The chart of accounts: Building a foundation for effective financial management

When running a company, you learn to roll with the punches. However, the financial aspects of running a business can be daunting. From keeping track of expenses to preparing for taxes to ensuring accuracy—there's a lot to learn. One of the most important ways to ensure you get and keep your finances in order is to build a chart of accounts (COA). 

The COA provides the foundation for your accounting system. Every time you record a business transaction—receive payments, buy office supplies, or pay for a team dinner—the chart of accounts (COA) helps you record it in the right account.

This article will discuss what a chart of accounts (COA) means, why it is important, and how to set it up. We will also discuss some challenges associated with COA and the best practices to tackle them. 

What is a chart of accounts and why is it important?

Definition and purpose of a chart of accounts

The chart of accounts is a list of accounts, all your company’s financial accounts that appear in your general ledger. While a general ledger (GL) records all transactions, a COA lists all the accounts in an organization. 

The COA is like an index. It organizes financial transactions by type of financial activity. This categorization makes it easier to track and manage your company’s finances.

Using the chart of accounts, you can break down all your business' transactions during a specific period into different subcategories. By separating your revenue, liabilities, assets, and business expenditures, a COA enables you to gain deeper visibility into the effectiveness of different areas of your business.

Importance of maintaining a well-organized COA 

Since it is an index, the COA facilitates easy referencing of numbers and monitoring the cash flow in and out of the company. 

A well-structured chart of accounts is a foundation for effective bookkeeping and financial management. It ensures that your financial records are accurate, up-to-date, and easy to navigate. The COA is key to understanding your finances. So, the last thing you want to find is that a transaction isn’t labeled and categorized, or worse, categorized wrong.

Used correctly, a COA separates assets, liabilities, revenue, and expenditures in a very granular way and equips you with all the information needed to make well-informed decisions—whether it's regarding investments, hiring, or marketing. It also helps you adhere to financial reporting standards, which further ensures more visibility, transparency, and compliance. 

How is a chart of accounts structured?

The layout and hierarchy of the COA vary from industry to industry and company to company. Also, it differs greatly for SaaS companies because, unlike product-based or service-based businesses, subscription revenue is recurring in nature and gradually recognized over the period of time specified in customer contracts. Thus, a SaaS company’s chart of accounts will include a general ledger account for deferred revenue as a liability. For other industries, this might be different.

In addition, there is no single format for preparing a chart of accounts. You can make your chart of accounts super detailed or you might want to keep it simple. The final structure and layout are dependent on the type of business and its size. Three levels of detail is usually necessary to have decent visibility into your business finances. However, you can make your COA as granular as you need to fully understand your business. 

Main types of accounts in a typical COA

The COA groups accounts into the following categories:

• Asset accounts – This category includes anything the business owns, which has monetary value. For SaaS companies, it can include tangible things, such as office space as well as intangible things, such as patents and trademarks. 
• Liability accounts – Liabilities include any money that is owed by the business, such as payments on loans. In SaaS, liabilities also include subscription fees remaining on customer contracts  because you haven’t provided those services yet. Equity accounts – This category includes any money invested in the business and withdrawn by investors. 
• Revenue accounts – Revenue includes all the money received through sales. In SaaS, revenue from sales is not collected all at once. Rather, revenue from each sale is collected over a period of  time. Given this, customer payments are categorized as revenue, while the remaining due on their contracts is categorized as a liability. 
• Expense accounts – This category is pretty straightforward. It includes any money the business has paid to other parties, such as vendor payments, payroll, etc.

Some organizations may also add the cost of goods sold (COGS) as a separate account in their COA. Some might have different accounts for operating and non-operating expenses. It all depends upon the data needs of the business.

Below is a simplified example of a COA for a typical SaaS company. Note that the category and statement columns shown here are not part of a typical COA. We’ve included them here to better illustrate the nature of each line item and how each account fits into your overall financial reporting.  

Your actual COA should be more detailed —including rows for two or more levels of sub-accounts in the accounts column, along with additional columns for the parent account number and name for every account—as shown in the example below. You would also need to include a column for a more detailed description of the account to make it easier to know how a transaction should be categorized.  

Using account numbers are critical for ensuring you code transactions to the right account. The order of  the chart of accounts categories can vary. Typically, the chart of accounts begins with numbers of three or four digits—1000s for assets, 2000s for liabilities, and so on. The first digit in the account number indicates the financial statement and section to which it corresponds. From there, sub-categories emerge to organize your accounts better. 

Most SaaS charts of accounts define at least three levels of accounts—a high-level account and two levels of sub-accounts as shown in the example COA excerpt above. Therefore, starting with six-digit account numbers gives you the space to add accounts in the future as your business grows.  

Key considerations in preparing your chart of accounts 

Every company needs a chart of accounts to fully understand its finances. Companies can create a COA that best suits their needs. However, the Generally Accepted Accounting Principles (GAAP) set by the Financial Accounting Standards Board (FASB) states that consistency and reliability are the first two “rules” for preparing a COA. 

• Consistency: GAAP emphasizes the importance of consistency in financial reporting. You should use the same chart of accounts  uniformly over time. Consistency ensures that financial statements remain comparable from one period to another. Conversely, comparing your financial information over a multi-year period will become difficult if you keep adding new accounts. 

• Relevance and reliability: The chart of accounts should ensure that transactions are recorded accurately, resulting in financial statements that are both relevant and reliable.

