Chart of Accounts 101: What it is and best practices to follow
Chart of Accounts 101: What it is and best practices to follow
Introduction
Imagine you’re the owner of a thriving, independent ad agency. Business is booming, and your clients are absolutely loving the work you’re creating for them. But behind the scenes, it’s pure chaos with your finances. Invoices are stacked haphazardly on your desk, receipts are pouring out of drawers, and your “bookkeeping” consists of scribbled notes and mental calculations.
When tax season approaches, you’re scrambling to figure out exactly what is going on — and you’re faced with the potential for missed tax deadlines and potential penalties. Worse, the idea of expanding to a second office is now off the table because you can’t secure a loan without providing clear financial statements. Now, the dream of turning your small, independent agency into a global powerhouse is becoming a bit more of a nightmare.
Unfortunately, this scenario is a common issue for entrepreneurs and business owners. At the heart of every business should be a strong financial foundation. But, without a clear and organized system to track and monitor your finances, it can feel like a confusing mess that actually ends up hurting you.
Enter: the Chart of Accounts (COA) — a fundamental financial tool that provides a complete listing of every account in the general ledger of your company. More than just a list of numbers, your Chart of Accounts is a structured document used to organize all your finances and give investors and shareholders a clear view of your company’s financial health.
In this article, we’ll dive deeper into what exactly a Chart of Accounts is, and what the best practices are for setting it up.
What is a chart of accounts?
A Chart of Accounts is a complete, categorized listing of every account in the general ledger of your company. It categorizes transactions into primary accounts like assets, liabilities, equity, expenses and revenue, and can use subaccounts for further indexing.
A standard Chart of Accounts is divided into 5 categories:
Assets: This is where you record things that your business owns, for example your cash on hand.
Liabilities: This is where you record debts that the business owes, for example any loans you might have.
Equity: This tracks the owner(s) contributions into the business as well as their share of ownership.
Revenue: This account tracks money earned through the sale of good or services, for example sales revenue.
Expenses: This is where you record the money you spend in an effort to generate revenue, for example payroll or rent for your office.
When put together, you get a clear picture of your finances as a business owner. But equally as important, you can share this overview with investors and shareholders.
What are the advantages of a solid chart of accounts?
There are countless reasons why you need a Chart of Accounts for your business, but it’s worth diving a bit deeper into all the benefits. Below are 5 of the most important to consider.
Full visibility across all revenue and expenses
A well-structured Chart of Accounts helps you organize a ton of financial transactions in a way that is easy to see and sort through. It shows the effectiveness and gaps in different areas of your business, and provides a full overview of where you’re making and spending money. And because transactions are displayed in an itemized and categorized way, investors and shareholders can get a quick view of specific financial data when they need it.
Clear classification of financial transactions
Your Chart of Accounts helps categorize all financial transactions into meaningful categories. These categories are typically standardized at a general level, but can be further modified according the the structure of your businesses. By organizing them this way, you can easily understand where your money is coming from and where it’s going. As a result, you provide visibility for stakeholders, can optimize your resource allocation, and identify trends overtime that need addressing. You can even avoid and prevent fraudulent activity using your CoA by spotting discrepancies.
A strong foundation for strategic decisions
Having a single source of truth gives you the right birds-eye view of all your important financial information to make strategic financial decisions. For example, seeing where you are overspending and underspending can help immensely with your budget management. For example, if you’re considering expanding your business you can see if you have enough assets to pay off your current debts before taking on a new loan.
Enhanced regulatory compliance
Having a disorganized or inadequate Chart of Accounts can lead to compliance issues that might expose your business to penalties or even legal ramifications. And come tax season, it can also present a lot of issues that increase the likelihood of making errors in your tax filings. By accurately setting up a solid Chart of Accounts, any potential audits are a lot more straightforward and protects you from potential fines or penalties.
5 best practices for setting up an effective chart of accounts
While a Chart of Accounts can be specifically modified for the needs of your business, there are generally accepted best practices to keep in mind as you set yours up for the first time.
1. Define clear categories and subcategories
Typically, the basic structure of a Chart of Accounts includes five main categories which we’ve covered above: assets, liabilities, equity, income, and expenses. Under these categories you would then further divide your Chart of Accounts into subcategories for more detailed tracking and analysis.
