There is no hard and fast rules about your chart of accounts set by the IRS or any state government. Your Chart of Accounts for your business simply allows you to organize your revenue, expense, asset, liability, and equity transactions. This organizational tool can be as simple or complex as you want to make it. At the end of the day, your chart of accounts dictates what your financials statements look like. If you are a sole proprietor, or small business, you should be able to see your entire income statement on one page. No need to break out every single type of software expense or office supply you buy, just lump like-minded transactions with each other.
For instance, I have clients ask me if their Gmail expenses and their marketing software should classified to the same account. If your business is large enough to have "internal software" and "marketing software" split out and it makes a substantial difference to your financial analysis, go fir it. The vast majority should classify all software expenses into one "Software Expenses" account. That way. if you're ever trying to hunt down an invoice or certain type of expense, you can easily track it down.
The Chart of Accounts for your business is specifically designed to give you a birds eye view of your business. So, the more accounts and sub-accounts you have, the harder it is to quickly diagnose your business month over month.
If you use an accounting system, like Quickbooks, you already have a chart of accounts and don't need to build one outside of that. Rather, you'll just need to refine the categories transactions belong in.
See this blog post on 30 common tax write offs for a small business owner to learn about eligible expenses you may have not known about.
The biggest benefit to an organized chart of accounts is accurate, useful reporting.
But how do I use it for analysis?
Every time a business transaction comes through your accounting system, it is recorded to your chart of accounts. But how do you know which accounts to record the transaction in? Generally, the transaction will either correspond to your income statement or the balance sheet.
An income statement is the small business owner's holy grail. This shows you what kind of money you have to work with. There are two types of accounts on your income statement:
Revenue accounts: because this is why you're in business
Expense accounts: this is where you try to write off everything as a deduction ;) Really, these are accounts that reflect the money and resources used to generate revenue for your business.
A balance sheet shows what your business owns (assets) and what it owes (liabilities), and what is leftover for the company owners after paying off any obligations (equity). There are three types of accounts on your balance sheet:
Asset Accounts - transactions recorded as assets show the resources your business owns that provides value. Examples of these transactions are accounts receivable, inventory, real estate, and equipment.
Liability Accounts - transactions recorded as liabilities shows all the debt your business owes. Examples of these transactions are accounts payable, taxes payable, wages payable, and benefits payable.
Equity Accounts - generally you will not record transactions to an equity account. Equity measures how valuable a company is to outside shareholders. Essentially, it is what's left when you subtract a company's liabilities from its assets. Examples of these transactions are common or preferred stock, owner's draws, owner's investment, and retained earnings.
If you're using Quickbooks, you may have seen an equity account titled, "Opening Balance Equity". When you add a credit card account to your Quickbooks, their system automatically creates a journal entry to the account, "Opening Balance Equity" to record the prior account balance present when adding it to your Quickbooks account.
Chart of Accounts Example
The naming convention is entirely up to you. I like to add the bank name and last three to four digits of each bank or credit card account I add to make it easier to identify. Below is an example of very concise financial statements. Remember, break out accounts only as they become meaningful to your business.
Balance Sheet
Assets
Chase Checking 1234
Chase Savings 4321
Accounts Receivable
Inventory
Computers
Vehicles
Office space deposit
Liabilities
Accounts payable
Wages payable
Health insurance benefits payable
Retirement plan payable
Chase Credit Card - Sapphire
Mastercard 6578
Equity
Owner's Draw
Owner's Investment
Retained Earnings
Income Statement
Income
Sales*
Sales - Consulting
Sales - Amazon book sales
Sales - "any other meaningful way you earn revenue"
Interest income (interest earned from bank accounts)
Expenses
Advertising & Marketing
Bank Charges & Fees
Contractors*
Contractors - Sales
Contractors - Administrative Assistant
Contractors - Marketing
Insurance
Interest Paid
Legal and professional services (attorney and accountant fees)
Meals expense
Office Expenses**
Payroll Expenses
Wages
Employer Tax
Employer Retirement Contributions
Rent Expense
Software Expenses
Taxes and Licenses***
Travel
Utilities****
*If you have multiple streams of revenue, or if you utilize a lot of contractors, I advise adding subaccounts to the main "Sales" and "Contractor" accounts to better understand where you are earning your money and where you are spending your money on outside labor.
**Office expenses consist of stationery, office furniture, computer equipment, paper shredding, continuing education, anything office related, throw it in here.
***You can deduct various federal, state, and local taxes such as sales tax and business income tax. Taxes associated with your personal tax return are not a qualified business expense. This account can also house annual filing fees, permits, licenses, etc as they are directly attributable to your business.
****Lump all expenses in utilities for internet, electric, water, gas, and cell phone. No need to break these out as they are fixed costs for running your business, and breaking them out would not help you better understand your business' financial operations.