ELI5
The chart of accounts is a list of all categories of a company’s financial transactions. A financial transaction has two categories.
Key Takeaways
- Think of “Account”, from “Chart Of Accounts”, as a category.
- The chart of accounts is a list of all categories of a company’s finances.
- Divide the list of categories into five key subsets. Income, expense, asset, liability and equity.
- Connect the chart of accounts to the general ledger and financial statements. A mistake may lead to huge errors in tax filings and financial statements.
What is the chart of accounts?
The chart of accounts is a list of al the income, expense, asset, liability and equity categories. Every financial transaction has two accounts which debit and credit from one another.
Here is a sample chart of accounts of a hypothetical toy retailer:
- Income accounts
- Sale of party items
- Sale of Power Ranger toys
- Expense accounts
- Payroll of store salespeople
- Rent & Utilities
- Asset accounts
- Inventory of party items
- Inventory of Power Ranger toys
- Liability accounts
- Bank loan
- Equity accounts
- Common shares
What is a chart of accounts used for?
A chart of accounts organises a company’s finances. One purpose of financial transactions is to generate financial statements. These statements gives investors and management information about a company’s financial health.
How you categorise a financial transaction has a huge impact on financial statements. For example, take a financial transaction of a $1M inventory order of toys. The retailer categorises this in an expense category. The transaction will show up on the income statement as a $1M expense.
But this is not correct. According to the GAAP accounting standards, this transaction should be an asset category. The transaction will not show up on the income statement.
This is because buying toys is not a typical expense, but rather an investment into an asset (i.e. toys). The company plans to sell this inventory asset in the future. Since the toys are a capital asset, the transaction in categorised as an asset account.
Connect the chart of accounts to the general ledger and financial statements. A mistake in the chart of accounts may lead to major errors in financial statements. Thus it can affect tax filings submitted to the government.
Does the chart of accounts look very different from business to business?
This depends on the industries that you’re comparing. There are usually some similarities between charts of accounts of different industries. For example, many companies have “Common Stock” in their equity accounts.
But companies usually have different income accounts. For example, a toy retailer has the income account “Sale of Power Ranger toys”. A digital marketing company may have “SEO marketing services” as an income account.