Accounting 101: Demystifying the Chart of Accounts
Part of my goal as an accountant and small business adviser is to educate my clients on understanding their financial statements and using that information to better manage their business. This blog post is a first in a series of articles designed to help you learn the underlying fundamentals of accounting and to better understand your financial statements.
The General Ledger consists of a series of accounts called The Chart of Accounts and is the backbone of your financial statements. The accounts are used to categorize all of the financial transactions of your business, as well as prepare your financial statements, such as a Balance Sheet and Income Statement. Getting the information into the correct account is crucial, since improperly classified transactions can result in inaccurate and misleading financial statements.
The easiest way to think of the chart of accounts is as a filing cabinet for your accounting transactions. Just like you would file paperwork into different folders in a filing cabinet, you enter transactions into different accounts to categorize and organize the transactions into meaningful financial data.
Although having account numbers isn't critical, I often recommend that my clients use account numbers along with account names/descriptions to help make it easier to put transactions into the proper account. Accountants use a standard numbering system when assigning numbers to accounts, similar to how the Dewey Decimal System works for a library (if you are old enough to remember the Dewey Decimal System!) The number system works like this:
Assets - start with the number 1
Liabilities - start with the number 2
Equity - start with the number 3
Income - start with the number 4
Direct Expenses/Cost of Goods Sold - start with the number 5
Administrative/Overhead Expenses - start with the numbers 6-7
Other Income/Expenses - start with the numbers 8-9
The individual accounts and the exact numbering scheme are unique to each company. Some companies only need a small number of accounts; large corporations often have many accounts, sometime broken down into sub-accounts identifying divisions or profit centers. When setting up a chart of accounts for your business, it is advisable to consult with a qualified accountant to assist you in developing a chart of accounts that suits your business and will give you the best financial reporting.