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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.

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

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?”

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. 

Three Steps to Correct Cash Flow Statement Errors

By Charles Hall | Accounting

Related Party Transactions: Fraud

By Charles Hall | Auditing , Financial Statement Fraud , Fraud

How to Review Financial Statements

By Charles Hall | Accounting and Auditing

Most CPA firms create financial statements for their clients. This blog post tells you how to create and review financial statements efficiently and effectively.

Create Financial Statements

First, where possible, electronically link the trial balance to the financial statements. (Linking is often done from the trial balance to Excel. Then the Excel document is embedded into a Word document.) Doing so will expedite the financial statement process and enhance the integrity of the numbers.

Do the following:

• Prepare the initial draft of the statements
• Create clear disclosures
• Complete a current financial statement disclosure checklist 
• Research any nonstandard opinion or report language (place sample reports from PPC or other sources in the file). Later the partner or manager will compare this supporting document to the opinion or report
• Research any additional reports (e.g., Yellow Book, Single Audit). Place a copy of such reports in the file. Later the partner or manager will compare the supporting document to the opinion or report. 
• The staff person should review the audit planning document to see if any new standards are to be incorporated into this to year’s financial statements

Next you’ll need to proof the financial statements.

Proof the Financial Statements

Proof your financial statements. The proofer usually does the following before the partner or managers’ review:

• Add (foot the numbers for) all statements, notes, schedules
• Tick and tie numbers such as:
  • Total assets equal total liabilities and equity
  • Ending cash on the cash flow statement agrees with the balance sheet
  • Net income on the income statement agrees with the beginning number of an indirect method cash flow statement
  • Numbers in the notes agree with the financial statements
  • Numbers in the supplementary schedules agree with the financial statements
• Review financial statements for compliance with firm formatting standard 
• Read financial statements for appropriate grammar and punctuation (consider using Grammarly)
• Compare the table of contents to all pages in the report
• Review page numbers

Partner or Manager Review

Finally, the partner or manager reviews the financial statements. Having the proofer do their part will minimize the review time for this final-stage review.

Here are tips for the final review:

• Scan the complete set of financials to get a general feel for the composition of the report (e.g., Yellow Book report, supplementary information, the industry, etc.). This is a cursory review taking three or four seconds per page.
• Read the beginning part of the summary of significant accounting policies taking note of the reporting framework (e.g., GAAP), type of entity (e.g., nonprofit), and whether the statements are consolidated or combined. Doing so early provides context for the remaining review of the financials.
• Read the opinion or report noting any nonstandard language (e.g., going concern paragraph)
  • Agree named financial statement titles in the opinion or report to the financial statements
  • Agree the dates (e.g., year-end) in the opinion or report to the statements
  • Compare supporting sample report (as provided by your staff member and noted above) to the opinion or report
  • Compare representation letter date to the opinion or review report date
• Review the balance sheet making mental notes of line items that should have related notes (retain those thoughts for review of the notes)
• Review the income statement
• Review the statement of changes in equity (if applicable)
• Review the cash flow statement
• Review the notes (making mental notes regarding sensitive or important disclosures so you can later see if the communication with those charged with governance appropriately contains references to these notes)
• Return to the balance sheet to see if there are additional disclosures needed (since you just read the notes, you will be more aware of omissions — e.g., intangibles are not disclosed)
• Review supplementary information (and related opinion for this information if applicable)
• Review other reports such as Yellow Book and Single Audit (the staff member preparing the financial statements should have placed supporting examples in the file; refer to the examples as necessary)
• If the review is performed with a printed copy of the statements, use yellow highlighter to mark reviewed sections and numbers
• If you review a paper copy, pencil in corrections and provide corrected pages to the staff member for amendments to be made
• If the review is performed on the computer, take screenshots of pages needing corrections and provide to the staff member
• Better yet, review electronically. See my related post Review Financial Statements on Computer Screens

Last Step

Destroy all drafts. Or at a minimum, don’t leave them in the file. Once the financial statements are complete, there is no reason to retain drafts.

Your Suggestions

What other review procedures do you use?

