chart of accounts
Mar 21

Understanding the Chart of Accounts: A Fundamental Guide

By Charles Hall | Accounting

What is a chart of accounts? If you are new to accounting, you may not know. But you need to understand this part of bookkeeping and accounting whether you use a manual system or an online one such as QuickBooks. A chart of accounts is helpful whether you are using FASB, GASB, or special purpose frameworks

Below, I explain what a chart of accounts is and how you will use it in bookkeeping and accounting. I also provide thirteen steps to developing a chart of accounts. 

What is a Chart of Accounts?

A chart of accounts (COA) is a structured list of an organization’s financial accounts used to categorize and record financial transactions. It serves as the backbone of an accounting system, providing a framework for organizing financial data in a logical manner. The COA is tailored to an organization’s needs and can vary widely in complexity.

The COA is usually hierarchical, with accounts organized in categories and subcategories. These categories include assets, liabilities, equity, revenue, and expenses. Each account within the COA is typically assigned a unique identifier, usually a numerical code (see examples below), to facilitate data entry and reporting.

chart of accounts

Example Chart of Accounts

Here’s an example of a chart of accounts:

Assets

– 1010: Cash

– 1010.1 Operating Checking

– 1010.2 Payroll Checking

– 1010.3 Special Projects Checking

– 1020: Accounts Receivable

– 1030: Inventory

– 1040: Fixed Assets

– 1040.1: Buildings

– 1040.2: Machinery

Liabilities

– 2010: Accounts Payable

– 2020: Loan Payable

– 2030: Accrued Expenses

Equity

– 3010: Owner’s Capital

– 3020: Retained Earnings

Revenue

– 4010: Sales Revenue

– 4020: Interest Income

Expenses

– 5010: Cost of Goods Sold

– 5020: Rent Expense

– 5030: Utilities Expense

– 5040: Salaries and Wages

Next, I’ll show you how to create account codes. 

Account Coding

The numbers used to identify an account (e.g., 1010 for Cash) vary from entity to entity. Account coding involves several elements, including the following:

  • Length of the code (the number of digits or characters in the account number)
  • Use of spaces, dots, or spaces
  • Hierarchical structure (using general categories and subcategories)
  • Numerical and alphanumeric (numbers and letters; e.g., 1010AA-15)

Here are examples of operating cash accounts for different companies:

Account number for operating cash

Entity

100.01

Joe’s Machine Shop

1000-01

Wonderful Coffee, Inc.

10-100-01

Jet Products Partnership

10-10-1000-01-A

Bose Industrial

C-10-10-1000-01

Johnson Farms, Inc.

As you can see, the account code for each operating cash account can vary significantly from entity to entity. So, why the differences?

Factors Affecting Account Coding

Several factors drive the account coding, including the following:

  • Laws or regulations (e.g., state law can dictate account coding for governments)
  • Industry guidelines
  • Business needs for certain information
  • Software requirements (some software packages require the use of specific account coding, such as the number of characters)

Additionally, some entities use prefixes to identify the type of asset, liability, equity, revenue, or expense. Here are examples:

Prefix

Type

10

Asset

20

Liability

30

Equity

40

Revenue

50

Expense

Using the prefixes, the cash and receivable accounts might appear as follows:

Account Number

Account

10-1000

Operating account

10-1005

Payroll account

10-1010

Capital construction account

10-1020

Accounts receivable

10-1025

Due from employees

chart of accounts

More complex entities may have longer account codes to accommodate the reporting needs of the entity. For example, a company might use prefix numbers for specific accounts, such as cash. Here’s an example with the first 10 representing assets and the second 10 representing cash.

Account Number

Account

10-10-1000

Operating account

10-10-1005

Payroll account

10-10-1010

Capital construction account

10-20-2000

Accounts receivable

 

So, why would you add these additional layers in the chart of account number? Additional account coding can make it easier to create financial statements. For example, in the preceding table, total cash can be determined by adding all accounts preceded with 10-10.

So, a company can use account coding to generate certain information, such as total cash.

Next, I’ll show you how the chart of accounts is a part of the financial statement building process. 

