- What is a chart of accounts?
What is a chart of accounts?
When creating the Profit & Loss statements for an organization, accountants need to segregate the companies’ transactions into various lists, to make the whole process practical and convenient. The organization’s structure will determine the kinds of accounts it will need to create. But there are generic and compulsory account types that it creates. The following article will give you a chart of accounts list with definitions.
There are five broad types of accounts: Assets, Liabilities, Expenses, Revenue, and Equity. Let us take a closer look at each of them.
Assets can be defined as objects or entities, either tangible or intangible, that the organization owns, and yields economic value through them. Tangible assets would be physical objects that can be seen and touched, that the business owns. Examples of tangible assets would be machinery, land, furniture, etc.
Intangible assets are properties that represent monetary value but cannot be physically felt, such as digital images, copyrights, songs, etc.
Current assets are objects or properties that are consumed or converted into cash within 12 months or less. Examples of current assets would be prepaid expenses, inventory, bills receivable, etc.
Fixed assets are tangible assets with a life span of at least 12 months or longer. Fixed assets may include vehicles, machinery, buildings, and so on. Fixed assets are usually not very liquid. Because of this, assets are depreciated, or "written off" over a number of years at a particular depreciation rate/percentage.
The next point in our chart of accounts numbering is liabilities. Liabilities are the financial obligations that are to be paid off by businesses to other entities. They are basically what an organization owes to others.
Liabilities are classified as either current or long-term. Current liabilities are those financial obligations that need to be paid off in 12 months or less. Examples of current liabilities would be accounts payable and customer deposits. Current liabilities are generally paid off with current assets, for example, cash. An organization’s working capital is the difference between its current assets and current liabilities.
Long-term liabilities mainly consist of mortgages or loans used to purchase and/or maintain fixed assets and are paid off in years and not months.
Image Name: liabilities-chart-of-accounts
Alt Text: liabilities chart of accounts
Expenses are expenditures that are necessary for an organization to run smoothly. Some examples of expenses would be rent, office supplies, travel.
Expense accounts are temporary accounts that are used to collect data for one accounting period and are reset to zero at the commencement of the next financial period. Items with higher costs like machinery and computer systems, are not expensed but depreciated or written off over the life expectancy of the asset.
Any chart of accounts example would be incomplete without including expenses, which are vital to the functioning of a company.
While Accounting chart of accounts, this particular topic is generally the most favorite for organizations. Revenue refers to earning of business from selling a product or service, or from interest and dividends on marketable securities.
Net income is revenue minus the expenses. Income is "realized" differently by an organization depending on the accounting method they use.
Equity is of the highest importance to business owners as it is the owner's financial share of the company. It can be defined as that portion of the total assets of the company which the owner fully owns.
Equity can be in assets such as buildings and machinery, or cash. Equity is the same as ‘Net Worth’. For example, if you purchase equipment worth $25,000 with a $20,000 loan and $5,000 in cash, you acquire an asset of $25,000, but own only $5,000 of equity.
The Balance Sheet equation would be:
Assets = Liabilities + Owner's Equity
You can see how this equation works with the example:
$25,000 Asset = $20,000 Liability + $5,000 Owner Equity
Types of Equity Accounts
What is an equity account?
Equity accounts can be of three types. Each account meets the different needs of most small enterprises. The account name varies depending on the structure of the organization.
Contribution (Money Invested): This is the type of account used when company owners invest their own capital into the company. It can be start-up capital or a later influx of cash. When this happens, a Capital or Investment account is credited.
Distribution or Draw (Money Withdrawn): When a business is earning profits, the proprietors often expect some of the profit returned back to them. A Draw or Distribution account is debited to track this activity. This is the only type of Equity account (non-contra) that receives debits.
Accumulation from prior years: Retained Earnings (Owner's Equity) is credited to track an organizations’ Net Income as it accumulates over the years. On day one of the financial year, most accounting software or programs automatically credit this account with last year's Net Income.
Why do we need a chart of accounts?
The most important reason for having a chart of accounts is to differentiate expenditures, revenue, assets, and liabilities to assist viewers in getting a sense of an organization’s financial health. A well-designed chart of accounts meets the information needs of the company’s management. It also helps an organization to comply with financial reporting standards. An organization has the flexibility to customize its chart of accounts according to its needs.
The chart of accounts serves as the foundation for an organization’s financial record keeping structure. It provides a logical system that aids in the addition of new accounts and the deletion of old accounts.
The complexity of the chart of accounts will depend on the size and structure of an organization. An international corporation with multiple divisions might need thousands of accounts, while a small company may only need one hundred accounts.
We hope this article answered your queries about the chart of accounts. If you want to know more about other accounting terms, you can go through our other articles as well. If you want to make the accounting process for your company easier, read this article.