Term: Chart of accounts

ELI5

The chart of accounts is a list of all categories of a company’s financial transactions. A regular financial transaction should have two categories (which must be listed in the chart of accounts).

Key Takeaways

  • The “Account” from “Chart Of Accounts” can be thought of as a category.
  • The chart of accounts is a list of all categories of a company’s finances.
  • The list of categories will be divided into five key subsets – income, expense, asset, liability and equity.
  • The chart of accounts is connected to the general ledger and financial statements. Therefore a mistake could lead to huge errors in tax filings and financial statements submitted to the government.

What is the chart of accounts?

The chart of accounts is a list of all income, expense, asset, liability and equity categories of a company’s finances. Every financial transaction must have two accounts which debit and credit from one another.

Here is a sample chart of accounts of a hypothetical toy retailer:

  1. Income accounts
    1. Sale of party items
    2. Sale of Power Ranger toys
  2. Expense accounts
    1. Payroll of store salespeople
    2. Rent & Utilities
  3. Asset accounts
    1. Inventory of party items
    2. Inventory of Power Ranger toys
  4. Liability accounts
    1. Bank loan
  5. Equity accounts
    1. Common shares

What is a chart of accounts used for?

A chart of accounts is used to organise a company’s finances. Financial transactions are used to generate financial statements which gives investors and management of a company an overview of a company’s financial health.

How you categorise a financial transaction could have a huge impact on a company’s financial statements. For example, take a financial transaction of a $1M purchase of inventory of toys. By categorising the transaction in an expense category, this transaction will show up on the income statement as a $1M expense.

However, this is not correct. According to the GAAP accounting standards, such a transaction should be categorised in an asset category. The transaction will not show up on the income statement.

This is because the purchase of toys is not a typical expense but rather an investment into an asset (i.e. toys) which the company plans to sell in the future. Therefore since the toys are a capital asset, the transaction must be categorised in an asset account.

The chart of accounts is connected to the general ledger and financial statements. A mistake in the chart of accounts could lead to major errors in financial statements generated and therefore 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 and “Payroll” in their expense accounts.

But companies usually have different income accounts. For example, a toy retailer would have the income account “Sale of Power Ranger toys” whereas a digital marketing company might have “SEO marketing services”.

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