The Building Blocks of Financial Statements

Key building blocks in the creation of financial statements include:

  1. Chart of accounts
  2. Journal entries
  3. General ledger
  4. Trial balance
  5. Financial statement

First, let’s look at how the chart of accounts and journal entries work together

The relationship between journal entries and the chart of accounts is akin to the relationship between a script and its cast of characters. The COA serves as the cast—a structured list of all accounts where financial transactions can be recorded. Journal entries, on the other hand, are the script— the actual recording of financial transactions as they occur.

Each line in a journal entry uses an account from the COA. The account’s unique identifier (e.g., 1010.1) is used to specify where the debit or credit is to be recorded.

Account Description Debit  Credit
1010.1 Operating Checking 1,000
4010 Sales Revenue 1,000

 

Second, let’s see how the journal entries feed into the general ledger which feeds into the trial balance

The COA helps categorize transactions appropriately. For example, if a company makes a sale, it debits an asset account (like Accounts Receivable or Cash) and credits a revenue account (Sales Revenue), as defined in the COA. The company records each transaction (journal entry or accounting entry) in the general ledger account, and the general ledger totals create the trial balances.

For example, if there are ten checking account transactions in May, those are added or subtracted from the May 1 opening balance in the general ledger to arrive at the May 31 balance (e.g., $125,453 in the table below).

Third, here’s how the trial balance feeds into the financial statements

Now, the trial balance (the summary of all account balances) checking account balance reflects $125,453 at the end of May which is included in the financial statements

Accounting Sequence

So, let me summarize and say once more what the accounting sequence is.

  1. Accounting entries are made to the general ledger
  2. The general ledger feeds into the trial balance
  3. The trial balance feeds into the financial statement. 

Summarizing Accounts for Financial Statements

Here is an example of a company’s cash accounts being combined for presentation in the financial statements. 

Account Number

Account Name Balance
1010.1 Operating Checking  125,453
1010.2 Payroll Checking 55,871
1010.3 Special Projects Checking 144,120
Total Cash

$325,444

 

From here, we use the total cash balance in the balance sheet.

Financial Statements

Here are a few lines in the balance sheet:

ABC Company

Balance Sheet

12/31/20X4

 

Cash

$325,444

Account Receivable

     548,465

Inventory

  2,587,132

Current Assets

$3,461,041

 

In addition to assisting with financial statement creation, there are other advantages to using a chart of accounts. 

Four Advantages to a Chart of Accounts

  1. Consistency and Standardization: The COA provides a standardized framework for recording transactions. This ensures that everyone in the organization uses the same numbering system when making accounting entries, which is crucial for consistency and accuracy.
  2. Budgeting and Analysis: The COA allows for easier budgeting and financial analysis. Management can assess performance against budgets or historical data by reviewing entries in specific accounts (e.g., sales).
  3. Compliance and Regulation: A well-defined COA ensures that journal entries comply with regulatory requirements for financial reporting, especially in sectors like governments and nonprofits.
  4. Error Detection: A well-organized COA can help you quickly identify accounting entry errors. If an entry doesn’t align with the account type (e.g., crediting an asset account when it should be debited), it’s easier to spot. 

In light of the above, you may be wondering, “What steps should I follow to get this done?”

chart of accounts

Thirteen Steps to Set Up Your COA

Here are steps you can use to set up your COA:

