Your Chart of Accounts - The What, Why and How
Bookkeeping is largely a system of categorization of your financial transactions. The Chart of Accounts creates the categories.
The Big 5 – Main Accounting Categories:
Assets – Things you own that have value, including:
- Bank accounts
- Furniture & fixtures
- Loans you gave someone else
- Accounts receivable (amounts you have billed to customers that they have not paid)
Asset accounts appear on your balance sheet.
Liabilities – These are things that you owe to others:
- Auto loans
- Personal loans
- Payroll taxes or income taxes due
- Credit card balances
- Accounts payable (amounts you owe to your vendors)
Liability accounts also appear on your balance sheet
Equity – These accounts represent the amount that owners or shareholders have put into or taken out of the business. The specific names of the different equity accounts will vary depending on what type of entity you have (i.e. Sole Proprietor, LLC, Partnership, S-Corp or C-Corp). Equity accounts appear on your balance sheet.
Income – Most people are pretty aware of what these accounts are so we don’t need to go into a lot of detail here. It is a common mistake, however, for people to categorize any kind of deposit into their bank account as income. Only amounts billed to customers for services or products purchased should be classified as income. We will cover this in more detail in a later section. Income accounts appear on your P&L (Profit & Loss Statement).
Expenses – Expenses are the costs of products and services that you buy. There are two types of expenses. Cost of Goods Sold entries are direct costs associated with creating your product or service, such as labor and materials. Overhead types of expenses are simply called Expenses. Examples of this are Telephone Expense and Rent.
What Accounts Do I Need to Have?
All businesses need to have at least one of each of the basic account types. There are two criteria to help you decide what specific accounts you need in each category:
- Accounts your tax preparer needs in order to complete your return with minimum effort and time. There are several standard accounts that go on the tax returns. If you break these out on your financial statements, your tax preparer will be able to simply plug the numbers from your reports into her software with minimum time spent. This will save them time, thus saving you money.
Some examples of accounts that you need to have for tax preparation:
- Bank Account
- Fixed Assets (Vehicles, Furniture & Equipment, Computer Equipment, Buildings, Land)
- Inventory – if applicable to your business
- Notes Receivable (If anyone owes you money)
- Notes Payable (Mortgages, loans from others)
- Credit Card (If you have a business card you use)
- Equity – The types of equity accounts depend on what type of entity your business is (S-Corp, LLC, etc). Generally you should have 2 equity accounts for each owner/partner/shareholder. One is an equity contribution account, the other is a draw account.
- Cost of Goods Sold – This mainly applies if you have inventory. If you do not have inventory you don’t need a COGS account for taxes but you may want one for your own use.
Expenses – Certain expenses need to be tracked in specific ways:
- Auto Expenses. You should have an account called Auto Expense with the following subcategories: Gas & Oil, Repairs & Maint; License & Registration; Insurance; Parking & Tolls.
- You should track each type of insurance separately as a subaccount of this main account. Some examples: Workers Comp, General Liability, Health. In addition, there is an additional thing to remember about health insurance. If your business is an S-Corp you need to have an account called “Officer’s Health Insurance”. Any premiums paid on behalf of an officer need to be tracked separately. You would also include dental premiums in this category. If you pay life insurance for an S-Corp officer, you would need to have an account called “Officer’s Life Insurance”.
- If your business is an S-Corp, you are required to take a “reasonable” salary as an officer of the business. If this is the case, you would have payroll. Even if your business is an LLC and you do not take payroll, you may have W2 employees on staff. If you have payroll, you need the following accounts: Wages & Salaries – Officers; Wages & Salaries (Non-Officers); Payroll Tax Expense; Payroll Processing Fees.
- Accounts to help you manage your business. Bookkeeping is not just done so you can get your taxes filed. More important than that, your books are a tool to help you manage your business. If your books are well done, you can use the reports to see how you’re doing and where you might need to improve. While the tax return only asks for one income number so you could technically have just one income account in your chart of accounts, you may like to see how much you are generating in different categories. You could set up multiple income accounts to track this. Likewise, if you have non-standard types of expenses you’d like to track, you are free to set up whatever expense accounts might give you the information you need to see. Here are some examples of standard accounts that most businesses might need:
- Auto Expense (see above)
- Bank Service Charges
- Charitable Contributions
- Computer & Internet Expense
- Contract Labor
- Credit Card Merchant Fees (if your business accepts credit card payments)
- Insurance (see above)
- Interest Expense
- Licenses & Fees
- Office Supplies
- Postage & Freight
- Printing & Reproduction
- Professional Fees (Subaccounts: Accounting, Legal)
- Repairs & Maintenance
Of course, you can add or subtract accounts as needed. Generally less is more. Add accounts if you really need or want to track the costs. But if you can categorize something into an existing account and it makes sense, you should do it if only for simplicity’s sake. For instance, unless you have a compelling reason to track cell phones vs. land lines, you can put all of it into Telephone.