These subcategories vary depending on your business type and industry, but could include things like cash, investments, inventory, and accounts receivable under your assets. However, if you don’t carry inventory, that line item wouldn’t be necessary to track. By defining clear categories and subcategories you can ensure you track all necessary transactions that provide a full financial view of your business.
2. Establish a numbering system
Most Chart of Accounts employ a number system to organize transactions into categories. Typically, each account is numbered so that accountants can quickly identify it by the first digit.
Here’s an example of a simple structured coding system:
And as an example of how these numbers might look within your CoA with categorized transactions:
1000 Assets
1200 Receivables
1300 Inventories
1400 Cash
2000 Liabilities
2100 Accounts payable
2200 Taxes payable
2300 Other accrued expenses
3000 Equity
3100 Common stock
3200 Preferred stock
4000 Revenue
3100 Sales revenue
5000 Expenses
5100 Cost of Goods Sold
3. Maintain consistency
By establishing clear guidelines for categories, numbering, and account classifications, your Chart of Accounts becomes more consistent and easier to manage. This is important because it creates consistency for stakeholders reviewing your numbers over time, makes it easier for new employees to pick up where a previous accountant left off, and makes it easier to compare the performance of accounts over time.
4. Use accounting software
A lot of modern accounting software helps standardize many aspects of a Chart of Accounts, which ensures consistency over time and makes it easier to scale as your business grows. For example, platforms like NetSuite and Sage Intacct can both help provide a template for a standard Chart of Accounts and simplify coding. And when linked with accounting automation software like Brex, you can automate everything from initial transaction to GL coding to reporting.
5. Regularly review and update your Chart of Accounts
You should look at your Chart of Accounts as a dynamic, ever evolving tool that changes alongside your business. So it’s important to conduct periodic reviews that ensure your categories are still relevant, accurate, and aligned to your business needs and changing industry standards.
For example, at the end of the year review all of your accounts and identify if there are gaps or areas for consolidation. This ensures that managing your Chart of Accounts does not become a tedious mess, but instead a simple, accurate task.
A few common challenges you might encounter
Creating a Chart of Accounts can be quite simple, but whether you’re scaling or pivoting, you’re bound to face a few challenges with scaling and maintaining an effective Chart of Accounts. Here are a few to consider:
Overcomplicating things
Your Chart of Accounts should provide a quick overview of vital financial information for your business. By creating too many subcategories, or recording separate accounts for every single product you sell or every single utility you pay, you can create an overcomplicated beast of a chart that is impossible to read. The same goes for your numbering system, by adding too many variables, or two many subsets, it can be extremely difficult to keep track of what exactly you’re recording.
Too little detail
On the opposite side of the spectrum, it’s possible to have too little detail within your Chart of Accounts. By not categorizing transactions under suitable subcategories, it can be hard to evaluate what’s working and what’s not. Take for example your expenses category. If you just lump all of your expenses as transactions under that one category, it makes it difficult to discern where you might be overspending. But by creating subcategories for things like payroll, travel expenses, and cost of goods sold, you can more easily track and optimize your spending.
Deleting accounts too soon
Remember the point above in maintaining consistency? This is super important when it comes to renaming, merging, or deleting accounts. Best practice is to wait until the end of the year to delete old accounts to avoid any headaches with reporting or tax season. One thing to remember is that it’s difficult to add items back in once they’re deleted, whereas you can always create new accounts.
Not adjusting to the changing need of your business
When your Chart of Accounts no longer aligns to your business structure and operations, it can lead to major challenges and inaccuracies when reporting on your finances. That’s why it’s incredibly important to periodically review your categories and subcategories to ensure they accurately align with your products, services, and operational activities.
That’s it: You’re now a Chart of Accounts pro
Hopefully now you see the power and benefit of an accurate, detailed Chart of Accounts. If you consider the scenario from the introduction, as a booming independent ad agency it would be incredibly easy to secure a new loan for global expansion with the right Chart of Accounts in place. You can simply share it with potential shareholders or investors to generate the funding you need to expand, or prove you have the means to carry additional financial risk. It also gives you the confidence as a founder to take that risk on, knowing where your business stands.
And with the right tools in place like Brex, you can simplify every step of your spend management, reporting, compliance — and ultimately, the financial foundation you scale on. Book a demo today and see how we can help.