Debt Covenant Violations: How to Report

By Charles Hall | Accounting

How does a debt covenant violation affect the presentation of debt on a balance sheet? If a waiver from the lender is obtained, should the violation be disclosed? In this article, I will tell you how to report debt covenant violations.

Lenders commonly include debt covenants in loan agreements. Those covenants might require certain profitability, liquidity, or cash flow ratios. A violation of such requirements can make long-term debt callable. And, by definition, the debt becomes current since it is now due within one year of the balance sheet date. 

If a debt covenant violation occurs, the debt should be classified as current unless the lender provides a waiver for more than one year from the balance sheet date. (See an exception below when there are subsequent measurement dates within one year of the balance sheet date.)

How should debt be classified if a cure occurs prior to the issuance of the financial statements? Debt is shown as noncurrent if the company is able to cure a violation subsequent to the balance sheet date but before the issuance date (or date available for issuance) of the financial statements.

Additionally, some loans provide for a grace period. If the violation is cured during the grace period, the debt will be reported as long-term. Also if the cure has not already occurred but the company demonstrates it is probable that the cure will occur within the grace period, then the debt will be reported as long-term.

Reporting Debt Covenant Violations

When a violation occurs, the main consideration in classifying long-term debt is whether the amount is due or callable within one year of the balance sheet date. If the loan is due or callable within the year after the period-end, the amount generally should be reported as current. If a debt covenant violation is timely cured within a grace period, then the debt is no longer callable and will, therefore, remain long-term. Noncurrent classification is also appropriate if the creditor provides a waiver that extends more than one year beyond the balance sheet date.

Waivers do not, however, guarantee long-term debt classification, particularly if there are other measurement dates within the year after the period-end. 

Subsequent Measurement Dates

470-10-45 of the FASB Codification provides the following guidance:

Some long-term loans require compliance with quarterly or semiannual covenants that must be met on a quarterly or semiannual basis. If a covenant violation occurs that would otherwise give the lender the right to call the debt, a lender may waive its call right arising from the current violation for a period greater than one year while retaining future covenant requirements. Unless facts and circumstances indicate otherwise, the borrower shall classify the obligation as noncurrent, unless both of the following conditions exist:

a. A covenant violation that gives the lender the right to call the debt has occurred at the balance sheet date or would have occurred absent a loan modification.
b. It is probable that the borrower will not be able to cure the default (comply with the covenant) at measurement dates that are within the next 12 months.

If both of these conditions exist, then the debt is shown as current.

Consider a scenario where a company has a covenant violation on December 31, 2019, and it obtains a waiver from the lender that lasts through January 1, 2021. If a September 30, 2020 measurement date is required by the loan agreement and it is probable that the company will not be in compliance, then the loan is classified as current on December 31, 2019, even though the waiver was obtained. Why? The new violation would make the loan callable within one year of the balance sheet date. (The prior waiver was in relation to the December 31, 2019 violation, not a subsequent violation.)

Is Disclosure Required if a Waiver is Obtained?

If a company obtains a waiver for more than one year from the balance sheet date, must the financials disclose this fact (that a waiver was obtained)?

The AICPA answers this question–in Q&A section 3200 (paragraph 17)–with the following:

The authoritative literature applicable to nonpublic entities does not address disclosure of debt covenant violations existing at the balance-sheet date that have been waived by the creditor for a stated period of time. Nevertheless, disclosure of the existing violation(s) and the waiver period should be considered* for reasons of adequate disclosure. If the covenant violation resulted from nonpayment of principal or interest on the debt, inability to maintain required financial ratios or other such financial covenants, that information may be vital to users of the financial statements even though the debt is not callable.

*Emphasis added by CPAHallTalk

Translation: It is wise to disclose the debt covenant violation and the existence of the waiver.

FASB’s Current Work on a New Debt Standard

The FASB has an ongoing project regarding the classification of debt. The FASB issued a revised Exposure Draft on September 12, 2019, Debt (Topic 470): Simplifying the Classification of Debt in a Classified Balance Sheet (Current versus Noncurrent). Comments were due October 28, 2019. It has taken FASB over two years to deliberate this topic. So you call tell the classification decision is not an easy one.

Additional Information About Auditing Debt

See my post regarding the audit of debt.