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Setting up a Chart of Accounts

Apr 08, 2009

The accounts in a chart of accounts are organized in a particular way so that financial statements can be prepared efficiently. The five major types of accounts are as follows:

  • Assets

  • Liabilities

  • Equity and Retained Earnings

  • Income

  • Expense

The assets, liabilities and equity accounts are included in the balance sheet of the financial statements. The income and expense are included on the income statement. At the end of the reporting period, the net income or loss at the bottom of the income statement is added to (net income) or subtracted from (net loss) the retained earnings on the balance sheet. After this amount is added to the equity section of the balance sheet, the assets should equal the sum of the liabilities and the equity. Many software packages will “close” this income or loss into the equity accounts when you process an end of period closing.

Another way that accounts are typically organized is to list short term assets and liabilities before long term assets and liabilities. For example, cash is listed before inventory and inventory is listed before vehicles and equipment. Within liabilities, accounts payable would be listed before a line of credit with the bank and a line of credit with the bank would be listed before a mortgage on a building. By listing assets and liabilities in this organized fashion, it makes it easier for individuals looking at the financial statements to evaluate the state of the business.

If you are using packaged software such as Peachtree or Quicken, the accounts will organize themselves in this way. If you are not using packaged software, having your accounts set up this way will make your financial statements more understandable and professional looking to your banker, a potential partner or investor, and to your tax return preparer or the IRS.

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