Episode 34 – Part 1 – The Chart of Accounts
One of the most popular episodes in the podcast that started in May of 2022 is episode 7 – The Chart of Accounts. So, after two years, and graduating from a podcast novice to a sophomore podcaster, this episode is ready for a re-deux. I will go into more detail about the balance sheet accounts and the income statement (or Profit and Loss). Welcome to the first episode of year 3 of this podcast –
I’m ‘still recovering from tax season’ -- Paul Rosenblum
The COA (Chart of Accounts) is how one tells the financial story of their business. It’s so important to have a story that people, investors, banks, etc. can follow and understand about how your business is operating financially. I can’t fit everything in this two-part episode, so subscribe to the newsletter for more information about the Chart of Accounts, among other accounting tips and tricks. Sign up @ PaulRosenblum.substack.com
The chart of accounts is typically made up of 5 categories, sometimes 6, depending on the kind of business that you have. These are:
ASSETS
LIABILITIES
EQUITY
INCOME
EXPENSES
The sixth category would be cost of goods. (if needed) This is a typical category if you are selling goods or products or in the restaurant/hospitality field. It can also be used for subcontracted labor or outside services.
However, today, we are focusing in on only the balance sheet accounts, which are:
ASSETS
LIABILITIES and
EQUITY
The assets have specific categories. The main ones are:
Current Assets
Fixed Assets
‘Other’ Assets
Accounts Receivable
Shareholder Loans (For corp. and sometimes partnerships)
Current Assets are made up of bank accounts, petty cash, cash in a cash register at the start of the day, and any cash in a safe waiting to be deposited into the bank. Most accounting or bookkeeping software have these categories split up into bank accounts, and the rest of the current assets, named appropriately such as petty cash, cash on hand, or even misc. cash, if needed. If you have a POS system for your retail store or restaurant or bar or food truck business, then you’d need a ‘Cash on hand’ account that would be adjusted every month to match the POS (point of sale) system for sales purposes. The ‘Cash on hand’ account is an account used for cash and credit card sales deposited into the bank, so that the bank account can be reconciled. At the end of the month, the bookkeeper will adjust the value from the cash on hand account to the revenue or sales accounts to match the POS system.
Fixed Assets are made up of large equipment, office equipment, furniture, computers, cell phones, and Leasehold improvements to a building that you either own or rent, if your company is paying for those improvement(s). (such as plumbing, store front improvements, electrical, or drywalls to separate rooms)
Other Assets are made up of Security deposits that you pay out -- security for your office rent, or security for utilities, for two examples. Any money that you pay out that you will eventually get back is considered other assets. Another kind of Other Assets would be a Shareholder Loan for corporations and sometimes partnerships. They also include loans that your company makes to other people, companies, or even employees. If you make a very short-term loan to a person, company or employee, you could put them under current assets.
However, there are exceptions in some of these categories. Let’s say you own a restaurant or a bar, and you purchase a 2-year liquor license. How would that be booked into your accounting system? I’d book the payment for the 2-year license as an Asset. I’d enter it as a Fixed Asset because the definition of a fixed asset is any asset that you purchase that has a life expectancy of more than 1 year. On the day of the purchase, if entered as a fixed asset, the bookkeeper or the tax preparer can make an entry diminishing that fixed asset by half and increasing the expenses by the same amount. So, what will be left going into the next year is only the value of the second year of the asset which won’t be used up until the end of the next year. If the liquor license was purchased in March of 2024, then at the end of the year, 9 months of that year would be subtracted from the asset and moved into the expenses via an adjusting entry that the tax preparer or bookkeeper can do through an expense account called Amortization Expenses.
If you enter something that is a Fixed Asset but enter it as a Current Asset or Other Asset, it won’t affect the numbers on the balance sheet. Many tax preparers won’t even notice – as long as they are an asset that shows up on Balance Sheet reports. But in computerized software, the category can be changed at any time if needed.
Accounts Receivable-- an asset because it’s connected to customer invoices that you create in your bookkeeping system. When you create a customer invoice, the amount of the invoice minus the sales tax is automatically posted to Accounts Receivable by the software. Sales tax goes elsewhere, which we will talk about in a few minutes. Once you collect the unpaid accounts receivable invoice, the accounts receivable account goes down, and either the bank account cash asset increases or the petty cash or the cash on hand increases depending on how you collect money and if it goes into the bank or not.
Liabilities are made up of two kinds of accounts. Current, and Long-Term Liabilities.
