All About the Chart of Accounts

Posted 10/02/2024

When reviewing books for small businesses, some of the most common issues I see are redundancy and messiness within the chart of accounts. Because the chart of accounts is at the heart of bookkeeping, fixing up the chart of accounts is often my first priority when I work with a new company. If you are a small business owner, you need to understand the chart of accounts and how it works.  

What is the Chart of Accounts?:

If you're not familiar with the chart of accounts, think of it as a filing cabinet within your accounting software. When you add an account to the chart of accounts, it is like adding a folder to that filing cabinet. So imagine you label the folder "Automobile" and then put all related documents in that folder. That is essentially what is being done through the process of “categorization” or “classification”, wherein transactions are sorted into the appropriate account.

Redundancies: 

Let’s look at the example above of the folder labeled automobile in a filing cabinet. Imagine that you also put separate folders in that same cabinet titled "Car", "Truck", “Vehicles”, "Tires", "Windshield Wipers”, etc.

Now if you get a speeding ticket, what folder do you put it in? Or imagine that you paid for a punctured tire to be patched. What folder do you put that receipt in?

People can feasibly come up with different answers to this question, especially if related folders are not grouped together and they are not familiar with every folder in the cabinet.

If your chart of accounts has redundancies like in the example above, then you are likely to have expenses spread across multiple folders that ought to be grouped together. Now if you run a report to show all your “Truck” expenses, you’re going to get the wrong picture. Some truck expenses will not be included because they’ve been assigned to other accounts. Or some unrelated expenses will be included in your report causing you to overestimate your truck expenses.

Sub-Accounts:

One possible solution to avoid redundancies is to create sub-accounts. This is pretty straightforward in QuickBooks Online. When creating a new account, click the box that marks it as a sub-account, and then select the account it will be filed under. This is called the “parent account”. 

In the example above, one option would be to create an account that says “Vehicles”. Then sub-accounts could be created for “Maintenance and Repairs”, “Fuel”, “Tolls”, etc. A possible drawback of this approach is that any imbalance in the sub-account will cause the entire account to be out of balance. If you are working with an account that will need reconciliation regularly, you may want to not use a sub-account if possible.  

Account Numbers: 

Another approach involves the use of account numbers. Though the use of account numbers is not mutually exclusive with using sub-accounts, it can achieve a similar effect in some cases. In QuickBooks Online account numbers can be turned on in the settings menu. You can then go to your chart of accounts and add a 4 digit number to be associated with the account going forward.  

By convention, accounts are assigned to numbers in a certain manner. For example, cash accounts are usually assigned a number starting with 1. Often a checking account will be account 1000, a savings account 1010, etc. 

This approach can achieve an effect similar to the use of sub-accounts if you group similar accounts close together. For example, if “Car” is account #2000 and “Truck” is account #2010, you could make “Repairs and Maintenance” #2100, and “Tolls” #2200. 

It is important to note that using account numbers still requires consistency. No matter what the account numbers are, each transaction will only be recorded in one account at a time. The numbers just provide a way for people to find related accounts easily. 

Personally I always recommend my clients use account numbers. Not only does it make it easier to find accounts, it also makes it easier to talk about them. It is easier to say to an accountant that account #5025 has an issue than to say the “Car” account has an issue, because there is enough vagueness in the term “Car” that they may misinterpret what account is being referred to.   

Inactivating Accounts:

What if you have an account in your chart of accounts that is no longer being used? I would advocate for a streamlined chart of accounts, meaning there should be as many as necessary and no more. So if an account is not being used, get rid of it. 

In QuickBooks Online, an account can’t actually be deleted. It can however be inactivated. This will make the account invisible in the chart and on all financial reports. 

However, just because you can’t see them doesn’t mean it is gone. All transactions recorded to an inactivated account are still there, they just won’t show up on reports going forward. This is handy because if it turns out you needed that account, you can reactivate it at any time. 

Merging Accounts: 

If you do end up with redundancies, you can combine them and all transactions associated with them by merging accounts. In QuickBooks Online this is very simple, but there is one important thing to keep in mind: this process CAN’T BE UNDONE. Once the accounts are merged, there is no way to un-merge them or identify what transaction came from which account. The only way to undo this is to restore the entire company file to a back-up version from before the merge. 

Summary:

Managing the chart of accounts is a critical and ongoing process for any business. The main point to remember is that the chart of accounts should serve your individual  purposes. There is no 1 correct way to do things, because the needs of each business are different, and the chart of accounts ought to reflect this. 

If you need help with your chart of accounts, or any other bookkeeping issues, contact me by clicking here!