  1. Understand the Business Structure: Before you start, understand the nature of the business or organization. Is it a manufacturing company, a service provider, a nonprofit, or a government entity? The type of organization will influence the accounts you need.
  2. Identify Reporting Needs: Determine the financial statements and reports the organization will need. For example, review sample city financial statements to see what is required if your entity is a city government. This will help you structure the COA to align with the financial statements.
  3. Determine the Basis of Accounting: Cash basis accounting, for example, differs from generally accepted accounting principles (GAAP). GAAP requires accrual accounts such as Accounts Receivable, and the cash basis of accounting does not.
  4. Consult Regulatory Guidelines: For certain types of organizations, especially governments and nonprofits, regulatory guidelines might dictate the structure of the COA.
  5. Choose a Numbering System: Decide your account numbering system. A common approach is to use a series of numbers, often in increments of 10 or 100, to allow for future additions.
  6. Create Main Categories: List the main categories of accounts, such as Assets, Liabilities, Equity, Revenue, and Expenses.
  7. Add Subcategories: Within each main category, add subcategories. For example, Assets contain Current Assets and Noncurrent Assets.
  8. Assign Account Numbers: Assign a unique number to each account based on your numbering system.
  9. Provide Descriptions: Briefly describe each account to clarify its purpose (e.g., operating cash). This is especially useful for anyone not involved in setting up the COA.
  10. Implement in Accounting Software: Most accounting software allows you to customize your COA. Input the accounts, numbers, and descriptions into the software. Before creating your COA, ensure your accounting software allows your desired numbering system. For example, the software might limit the account number to ten digits.
  11. Test and Revise: Test the COA by recording sample transactions after initial setup. Make any necessary adjustments.
  12. Train the Team: Ensure that everyone using the COA understands how to use it correctly.
  13. Review Periodically: Business needs change, and your COA should accommodate those changes. Review the COA periodically and make updates as necessary.

Additional Chart of Account Considerations

Here are some things you need to consider as you develop your chart of accounts:

  1. Balance the number of accounts with your reporting needs. Create additional accounts only when necessary. For example, create salary sub-accounts for each department (e.g., operations salaries, logistics salaries, oversight salaries, management salaries) in a large organization, but one salary account might be sufficient in a small entity.
  2. Some industries, such as healthcare, provide sample COAs. (You’ll find healthcare COA examples on the Internet. The same is true of other industries.) Moreover, some sectors have required COAs. For instance, local governments in Georgia must follow a state-mandated COA.
  3. There are competing issues in developing account codes: Desire for short account numbers versus Desire for additional information. Short account numbers take less time to enter, but they may limit the entity’s informational abilities. The result: the company may need to export account numbers and balances to Excel and manually compute the required information. Many entities lengthen their account numbers to automatically generate information without additional steps (such as exporting to Excel). The 10-10 prefix for all cash accounts (see above) is an example.
  4. As you develop the chart of accounts, share it with all stakeholders, those that this will affect (e.g., department heads in your organization). It’s best to get negative feedback as you develop the chart of accounts, not after it is live in your accounting system. 
  5. If you are creating a new account coding system, consider all the information you need (now and in the future) and design the codes accordingly. A common problem for all entities is they outgrow their account codes; when they do, the business may need to revamp the entire account coding—not a pleasant process.

Give Some Love to COA

As I close, let me encourage you to give your chart of account decisions plenty of thought. You’ll be glad you did. If you don’t give your chart of accounts the early love it deserves, you may regret it. Creating a new accounting systems six years out, for example, would be a major headache. 

I wish you well as you create your chart of accounts. 

online information for CPAs
Mar 18

Online CPA Resources: Free and Paid Options

By Charles Hall | Accounting and Auditing

Are you looking for online CPA resources? You’ve come to the right place. 

There are plenty of online resources, including audit standards, compilation and review standards, illustrative reports, and fraud prevention information. The AICPA’s audit quality centers also offer resources. Some of them are free, while others require a fee. 

online CPA resources

Online CPA Resources

Here’s a list of online CPA resources that I commonly use (some AICPA documents require an AICPA membership):

AICPA Quality Center Resources

While the following are not free, consider joining audit quality centers if you have a concentration in areas such as governments and benefit plans. Once you join a center, you’ll have online access to their information (e.g., newsletters and alerts). In today’s environment, these memberships are vital. I don’t know how anyone can keep up with all the changes in accounting and auditing standards without resources like these. 

I have found the AICPA Governmental Audit Quality Center (GAQC) particularly helpful. They provide timely information alerts to keep you abreast of evolving changes such as those related to Yellow Book and Single Audits.

The Employee Benefit Audit Quality Center is also useful. These audit quality centers provide practice aids and CPE classes relevant to governments and benefit plans. 