Current Liabilities: This account is made up of money owed by your company in the form of
Loans (due within a year)
Credit Cards
Credit Lines
Accounts Payable
Vehicle or Machine Financing (not leasing)
Sales Tax Payable
Payroll Taxes
Liabilities for your business do NOT include taxes that you pay as an individual (sole props and partnerships and corporations are pass through companies – that is the profit of the company flows through to your personal taxes. You can pay your taxes with company money, but we’ll talk about that a little later on where to book those payments. Actual company taxes are not considered liabilities of your company except for payroll taxes that are paid quarterly.
Most corporations and partnerships have to report the balance sheet to the IRS in the tax forms, so it’s important that the balance sheet is correct.
Equity:
Equity accounts represent basically three things.
- The amount of money invested in the company by the owner or partners or outside investors. In a partnership or a corporation, this is tracked and reported to the IRS in taxes.
- The distributions taken out by the owner or partners back to themselves. This is a separate equity account, so one can see the total money invested and the total money taken out by an owner or/and an outside investor. In a sole proprietorship, the word ‘Draw’ is used, in a partnership or a corporation, the word ‘Distribution’ is used. (listen to episode 28 on partnerships where I go deeper into that issue) Included in a draw or a distribution is when the company pays for an expense such as dry cleaning which isn’t tax deductible for the company most or close to all of the time.
- Retained earnings -- That is -- a cumulative value of the overall profit or loss that the company has made in its entire history. For example, if the first year a company is in business, there is a loss of $50K, and the second year, there is a profit of $50K, then the retained earnings equity account will be at zero. This account should not be touched by bookkeepers since it’s an automatic cumulative account controlled by the software used and by the data entered.
The balance sheet is a cumulative value based on the historical transactions that a company has had from the very beginning of its creation, unlike the Profit and Loss which we will discuss in the next episode. You can, however, run detailed balance sheet for a particular time period as you wish.
There are always adjustments made on the balance sheet at the end of the year, usually by the tax preparer. As I have mentioned in other episodes throughout this series, distributions taken out by the owner of the business, could be booked as a shareholder’s loan which would not be taxable on the K-1 tax form. Some business owners do a December payroll for themselves that is 100% payroll tax. The owner doesn’t see a check, the entire payroll done for the owner is 100% payroll taxable, and the taxes withheld are entered on the balance sheet, the company’s share of the taxes are on the profit and loss. This way, the owner can get a refund on their payroll, and lower the profit of the company at the same time.
We’ve talked about this in other episodes, but worth saying again here. The books put together by the bookkeeper are not going to be what’s on your tax return, because of all the adjustments that will be made by the tax preparer.
And you thought bookkeeping was easy? This is why I sometimes rant about Intuit, the makers of QuickBooks online. Their marketing strategy is to tell people how easy this is when it’s not. But I will not digress anymore.
And where do trademarks and logos get booked into the chart of accounts? They are also balance sheet accounts counted as ASSETS. They get amortized, rather than depreciated because they aren’t a product that you can touch like a piece of furniture -- they are ideas, or writings or another one – website design – not just changing a picture or some text on the website, but actually designing the website. They would be fixed assets because the life expectancy of a website is more than one year.
Another exception – how about if a customer pays you for 1 year for services in advance that you haven’t performed yet? In accounting, we would call that a current liability, because if the services were never performed by you or your company, then you’d have to refund that money back to the customer. However, most computerized software allows you to enter negative accounts receivable. That is – the payment coming in from the customer will be booked to accounts receivable without a customer invoice being created. In that case, it would show a negative amount on the customers ledger. In accounting, there IS no negative accounts receivable (it’s counted as either income or a liability in this case at the end of the year)
So, lots of exceptions to the rules – it’s not just money in/money out. It’s a giant jigsaw puzzle with thousands of pieces to put together. This is why it takes a team to really do bookkeeping and taxes completely and accurately.
The Chart of accounts is the backbone of your accounting for the company. This is how you paint a picture of how your company is doing. The names of the accounts and what section those accounts are in are very important in creating accurate books.
In most software for accounting and bookkeeping, you can even create a second or a third accounts receivable account to track specific receivables, either by creating a subaccount of Accounts Receivable, or a regular current liability just called Accounts Receivable, although the function of that account in the software will act differently.
Any specific questions about this? Please drop me a line @ Bookkeepermensch@gmail.
It’s Friday and I’m happy to say since its after-tax season, I’m taking the weekend off!
Next up -- the other half of the Chart of Accounts -- the Profit and Loss (or income statement) accounts. In your ear next time --
I’m Paul Rosenblum