How To Set Up A Chart of Accounts
There are some things in life that haunt your nightmares forever. For me, it’s that dang bear scene in Revenant. For many business owners, it’s setting up a chart of accounts.
At first glance, a chart of accounts can be one of the scariest concepts in accounting. Faced with hoards of seemingly random numbers (that may bring traumatic flashbacks of high school algebra), it’s no wonder many new business owners become confused.
However, there’s a method to the madness. This post explains why this concept is so important and provides detailed, step-by-step instructions to setting up a solid chart of accounts (without having to hire an accountant). We’ve also included valuable tips from leading experts in the accounting world to make this process as easy as possible.
Table of Contents
- What Is A Chart Of Accounts?
- Why Do I Need One?
- How Should I Structure My Chart Of Accounts?
- Which Accounts Do I Need To Include?
- How to Use Your Chart of Accounts
- Expert Tips:
What Is A Chart Of Accounts?
A chart of accounts provides a way to organize financial information. It is usually divided into five categories: assets, liabilities, equity, income, and expenses (for definitions of these terms, check out our Guide to Accounting Terms and Concepts). Each category is then divided into sub-categories or “accounts” (hence the name).
Why Do I Need One?
Believe it or not, a chart of accounts isn’t just an accountant’s idea of a practical joke; it is an incredibly important tool for the financial health of your small business.
A proper chart of accounts lets you track specific business information. Your company probably spends money on multiple expenses (rent, license fees, office supplies, advertising, and so on). A chart of accounts can give you a clear picture of where your money is going and provide you the necessary information to make informed business decisions in the future.
The chart of accounts is also the basis for all accounting reports. CPA and Fit Small Business writer Crystalynn Shelton explains:
“The accounts that fall into the assets, liabilities and owner’s equity will appear on your balance sheet report and the accounts that fall into the income or expense type will appear on your profit and loss statement (or your income statement).”
Furthermore, the information saved in a chart of accounts is imperative for filling out small business tax forms like the Schedule C.
How Should I Structure My Chart Of Accounts?
A chart of accounts is based on a four-digit numbering system. This is the general template to follow when creating and numbering your accounts:
- Assets – 1,000 – 1,999
- Liabilities – 2,000 – 2,999
- Equity – 3,000 – 3,999
- Income – 4,000 – 4,999
- COGs – 5,000 – 5,999
- Expenses – 6,000 – 6,999
You want each account to be a few numbers apart from each other (ex. 1010 cash, 1020 petty cash, 1030 checkings, 1040 savings). This way, you can go back and add more accounts as your company grows without losing the effective organization of preexisting accounts.
Which Accounts Do I Need To Include?
When deciding which accounts to include, think carefully about the type of business you run and the common assets and expenses you have. Keep your chart of accounts as simple as you can. Only include information you actually need and account names that make sense to you (you can always add more accounts down the road).
The specific accounts you include will vary depending on the type of business you run; however, here is a template of the few basic accounts you’ll need to get started:
1040 Accounts Receivable
2010 Accounts Payable
2020 Sales Tax Payable
2030 Income Tax Payable
2040 Mortgage Loan
2050 Other Loans
3010 Owner’s Contributions
3020 Retained Earnings
4010 Sales From Products
4020 Sales From Services
5010 Materials and Supplies
5020 Labor Costs
6020 Car and Truck Expenses
6030 Contract Labor
6040 Office Supplies
6050 Rent for Property
6060 Rent for Equipment
6070 Travel, Meals, and Entertainment
Note: Although these are must-have accounts for most small business, the template above will still need to be adjusted to fit your needs.
A completed chart of accounts will look something like this:
Luckily, most small business owners will never have to create a chart of accounts from scratch. If you are using accounting software like Xero or QuickBooks, the software will generate a chart of accounts for you based on your industry and business type. In this case, you’ll want to follow these three steps:
- Delete any accounts you don’t need
- Rename any confusing accounts into something you’ll understand and remember
- Add opening balances to each account
How to Use Your Chart of Accounts
You’ve set up all of your accounts, now what?
There are a couple of ways you can successfully use your chart of accounts.
1. Stay on top of your money
One of the main purposes of a chart of accounts is to break down where your money is coming from. Take the Sales Account for example.
Your chart of accounts will show you a current balance of your sales. If you’re using a software like Xero, you can click on the balance for more detail. The software will then show you every transaction goes into the total balance.
2. Know what you owe
In the same way that you can view sales details, you can also understand how much you owe and why.
When you select the accounts payable balance, you can see the outstanding invoices you have received from vendors, but have not yet paid. This level of detail will help you stay on top of bills and expenses.
3. Track assets
A good chart of accounts will help you keep all of your assets together. This is important because assets are a key in creating the balance sheet, which is critical to keeping the books balanced. (See our Quick Guide to Accounting Terms and Concepts for more information).
In this account, Computer Equipment is a fixed asset. When the balance is expanded in accounting software, you can see all of the bills attached to that asset and the corresponding payments. With some software, like QuickBooks, you can create a subaccount under each asset to track the asset depreciation.
4. Fill out your tax forms
A proper, up-to-date chart of accounts is an efficiency lifesaver come tax season. Many small business owners are required to file a Schedule C.
If you set up your chart of accounts right, the information the IRS requires about expenses should match your chart of account categories. Simply take the total balances below and match them to the corresponding Schedule C lines.
No one knows a chart of accounts better than certified accountants and bookkeeping experts. That’s why we’ve had these CPAs share some of their top setup tips. These nuggets of wisdom are incredibly helpful for getting your business started on the right track.
Don’t Make the Accounts Too Specific
“Never set up an account to track a specific vendor or customer. You want to be able to use an account across multiple vendors and customers. For example, if you purchase office supplies for your business you don’t want to set up accounts for each vendor that you purchase them from (Staples, Target, Costco). Instead, you set up an account called office supplies and that way all office supplies (regardless of the merchant you purchased them from) will be categorized to the office supplies account. To find out how much you’ve spent with Staples, Target, Costco you can run vendor reports that are available in both QuickBooks and Xero to obtain this level of detail.” – Crystalynn Shelton, Fit Small Business
Use the Schedule C as a Template for Your Expense Accounts
“On tax return Form 1120 (if you are a corporation) or Schedule C (if you are a sole-proprietor or single-member LLC), there is a list of income categories and expense categories that the government specifically wants you to track. That list will be your basic chart of accounts also with your bank account, accounts receivable, accounts payable, credit accounts, and your equity in the company. Some of the income and expense categories on the tax forms will not apply to your particular business; don’t worry about having them or using them; the government understands that not everything is for everyone.” – Sally Balson, Balson Bookkeeping
If You Can’t Track Locations With Your Accounting Software, Try This…
“Some business may have various locations that they want to track separately. In this case a location identifier could be such as 1100.01 and 1100.02. This way they could track accounts receivable for location 1 and 2 separately.” – Joe Sterf, CPA
As one final tip, I recommend you spend some time looking at existing templates and examples of a good chart of accounts. Google will be your best friend in this case. Plenty of other beneficial sources, including Xero, QuickBooks, Accounting Verse, and Double Entry Bookkeeping, can help give you an idea of what a good chart of accounts looks like.
We hope that these tips will give you the knowledge and confidence to successfully tackle your chart of accounts and conquer one of the most difficult accounting concepts with ease.