Chart of Accounts Explained Part 2
This is part 2 of a two-part blog which will give you an in-depth explanation about the working parts of a chart of accounts. Revisiting, from part 1 of this blog, the chart of accounts is simply a list of all of the account types you might use when recording your business income and expenditure activities. The “account types” include assets, liabilities, equity, income, expenses, other income and other expenses. In part 1 we covered off assets, liabilities and equity which are accounts used to formulate the balance sheet report. In part 2 we will look at the remainder of the account types within the chart of accounts.
Account types known as expenses, income, other expenses and other income are the accounts you will find on a profit and loss statement. Let’s look at these accounts in more detail.
An expense in business terms, is any cost to a business as a result of its income-earning activities. The relationship between expenses and income is an important one. For an expense to be included in the chart of accounts, it must first in some way lead to your business earning income. In other words, whatever you purchase must in some way assist you to make your income.
There are 2 business expense categories and these include:
- Cost of sales, known as variable expenses
- All other expenses, known as fixed expenses or overheads
Let’s look at each of these categories separately.
Cost of Sales (Variable Expenses)
An expense is a cost of sale if it directly reduces sales profit. Types of cost of sale accounts are dependent on the nature of the business and as such are different for each industry. In general however, these sorts of expenses can include:
- Merchant bank fees (PayPal, AMEX, bank, Eventbrite, Ebay charges etc)
- Freight/postage (for purchasing or sending inventory to customers)
- Contractor charges (for customer jobs you outsource)
- Discounts or refunds given to customers
- Stock purchases
Overhead or Fixed Expenses
All of the costs incurred while running your business other than variable expenses, are known as overheads or fixed expenses. Each category will probably have sub-categories as shown below. They include things like:
- Administration (Accounting fees, bank fees, donations, bad debts, depreciation etc)
- Employment (Salaries and wages, superannuation, staff amenities, workcover insurance)
- Motor vehicle (Fuel, maintenance, insurance, registration)
- Insurance (liability, professional indemnity, business etc)
- Telephone (Office, mobile, fax)
- Computer (hardware, software, consumables)
- Travel (international and national and usually further separated by type e.g. flights, accommodation, meals, taxi, bus, train, parking fees)
- Marketing (advertising, signage, social media, branded uniforms or stationery)
- Office (stationery, postage, repairs, cleaning)
- Training (webinars, courses etc)
- Utilities (electricity, gas, waste disposal, internet)
- Website (hosting, maintenance, design etc)
To see more examples of expense accounts for different business structures, please see our blog “Chart of Accounts Free Download”.
This account is probably the easiest to understand and the most important to all business owners! Income is the thing that keeps our businesses afloat and hopefully allows us to enjoy professional and personal success via accruing profits. Your business probably has different sources of income specific to your chosen industry. To track your business income properly, you should create income accounts for each of these sources. Doing this will allow you to see how each of your income streams is doing each month via the profit and loss statement. A working example of different income streams or accounts could be those required for a guitar teacher. His income accounts list might look like this:
- Guitar lessons (public)
- Guitar lessons (schools)
- Music book sales
- Guitar accessories sales
- Events or gigs
This account is where you might record funds coming into the business that are not related to the actual sales or income made by your business. These types of funds may or may not be received very regularly. Other income can include things like:
- Interest income from bank accounts
- Foreign exchange gain
- Rental income
- Profit from the sale of business assets
This account is similar to the “other income” account in that it is used to record transactions that aren’t directly related to your business, in particular, expenditure. Other expenses can include (but not limited to) the following:
- Interest charges from bank accounts
- Borrowing charges
- Miscellaneous expenses, not included in the general expenses list
- Foreign exchange loss
- Loss from the sale of business assets
- Suspense (This account is used to record any transaction that you are unsure about and need your accounting professional to sort out for you)
So to recap, there are 7 main accounts in a chart of accounts: assets, liabilities, equity, expenses, income, other income and other expenses. The first 3 are used to create the balance sheet and the rest are found on the profit and loss statement. The types of categories within each account is dependent on your industry and specific business needs. Once you have set up your chart of accounts and have been recording transactions against it for a while, you will be in a position to create your profit and loss and balance sheet reports. Next time we delve deeper into these 2 reports – what they look like, what they mean and how you can use them to understand what is happening in your business. Until next week, happy bookkeeping!