successful small business owners know that there is more to building a successful business than just …