Chart of Accounts
Given that many firms will have a large number of accounts in their general ledger, it is important to have some way of organising these accounts, and finding the correct one when it is needed. The chart of accounts classifies all the accounts in the general ledger, giving each of them a unique reference number. This makes it easy for accountants to organise the accounts, and allows new accounts to be added into the system as the business grows. It also provides accountants with a systematic method for compiling the general ledger into the financial accounts.
In order to creating a chart of accounts for a business, an accountant must identify all the accounts the business uses, and classify each one based on what it records. For example, asset accounts should be kept different from liability accounts, revenue accounts etc. Additionally, different types of asset accounts should have different classifications to help with identification, such as separating cash based accounts from inventory and materials accounts. Once the accounts have been identified and classified, they can be fitted to the numbering system.
There will often be specific industry standards dictating how these accounts should be classified. For example, in a four digit accounting system any account starting 1XXX could be an asset account, any starting 2XXX a liability account, 3XXX for equity accounts, 4XXX for revenue accounts and so on. Within the asset accounts, 10XX could be for cash accounts, 11XX could be for trade receivable accounts, 12XX for materials accounts and so on. Within such a system, it is important to leave gaps in each category to ensure than new accounts can be added without breaking up the structure of the charts.
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When defining the accounts, it is important to recognise that different businesses will perform their accounting in a different way, and hence will need different account classifications. So whilst Toyota would need lots of material accounts because of the various car parts they use, Tesco would have lost of purchasing accounts for the different food lines they offer and Barclays would have lots of asset and liability accounts for their various financial products. As the type of accounts often vary per industry, many industry associations publish recommended charts of accounts for consistency, and to ensure that accountants and auditors are easily able to understand the accounts across an industry. In addition, most accounting software packages tend to include predefined account charts and the recommended industry charts for various businesses.
One consideration businesses, especially new businesses, must take is that there will always be a trade off between keeping accounts simple and making sure the accounting history can easily be understood. This trade off mainly manifests itself in the number of accounts included in the accounting chart and the reference system used. Whilst keeping a small number of accounts will make the accounting system simple to operate, as the business grows more accounts may be needed, and existing accounts may have to be split into different ones. This could make it difficult to trace how expenses, assets and revenues have developed over time, as there would be no way to easily understand the relationships between the accounts. In contrast, having a large number of accounts will make the accounting process more complicated, particularly deciding which account transactions belong to, but will make it less likely the business will have to create more accounts as it grows. As such, more detailed charts with more accounts in them will help businesses to track their historical performance.
Another consideration is that some accounts need to be broken down according to tax reporting and auditing requirements. One common example of this is that miscellaneous non operating expenses such as travel, advertising and entertaining need to be tracked individually so it is clear how much a business is spending in each of these areas. As such, the accountant has a responsibility to check that the chart of accounts is consistent with the legal and regulatory requirements governing the business.