Establishing Your Chart of Accounts
Setting up your chart of accounts from scratch can seem daunting. There’s a lot of planning and organization involved and figuring out the best way to set things up can feel overwhelming.
The good news is that constructing a chart of accounts isn’t all that difficult. However, the most crucial step is the initial setup because if set up correctly, your chart of accounts can be extremely effective.
So, to set up your chart of accounts the right way, we’ll dive into what a chart of accounts is, why your organization needs one, and how you can set one up that will be sure to benefit your business or nonprofit.
What is a Chart of Accounts?
The point of a chart of accounts (COA) is to organize all your ledger accounts. A COA records all financial activity and ensures your ledger accounts stay in balance and your financial statements are accurate. Typically, your COA will be divided into five main categories:
Of course, each category comes with its own subcategories, but it’s important that you start with these five before you begin to branch off.
Why Do I Need a Chart of Accounts?
What makes having a chart of accounts so important is that it’s the financial heart of an organization—everything flows through it. That includes your accounts payable, your payroll, your receivables, and so on. Your financial reports pull information from your ledger, so it’s imperative that the accounts are organized correctly and activity is posted to the correct account.
Setting Up a Chart of Accounts
Step 1: Create a List of Accounts
The first step toward building an effective COA is to create a list of what your company will need to account for in the future. If you break down the five main categories that were shown above, you can get an idea of what you’ll need to document.
So, depending on your organization, you might need accounts for insurance, equipment expenses, cost of goods sold, payroll taxes, office supplies, and so on.
It’s important to determine what your organization looks like now, what it will look like 5 years from now, and what will need to be recorded. Of course, in the future you can add and remove accounts, but it’s important to get most of the structure set up at the start.
Step 2: Establish a COA
Here are the account types I listed earlier, with the most common breakdown of how they’re numbered.
|1. Assets||1,000-1,999||What you own|
|2. Liabilities||2,000-2,999||What you owe|
|3. Equity/Net Assets||3,000-3,999||What you earn|
|4. Sales||4,000-4,999||Total Income|
|5. Expenses||5,000-5,999+||Total Losses|
Assets are what you own. This is everything from the chair you purchased for your office to the computer you’re working from. If you happen to own land or patents, this will also be included here. Anything that adds value to your company.
Liabilities are what you owe. This is for any debt your organization might have accrued, including any bank loans, mortgages, etc.
Equity/Net Assets is what you earn. If you take away your organization’s assets and liabilities, whatever is leftover is equity. That may include stocks or retained earnings. Typically, nonprofits use the term Net Assets rather than Equity.
Sales represents your total income that comes from sales and services.
Expenses represent your total losses, or the usual expenses your business or nonprofit pays for rent, utilities, payroll, and wages.
Step 3: Create Subcategories
Finally, the subcategories are made from the list you created for your company’s accounts. Below is an example of how you can organize them.
Be sure to title your accounts in a way that’s easy to understand. If you look at Assets, the numbers you use for your accounts can be anywhere between 1,000-1,999, so that gives you the option to set up 999 Asset accounts. Be careful not to make too many accounts for every little thing—this will only make things confusing.
Ideally, you want to keep your records organized the same way for as long as possible. If you drastically change your COA all the time, you run the risk of complicating your financial data, making it difficult to track your company’s financials from one year to the next.
In your chart of accounts, there might be accounts you haven’t used for some time. When you complete your year-end processes, it can be helpful to delete any accounts you haven’t used. Doing this kind of maintenance will keep your accounts organized and could help reports generate faster.
Your COA will begin to build over the years, but it’s important you keep your accounts set to this pattern so you will never have to repeat this process again. Having your ledger set now gives you the opportunity to see how your organization will grow over the years.
So, now that your chart of accounts is done, you can focus on growing your organization.