Another great resource (though not free) is the Center for Plain English Accounting (CPEA). The CPEA provides written responses to your technical questions; the AICPA Technical Hotline listed above is free but they don’t provide written responses, only verbal. The CPEA also provides timely articles about accounting and auditing changes, some of the best I have seen. Their quarterly accounting and auditing CPE update is also quite useful. 

Your Online Resources

What online resources do you use as a CPA? Leave a comment.

Audit mistakes
Feb 09

Audit Mistakes: Seven Deadly Sins

By Charles Hall | Auditing

Seven deadly audit sins can destroy you. These audit mistakes kill your profits and effectiveness.

You just completed an audit project, and you have another significant write-down. Last year’s audit hours came in well over budget, and—at the time—you thought, This will not happen again. But here it is, and it’s driving you insane.

Insanity: doing the same thing year after year but expecting different results.

Are you ready for better results?

Audit Mistakes

Here are seven deadly (audit) sins that cause our engagements to fail.

Audit mistakes

1. We don’t plan

Rolling over the prior year file does not qualify as planning. Using canned audit programs is not planning.

What do I mean? We don’t know what has changed. Why? Because we have not performed real risk assessment such as current year walkthroughs. We have not (really) thought about current year risks of material misstatement.

Each year, audits have new wrinkles.

Are there any fraud rumors? Has the CFO left without explanation? Have cash balances decreased while profits increased? Does the client have a new accounting program or new staff? Can you still obtain the reports you need? Are there any new audit or accounting standards?

Anticipate issues and be ready for them with a real audit plan.

2. SALY lives

Elvis may not be in the house, but SALY is.

Performing the same audit steps is wasteful. Just because we needed the procedure ten years ago does not mean we need it today. Kill SALY. (No, I don’t mean your staff member; SALY stands for Same As Last Year).

I find that audit files are like closets. We allow old thoughts (clothes) to accumulate without purging. It’s high time for a Goodwill visit. After all, this audit mistake has been with you too long. So ask yourself Are all of the prior audit procedures relevant to this year’s engagement?

Will better planning require us to think more in the early phases of the engagement? Yes. Is this hard work? Yes. Will it result in less overall effort? Yes.

Sometimes the Saly issue occurs because of weak staff.

3. We use weak staff

Staffing your engagement is the primary key to project success. Excellent staff makes a challenging engagement pan out well. Poor staff causes your engagement time to balloon–lots of motion, but few results. Maybe you have smart people, but they need training. Consider AuditSense.

Another audit mistake is weak partner involvement.

4. We don’t monitor

Partners must keep an eye on the project. And I don’t mean just asking, “How’s it going?” Look in the audit file. See what is going on. In-charges will usually tell you what you want to hear. They hope to save the job on the final play, but a Hail Mary often results in a lost game.

As Ronald Reagan once said: Trust but verify.

Engagement partners need to lead and monitor. They also need to provide the right technology tools.

5. We use outdated technology

Are you paperless? Using portable scanners and monitors? Are your auditors well versed in Adobe Acrobat? Are you electronically linking your trial balances to Excel documents? Do you use project management software (e.g., Basecamp)? How about conferencing software (e.g., Zoom)? Do you have secure remote access to audit files? Do you store files securely in the cloud (e.g., Box)? Are you using data mining software such as Idea? Do you send electronic confirmations

Do your staff members fear you so much that they don’t give you the bad news?

6. Staff (intentionally) hide problems

Remind your staff that bad news communicated early is always welcome.

Early communication of bad news should be encouraged and rewarded (yes, rewarded, assuming the employee did not cause the problem).

Sometimes leaders unwittingly cause their staff to hide problems. In the past, we may have gone ballistic on them–now they fear the same.

And here’s one last audit mistake: no post-engagement review.

7. No post-engagement review

Once our audit is complete, we should honestly assess the project. Then make a list of inefficiencies or failures for future reference.

If you are a partner, consider a fifteen-minute meeting with staff to go over the list.

