The Chart of Accounts is simply a list of all the account types you might use when recording your business income and expenditure activities. The "account types" include assets, liabilities, equity, income, expenses, other income and other expenses. The accounts are separated like this for reporting purposes and are used to build the balance sheet and the profit and loss report. Business owners and accounting professionals use these reports to ascertain the financial health of the business. As a business owner, it is very important that you understand these reports. In order to do this, you must first be across each of the account types found in the chart of accounts. In this blog, we will look at these account types and explain what they mean and their accounting purpose.
There are seven account types residing within the chart of accounts. These included:
Assets
Liabilities
Equity
Expenses
Income
Other Expenses
Other Income
For reporting purposes, the assets, liabilities and equity accounts are found on the balance sheet and the remainder of the accounts fall to the profit and loss report.
ASSETS
Business assets are "capital" items that the business owns. These might include things like bank accounts, cash, computers, vehicles, buildings or land. For bookkeeping purposes, they are separated into sub-accounts depending on how soon they can be converted into cash. The sub-headings include:
Current Assets
Non-Current Assets (or Fixed Assets)
Intangible Assets
Any assets that could be converted into cash within the next 12 months are categorised as "Current Assets". These could be things like:
Bank accounts and/or cash
Short-term investments, like shares or unit trust holdings
Accounts receivable - all of the money customers owe you
Inventory - all stock or raw materials held by the business for later onsale to customers.
Any assets owned that cannot be readily converted into cash within 12 months are put into the "Non-Current Asset" category. These are things like:
Land and Buildings
Plant and Equipment - new computers, machinery, tools, furniture, etc.
Motor Vehicles - any vehicle owned by the business
Accumulated Depreciation - the amount the accountant has claimed back in previous tax returns on non-current assets
Other assets that are not readily converted into cash are known as "Intangible Assets". These assets can't be seen or touched, hence the intangible part. They include things like:
Borrowing expenses - banking expenses related to a business loan
Formulation expenses - expenses related to setting up a company
Goodwill - usually part of the purchase price of a business.
LIABILITIES
Liabilities are all of the amounts your business owes to other stakeholders. They can include credit card accounts, suppliers bills, GST, PAYG Withholding, Superannuation Guarantee, bank loans, loans from others, loans to buy assets, etc.
Liabilities are separated into sub-categories just like the assets.
Current Liabilities
Non-Current Liabilities
Current Liabilities are those which are due for payment within one year. These can include:
Credit cards
Overdrafts
Accounts Payable - money you owe suppliers
Other - customer deposits, short-term director loans
GST
PAYG Withholding
Superannuation Guarantee
Non-Current Liabilities are those items which are not due to be paid within one year and can include:
Bank loans
Loans from others - money loaned from family and friends
Hire purchase or chattel mortgage - often vehicles and equipment is purchased via these type of loans.
EQUITY
Put simply, the result of subtracting liabilities from assets is known as "equity". This is the "interest" a director, shareholder or business owner has in the business. Equity is made up of capital contributed and the profit and loss built up over time.
There are different equity accounts used for each business structure. These are outlined below:
Sole Trader
Equity accounts for sole traders can include:
Owner's capital - contributions made by owner
Owner's drawings - personal spending
Current year's profit (or loss) - the net profit or loss (taken from the Profit and Loss report)
Partnership
Equity accounts for a partnership can include:
Partner's capital - there needs to be one for each partner
Partner's drawings - again, there should be one for each partner
Distribution of profit - the accountant writes profit distribution for each partner to this account at the end of the year.
Companies and Trusts
The main equity accounts for companies and trusts include:
Retained earnings - income retained by a company that isn't distributed to shareholders. These earnings or losses build up from one year to the next
Current year's earnings
Dividends paid - if shareholder receives a profit distribution, this payment is recorded here. For trusts, this account is known as "Trust Distributions Paid"
Shareholder capital - this is the value of all shares issued. This is known as "Issued Ordinary Units" in a trust structure.
Account types known as expenses, income, other expenses and other income are the accounts you will find on a Profit and Loss Statement. Let's look at these in more detail.
EXPENSES
An expense in business terms, is any cost to a business as a result of its income-earning activities. The relationship between expenses and income is an important one. For an expense to be included in the chart of accounts, it must first in some way lead to your business earning income. In other words, whatever you purchase must in some way assist you to make income.
There are 2 business expense categories and these are:
Cost of sales, known as variable expenses
All other expenses, known as fixed expenses or overheads
Let's look at each of these categories separately.
Cost of Sales (Variable Expenses)
An expense is a cost of sale if it directly reduces sales profit. Types of cost of sales accounts are dependent on the nature of the business and as such are different for each industry. In general however, these sorts of expenses can include:
Merchant bank fees (PayPal, Amex, bank, Eventbrite, Bay charges, etc)
Freight/postage (for purchasing or sending inventory to customers)
Contractor charges (for customer jobs you outsource)
Discounts or refunds given to customers
Stock purchases.
Overhead or Fixed Expenses
All of the costs incurred while running your business other than variable expenses, are known as overheads or fixed expenses. Each category will probably have sub-categories as shown below. They include things like:
Rent
Administration (accounting fees, bank fees, bookkeeping fees, donations, bad debts, depreciation, etc)
Employment (salaries and wages, superannuation, staff amenities, work cover insurance)
Motor Vehicle (fuel, maintenance, insurance, registration)
Insurance (liability, professional indemnity, business, etc)
Telephone (office, mobile)
Computer (hardware, software, consumables)
Travel (international and national and usually separated by type, eg: flights, accommodation, meals, taxi, parking fees)
Marketing (advertising, signage, social media, branded uniforms or stationery)
Office (stationery, postage, repairs, cleaning)
Training (webinars, courses, etc)
Utilities (electricity, gas, waste disposal, internet)
Website (hosting, maintenance, design, etc)
INCOME
This account is probably the easiest to understand and the most important to all business owners! Income is the thing that keeps our businesses afloat and hopefully allows us to enjoy professional and personal success via accruing profits. Your business probably has different sources of income specific to your chosen industry. To track your business income properly, you should create income accounts for each of these sources. Doing this will allow you to see how each of your income streams is doing each month via the profit and loss statement. A working example of different income streams could be those required for a guitar teacher. Their income accounts list might look like this:
Guitar lessons (public)
Guitar lessons (schools)
Music book sales
Guitar accessories sales
Events or gigs
OTHER INCOME
This account is where you might record funds coming into the business that are not related to the actual sales or income made by your business. These types of funds may or may not be received very regularly. Other income can include things like:
Interest income from bank accounts
Foreign exchange gain
Rental income
Profit from the sale of business assets
OTHER EXPENSES
This account is similar to the "other income" account in that it is used to record transactions that aren't directly related to your business, in particular, expenditure. Other expenses can include (but not limited to) the following:
Interest charges from bank accounts
Borrowing charges
Miscellaneous expenses, not included in the general expenses list
Foreign exchange loss
Loss from the sale of business assets
Suspense (this account is used to record any transactions that you are unsure about and need your accounting professional to sort out for you).
So, to recap, there are 7 main accounts in a chart of accounts: assets, liabilities, equity, expenses, income, other income and other expenses. The first 3 are used to create the Balance Sheet and the rest are found on the Profit and Loss Statement. The types of categories within each account are dependent on your industry and specific business needs. Once you have set up your chart of accounts and have been recording transactions against it for a while, you will be in a position to create your profit and loss and balance sheet reports.
Keep a watch out for future blogs where I delve deeper in these 2 reports - what they look like, what they mean and how you can use them to understand what is happening in your business.