Bookkeeping Essentials – Get your Chart of Accounts right
A Guide to setting effective Chart of Accounts
At its core, accounting is about preserving a balance between what you own and what you owe. Generally, your accountants will help you set up and organize your books. However, it is a good idea for business owners who are just starting out or do their own bookkeeping to understand the basics.
The Details of a Chart of Account
A chart of account comprises of a list of key account categories and codes that are relevant to the finances of your business. There are four general sections in a chart of accounts, that you should familiarize yourself with:
- Assets Account
- Liabilities Account
- Income Account
- Expenses Account
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- What are Asset Accounts?
An asset is anything that retains value and can also be considered a resource to help businesses generate cash flows in the future. For instance, a property is an asset through which you can earn additional rental income. Earning income using assets can be considered as revenue, how you categorize your assets can be complex and therefore it is advisable to consult an expert accounting firm to provide value-added accounting services.
What are the Main Types of Assets?
There are two primary types of assets: current and non-current.
- Current assets: are generally liquid and are expected to be consumed within a year. Current assets include debtors, cash, marketable securities, accounts receivable and inventory.
- Non-current assets: are generally held for long term investment purposes. Non-current assets include tangible fixed assets ( e.g buildings, furniture, equipment and vehicle), intangible fixed assets (e.g copyrights, trademarks and patents) and goodwill.
Utilising an effective chart of accounts can help you organize a number of accounts via account codes to keep better track of multiple items simultaneously. A Chart of account is a map which shows how various transactions get mapped in your accounting system. This can then be used to help in preparing effective management accounts and performance reporting reports.
- What are Liability Accounts?
Liabilities are financial obligations you or your business owe others. Some common examples of liability accounts are creditors, bank loans, personal loans, mortgages, payroll taxes, income taxes payable, bills, etc.
Pro Tip: When entering a loan amount in your liabilities account, you need to remember not to subtract the interest payments from the principal amount in the liability. If you are making monthly loan repayments, you must keep in mind that, you have to add the interest payment as an expense in your P&L, while the principal payment will be deducted from your loan liability, hence reducing it.
- What are Income Accounts?
The Income account comprises the amount of income generated through various sources of the business. Many business owners do not spend too much time on the income account and usually split their income into two general categories “product sales” or “services.”
However, unless your business only generates revenue from one or two sources, these categories are not enough. It is more beneficial for business owners to separate each source of income to better track their finances based on the income type.
First, identify your most profitable income sources and sort them by their income type. Once you figure out the most profitable areas of your business, you will get a better understanding of your business’s cash flow and budgeting.
For example: if you are a repair shop owner who provides car body parts/kits, repairing and car valeting services. The best way to separate your income account would be by creating separate account codes for each income type, income codes on your chart of accounts for Income such as income from cleaning services, income from repairing services, etc. Then you can easily compare each income code and costs code that was incurred in providing those services, to get a holistic view of the financial health of your business.
Remember: It is very important to include everything that is adding up to revenues whilst working out your company’s income account.
What is an Expense Account?
An expense account helps you get a better track of the expenses being incurred for the business and in some cases the cash being spent. The Expense account comprises the expenses incurred whilst managing the operations and finances of your business, in other words, the money you have spent to run your business activities. For instance, when you spend on fuel for running your business vehicles, an expense is recorded in your repair & maintenance expense account.
Similar to income accounts, spreading your expenses into different codes is always a good idea. Breaking down your expenses, managing and tracking them can get very frustrating, so it’s advisable to seek the expertise of an accountant or bookkeeper to help you save time for other primary responsibilities.
- If you are running a startup and struggling to organize your business’s chart of accounts, you should remember that simplicity is key. When setting account codes, you should avoid assigning complicated titles to them for transactional purposes. Instead, choose simple titles like ‘’bank fees’’ or ‘’repair & maintenance’’ for them, so that it is understandable for your management team and your accountants as well.
- You can also utilise the sub-accounting feature of your accounting software to meet the need of creating new sub-codes over time. Creating additional account codes instead of using sub-codes can clutter your chart of accounts and make it very confusing to track.
For instance, you are paying rent for a building or machinery, to track the expenses for this particular cost, you might add a rent expense account and further divide it into subcategories such as building rent and equipment expense. You might want to track expenses incurred for maintenance and repair as well, so for this purpose, you can break down your repair and maintenance account into sub-codes such as repair expenses and fuel expenses(to maintain your machinery) separately, so that you can easily navigate any discrepancy resulting in the imbalance of your business books.
Hire an accountant to manage your chart of accounts
Your chart of account reflects your business’s past performance and helps projects future financial conditions. With time, you will take steps to expand your business, and as the scale of your business increases, so will the need for accurate and reliable financial reporting. If you are able to set up an effective chart of account, you can ensure error-free and reliable accounting practices for your business enabling you to make well-informed business decisions in the future.
With growth, comes numerous complications, so it’s advisable to hire a competitive business accountant to help you track your businesses finances, save time and money.
Clear House Accountants are specialist Accountants in London. Having worked with a large number of businesses we understand the importance of building the correct foundations, be it through effective bookkeeping methodologies or through setting up an effective chart of account. Speak to us to learn more.