Your ideas to overcome audit mistakes

What do you do to keep your audits within budget?

internal control reporting
Feb 05

Internal Control Reporting When There are No Issues

By Charles Hall | Auditing

In this post, I provide an overview of the internal control reporting requirements when no significant deficiencies or material weaknesses are noted in an audit of the financial statements. I also provide guidance for when such an engagement is subject to the Government Auditing Standards (i.e., Yellow Book). You’ll see a video that shows you what the audit opinion and Yellow Book reports look like when both are in play, and there are no issues. 

internal control reporting

Internal Control Reporting Standards

There are two sets of rules when you perform an audit that is subject to the Yellow Book requirements:

  1. Generally accepted auditing standards from AICPA
  2. Government Auditing Standards (i.e., Yellow Book) from GAO

And only one set of rules if the audit is not subject to the Yellow Book requirements:

  1. Generally accepted auditing standards from AICPA

Consider two scenarios.

1. Perform an audit not subject to Yellow Book 

If you perform an audit (not subject to Yellow Book) and have no significant deficiencies or material weaknesses, then no internal control letter is required (for anyone). I refer to this letter as the “SAS 115 letter” since that’s where the original generally accepted auditing rule came from. Some people opt to issue one anyway. But again, this is not required.

In this scenario, you issue one report:

Audit opinion (and no internal control letter is issued)

2. Perform an audit subject to Yellow Book 

If you perform an audit that is subject to Yellow Book and have no significant deficiencies or material weaknesses, then no SAS 115 internal control letter is requiredSome people opt to issue one anyway.

A Yellow Book report is required (even though there are no significant deficiencies or material weaknesses) and is included in the audited financial statements, usually after the notes to the financial statement. 

You do not need to send this report to anyone separately (i.e., the government) since it’s included in the bound audit report.

So, in this scenario, you issue two reports:

  1. Audit opinion, and
  2. Yellow Book report

But what do these reports look like? 

Yellow Book Report and Amendments to Audit Opinion

Here is a video that shows you what a Yellow Book reports looks like when there are no significant deficiencies or material weaknesses. 

I also show you how to amend your standard audit opinion (governmental example) when the Yellow Book report is provided. 

See my related article about capturing and reporting control deficiencies. I define significant deficiencies and material weaknesses in another post.

YouTube player
predecessor auditor
Feb 03

Tips for Communicating with a Predecessor Auditor

By Charles Hall | Auditing

Communicating with a predecessor auditor can be trying. Even so, audit standards require that you (at least try to) contact them. 

After not sufficiently vetting a potential new client and paying the price for it, I can tell you, “This part of client acceptance is crucial.” You can avoid many headaches. 

In this article, I tell you when to make contact, what inquiries to make, what responses you might receive, how to document the conversations, and how reviewing predecessor work papers will help you audit opening balances. 

Let’s start with an example conversation between the prospective and predecessor auditors.

predecessor auditor

Example Conversation with Predecessor Auditor

“Hi Bill, I am Charles Hall of Johnson & Hitchcock CPAs. I am calling about the 2024 audit of Bird Lighting. They said they would contact you and authorize this conversation. Have they done that?”

“Yes, we heard from them last week. I can respond to your questions.”

So, I ask, “Have there been any illegalities or noncompliance issues you’ve encountered previously?” His response is a hesitant no. I sense Bill is not happy to talk with me (which I understand–we’ve been cross-town competitors for over a decade). He’s responding but is not volunteering any additional information. Probing further, I question the company’s financial condition. Bill admits to cash flow troubles, causing difficulties in compensating accounting staff. 

Now, I’m wondering if they have competent accountants. 

I ask, “How many journal entries did you propose last year, and were there any disagreements about those?” And he responds, “about 35.” He hesitates before disclosing that a heated debate preceded the posting of two material entries

We discuss other matters before arranging a meeting to examine their work papers. Bill says, “We’ll make the prior year’s work papers available for viewing in our office on May 4 at 10:00 a.m. You can request copies of work papers, but we reserve the right to refuse. For example, we don’t give copies of our walkthroughs or risk assessments. We’ll also ask that you sign a letter stating that you will not use this information in any way that might harm our firm.”