How to set up a chart of accounts for your business

Setting up a chart of accounts requires factoring in the business's structure, operations, and current & future financial needs. Your industry, revenue streams, and business model play a huge role in determining the type of accounts you must list.

The following steps can help with setting up a chart of accounts for your business:

1. Identify the time frame

Typically, the chart of accounts begins with determining whether you prefer to monitor your finances on a monthly, quarterly, or yearly basis. This interval will serve as the timeframe for structuring your transactions.

2. Determine the account types

The COA groups the GL accounts into broad categories known as account types. The account types discussed above will be similar for most businesses because they correspond with the key sections in the P&L or income statement and the balance sheet. 

3. Categorize and sub-categorize accounts

Assess the depth and complexity of your business operations, such as sales, expenses, assets, and liabilities, to determine the categories and subcategories you want to include in your chart of accounts. Ensure that you maintain a balance between having enough accounts to capture relevant information while avoiding unnecessary accounts. Remember that your COA will always be work-in-progress; changes in your business will require changes to your COA. 

Pro Tip: Keep it simple. While you may be tempted to add intricate details, it's best to maintain a high-level overview. It will naturally get more complicated over time. Starting with a simpler structure will ensure clarity and ease of use as your COA evolves.

4. Establish account numbers

Account numbering and naming conventions ensure structure and consistency in your COA. Assigning numerical codes to accounts creates a logical hierarchy. Clear naming conventions are equally important. Opt for concise and descriptive names that resonate with your team members, avoiding overly technical jargon.

What are the main uses of a chart of accounts in financial statements?

Your chart of accounts provides insights into cash inflows and the sources of your business funds. It lays the groundwork for the balance sheet and income statement by organizing financial transactions into relevant categories. 

Role of COA in generating income statements

The COA serves as the backbone for generating income statements. It provides a structured framework to organize and analyze financial data related to a company's revenue and expenses. 

When viewed alongside other financial statements like the cash flow statement, your chart of accounts provides insights into cash inflows and the sources of your business funds. You can monitor sales activity or marketing efforts by examining income statement accounts. 

How does a COA help in balance sheet forecasting?

A COA categorizes financial transactions into assets, liabilities, and equity accounts—the main components of a balance sheet. With broader categories at the top level followed by more detailed accounts, the hierarchical structure makes it easier to locate and reconcile individual accounts. A well-structured COA provides the foundation for generating balance sheet reports that accurately reflect the company's financial position at a given time. For instance, reviewing balance sheet accounts offers insight into the assets readily available for liquidation in case of urgent cash needs. 

A COA also helps companies in balance sheet forecasting, which enables them to make more informed business decisions regarding new investments, expansions, and resource allocations. When creating a forecast, the chart of accounts helps you tease out what the key drivers are that could affect your forecast.

To do this, it's important to check the account names and numbers (dollar values) when looking at the chart of accounts. Some accounts may seem big but only make up a tiny part of spending. Others might seem small but account for a big chunk of the expenses.

For example, an account that's just 1% of total spending might not need much attention, but it's worth focusing on if it's 10%. To manage this, you can group small items and estimate their spending, making it easier to plan your budget. This way, you can ensure you're focusing on the expenses with the biggest impact on your business.

Best practices for building and maintaining your chart of accounts over time

By adhering to these best practices, you can maintain efficiency in accounting processes and avoid the challenges of managing multiple COAs.

Revisit your COA annually

Review your COA frequently, updating it as your business grows and evolves. Ideally, your COA shouldn't dramatically change year over year. (You want to make comparing different accounts' performance easy over time.) However, it should adapt and evolve just like your business does! Add sub-accounts that work and deactivate accounts that don’t add value anymore. 

Keep your COA as simple as possible

Your COA is meant to be a quick lookup table. While it is tempting to go as detailed as possible, you don't need to create a separate account for every transaction, utility, or sale. The simpler, the better.

Have as few COAs as possible

Keeping a single COA per entity streamlines consolidation efforts and reduces complexity, especially when managing multiple subsidiaries. Also, aligning the COA with your business structure and objectives, whether it involves categorizing income by product or subsidiary. Building with expansion in mind ensures flexibility for future growth and facilitates financial planning and analysis (FP&A). 

Pro Tip: Avoid deleting old accounts from your company's chart of accounts. Doing so can lead to inaccuracies in historical reports. Instead, if you wish to prevent transactions from being posted to an account, consider deactivating the account and renaming it to include the word "INACTIVE" at the end.

Use tagging to balance simplicity and complexity

Tagging your chart of accounts allows you to clearly visualize the expense breakdown by categorizing costs by department or as fixed or variable expenses. This helps you understand your spending better and calculate key financial metrics. 

Using technology to unlock the full potential of your COA

A well-organized COA ensures accurate record-keeping, facilitates financial analysis, and simplifies the preparation of financial statements. It enables finance teams to monitor expenses, revenues, and assets, aiding in strategic decision-making. 

When integrating your accounting system with financial reporting software your COA will help you illustrate your financial transactions in a way that stakeholders can easily understand. 

Further, if you are considering or currently using a full-featured FP&A software like Drivetrain, that's capable of working with your data across multiple dimensions, your COA will help you understand your business at a much deeper level, facilitating data-driven decision-making. Check out Drivetrain to learn how you can use your chart of accounts to its full potential and move your business forward faster!