The Chart of Accounts (COA) is the foundation to your accounting system. It is how you will categorize each transaction that takes place within your accounting system. If it's set up properly, it will show you how your business is performing and give you valuable insight on how to grow.
If it's not set up properly, it may cause a mess on a yearly basis. Even if you meticulously categorize each transaction, if your categorizations aren't useful to you and don't capture the important aspects of your business, they're next to useless. A little foresight in the beginning of your business can save a big headache later.
There are five basic categories in the Chart of Accounts:
- Assets
- Liabilities
- Equity
- Revenue
- Expenses
Let's talk about each in their turn.
Assets
Assets are the resources that belong to your business. In a standard chart of accounts, they will usually have an account number that starts with 1. They could be bank accounts, payments that your customers owe (also known as accounts receivable), prepayments on expenses (such as rent or insurance), equipment, and inventory. Assets come in two types: current and long-term.
A current asset is something that you expect to use within the next 12 months. If you prepay your rent, for example, this would probably be a current asset. Accounts receivable is also a current asset, as you certainly don't want your customers waiting more than a year to pay you! Inventory is also generally a current asset, as items that sit around tend to quickly become obsolete.
A long-term asset, on the other hand, is something that you expect to have around more than a year. A building is a great example of this. Another example might be investments that you are holding.
Liabilities
Liabilities are the debts that your business owes. These could be monetary debts, or they could be debts of service, where you've been paid to do something, but haven't yet completed that work. In a standard chart of accounts, they will usually have an account number that starts with 2. Some common liabilities are things like loans, amounts that you owe to your vendors (accounts payable), and unearned revenue. Much like assets, liabilities come in two types: current and long-term.
A current liability is any debt that must be paid over the next 12 months. Accounts payable falls into this category, as well as credit card payables and interest payable. Unearned revenue will also likely fall within this grouping.
A long-term liability is any debt that must be paid in more than 12 months. A very common example would be a mortgage or a vehicle loan. These are large expenses that aren't going to be immediately due, but are instead paid over a long stretch of time.
Equity
Equity is the third component that makes up the Balance Sheet. In a standard chart of accounts, they will usually have an account number that starts with 3. Depending on your business type, this may take slightly different forms.
In a for-profit business, Equity is the owner's claims against the business. It's how much they've put into the business, and it's how much they've taken out. If your business is public, this would also be known a stockholder's equity.
In the non-profit world, you may instead refer to this as net assets. Instead of reflecting an owner's stake in the business, it becomes a reflection of the non-profit's sustainability and ability to continue serving its target population. It is also a place for non-profits to reflect any restrictions that are placed on their net assets.
Revenue
Revenue is the lifeblood of your company. It's the money that you earn by providing a service to your customers. In a standard chart of accounts, they will usually have an account number that starts with 4.
Cost of Goods Sold
This is the direct costs that your company incurs in producing a product. If you make clothes, it's the cloth, the thread, the salary of the person who makes the clothes. If you're in the construction business, it's labor costs, materials, subcontracts, equipment, fees, permits, etc. If you're consulting, more than likely it's just your time (possibly the most valuable resource of all!). Regardless of what form it takes, cost of goods sold provides vital information on the inputs that allow you to produce your revenue. If those inputs are costing more than the revenue that you're producing, that's vital information for you to know. In a standard chart of accounts, they will usually have an account number that starts with 5.
Expenses
Also known as overhead, these are the expenses that are related to your business, but can't be directly traced back to any one project. This may be things like utilities, rent, office supplies, admin staff, and depreciation. In a standard chart of accounts, they will usually have an account number that starts with 6 or higher.
For more Information, check out these links:
Understanding the Chart of Accounts: A Fundamental Guide