Now that we’ve visited a typical predecessor auditor conversation let’s see what the audit standards say about this. 

When to Initiate the Conversation

The auditor should initiate this communication before being engaged to perform the engagement.

Why? Because you want to be aware of any potential problem areas before you accept the engagement. For instance, if management is unethical, you want to know that. If management has used fraudulent accounting, being aware of such practices is to your advantage. Consequently, audit standards necessitate communication before the auditor is engaged.

Contacting the Predecessor Auditor

You should initiate communication with the predecessor auditor and make inquiries according to AU-C 210, Terms of Engagement. Such inquiries should include potential fraudulent activities involving management or employees and noncompliance or suspected noncompliance with applicable laws and regulations. Those inquiries might also include asking if the predecessor knows why the auditee is making the change in auditors. 

Additional potential problem areas include:

–leadership integrity issues

–combative attitudes

–financial problems

–lack of client responsiveness to requests for information

–excessive number of audit adjustments

–client expectations that you do additional work without compensation

–management override of controls

–disagreements over audit fees

Before establishing contact, the company’s management must authorize the predecessor auditor to respond to the successor auditor’s inquiries. If the potential client does not permit this communication, think twice about doing this audit. 

A prospective auditor can make a proposal to do the audit before contacting the predecessor auditor, but can’t accept the engagement (it’s not final) until they have communicated with the predecessor auditor. 

Not communicating with the predecessor auditor can be equivalent to walking into a minefield when anticipating a leisurely hike. The more you know as you accept a new client, the better. 

The Predecessor Auditor’s Response

Sometimes, the predecessor will not respond, as though you don’t exist. (Makes me think, “E.T., phone home.”) Why? They are probably unhappy that you’ve just taken a client from them. That’s understandable. It may not be professional, but again, it’s understandable. (This is what makes these conversations so difficult.)

The predecessor auditor is to be timely in their responses. 

Predecessor auditor

Limited Responses

Other times, the predecessor might give you a limited response. You might think this when there are conversational pauses or stammerings. Such hesitations might indicate that you need to tread carefully and consider whether you should accept the client. For example, is the predecessor privy to information that would be useful to you but potentially damaging to them (i.e., the company sues them for slander)? Sometimes, you don’t know. 

Additionally, the predecessor auditor sometimes provides a limited response due to extenuating circumstances, such as pending litigation. In that case, they should say their response is limited per AU-C 210, Terms of Engagement

Now, let’s think about evaluating the responses. 

Evaluate the Responses

The successor auditor should evaluate the implications of the responses received (or not received) and document that information in the audit file. Why? One reason is peer reviewers look for predecessor auditor communication in an initial audit file. You need to prove you at least tried to initiate a conversation.

There’s little you can do when a predecessor auditor is nonresponsive. Even so, document your attempts to communicate. For example, include copies of letters and emails in your audit file. 

If the predecessor does respond, consider asking to see their prior year’s audit work papers. 

Reviewing Predecessor Audit Work Papers

A customary request by a potential successor auditor pertains to accessing predecessor auditor work papers. Viewing those work papers facilitates verification of opening balances for your new audit if you accept the engagement.

By the way, it is usual for the predecessor to ask you to sign a letter saying that you’ll not use the prior year’s work papers in any manner that might harm them, which is a reasonable request. 

The predecessor decides whether you can see any work papers and what they will allow you to review. They might not provide, for example, their walkthroughs. Why? Because it takes a great deal of time to create these, and they may not want to give their competitor free work.  

Summary

Not only do professional standards require you to contact the predecessor auditor, but it’s the better part of wisdom for you to do so. No, it’s not a fun process, but you’ll be glad you did. Your peer reviewer will also be happy you followed the audit standards. 

In June 2022, the AICPA Auditing Standards Board (ASB) issued Statement on Auditing Standards (SAS) No. 147, Inquiries of the Predecessor Auditor Regarding Fraud and Noncompliance With Laws and Regulations. It is effective for periods beginning on or after June 30, 2023.

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