Chart of Accounts: Setting Up Categories That Make Sense

What a Chart of Accounts (COA) Does

A chart of accounts is the organized list of categories your bookkeeping system uses to store transactions. Each transaction is posted to one or more accounts, and those accounts roll up into financial reports. A well-built COA makes it easy to answer questions like: How much cash do we have? Who owes us money? What do we owe? Are we profitable? Where are expenses going?

Think of the COA as a filing cabinet: if the folders are clear and consistent, reporting is clear and consistent. If folders overlap (duplicates) or are vague, reports become confusing and unreliable.

How the COA Connects to Reports

Most small-business reporting centers on two statements:

• Balance Sheet: shows what you have and owe at a point in time (Assets, Liabilities, Equity).
• Income Statement (Profit & Loss): shows performance over a period (Revenue, Expenses).

Your COA should be structured so every account clearly belongs to one of these report sections.

Account Types (and How to Read Them)

Assets

Assets are resources the business controls that have value. Common small-business asset accounts include:

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• Cash: money in bank and on hand.
• Accounts Receivable (A/R): amounts customers owe you for invoices you’ve issued.
• Supplies (optional): supplies on hand that will be used later (some businesses expense supplies immediately instead).

On the Balance Sheet, assets are typically listed in order of liquidity (how quickly they can be turned into cash), with Cash near the top.

Liabilities

Liabilities are obligations—amounts you owe to others. Common liability accounts include:

• Accounts Payable (A/P): bills from vendors you haven’t paid yet.
• Payroll Taxes Payable: payroll-related taxes withheld or owed that haven’t been remitted yet.

Liabilities are usually grouped into current (due soon) and long-term (due later), though many small businesses start with only current liabilities.

Equity

Equity represents the owner’s claim on the business after liabilities are subtracted from assets. Typical equity accounts include:

• Owner’s Capital (or Common Stock for a corporation): owner investment.
• Owner’s Draw (or Distributions): money the owner takes out (often tracked separately from expenses).
• Retained Earnings: accumulated profit kept in the business (often system-managed in accounting software).

Equity accounts live on the Balance Sheet and help separate business performance (Income Statement) from owner activity (Equity section).

Revenue

Revenue accounts track income earned from normal operations. Examples:

• Sales Revenue: sales of goods or services.
• Service Revenue (optional alternative): if you want to separate service income from product sales.

Revenue accounts appear on the Income Statement.

Expenses

Expenses are costs incurred to run the business. Common examples:

• Supplies Expense: supplies used during the period.
• Rent Expense: facility or office rent.
• Wages Expense: gross wages paid to employees.

Expenses appear on the Income Statement and are typically grouped in a way that helps you manage spending (for example, payroll-related expenses together).

Typical Subaccounts for Small Businesses (and Why They Matter)

Subaccounts are “child” categories under a broader “parent” account. They help you see detail without cluttering the top level of reports.

Naming and Grouping: How Your Choices Change Reporting

Use names that match how you manage the business

Account names should be specific enough to be meaningful but not so detailed that you create dozens of tiny categories. For example:

• Good: Rent Expense, Supplies Expense, Wages Expense
• Too vague: Miscellaneous (use sparingly, and review regularly)
• Too detailed too early: Paper Clips Expense, Printer Ink Expense (usually better grouped under Supplies)

Group similar items so reports tell a story

Grouping affects how easy it is to interpret the Income Statement. A common approach is to group by function:

• Revenue (sales/service lines)
• Cost of Goods Sold (if you sell products)
• Operating Expenses (rent, supplies, utilities, marketing)
• Payroll-related (wages, payroll taxes, benefits)

Even if your software doesn’t show “groups” explicitly, the way you name and order accounts (or use parent/subaccounts) influences how cleanly reports read.

Avoid duplicates: they split your data

Duplicate or overlapping accounts make totals misleading because similar transactions end up in different places. Common duplication problems include:

• Rent and Office Rent used interchangeably
• Payroll Tax Expense and Employer Payroll Taxes both used for the same costs
• Supplies (asset) and Supplies Expense (expense) used without a clear rule

Set a rule for each area. Example: “All consumable supplies are posted to Supplies Expense when purchased,” or “Supplies are recorded as an asset and expensed as used.” Pick one approach and apply it consistently.

Practical Setup Exercise: Build a COA for a Small Service Business

Scenario: You run a small service business (e.g., a cleaning company, consulting practice, or repair service). You invoice some customers, pay rent for a small office, buy supplies, and have employees.

Step 1: Decide the minimum accounts you need (start simple)

A practical COA starts with the accounts required to track cash, what customers owe, what you owe, core income, and major expense categories.

Start with this minimum set (includes the required accounts):

• Assets
  • Cash
  • Accounts Receivable
• Liabilities
  • Accounts Payable
  • Payroll Taxes Payable
• Equity
  • Owner's Capital
  • Owner's Draw
• Revenue
  • Sales Revenue (or Service Revenue if you prefer that label)
• Expenses
  • Supplies Expense
  • Rent Expense
  • Wages Expense

Step 2: Explain why each account exists (tie it to decisions)

• Cash: needed to track bank balance and cash flow.
• Accounts Receivable: needed if you invoice customers and collect later; supports tracking overdue invoices.
• Accounts Payable: needed if vendors bill you and you pay later; supports tracking unpaid bills.
• Payroll Taxes Payable: needed to separate taxes owed from wage cost; helps ensure timely tax payments.
• Owner's Capital and Owner's Draw: needed to keep owner activity separate from business income/expenses.
• Sales Revenue: needed to measure income earned from providing services.
• Supplies Expense: needed to monitor operating costs that can fluctuate month to month.
• Rent Expense: needed to track a major fixed cost for budgeting.
• Wages Expense: needed to track labor costs, often one of the largest expenses.

Step 3: Add only the next layer of detail if it will change decisions

If you want clearer payroll reporting, you might add subaccounts under expenses:

• Payroll Expenses (parent)
  • Wages Expense (subaccount)
  • Employer Payroll Tax Expense (subaccount)

Keep Payroll Taxes Payable as a liability for amounts owed but not yet paid. This separation makes reports clearer: the Income Statement shows payroll cost; the Balance Sheet shows what’s still owed.

Step 4: Set naming rules to prevent duplicates

Write simple rules and follow them every time you add an account:

• One concept, one name: choose Rent Expense (not also Office Rent).
• Use consistent wording: pick either Sales Revenue or Service Revenue and stick with it.
• Use parent/subaccounts instead of near-duplicates: if you need detail, create subaccounts under a parent like Supplies Expense rather than creating separate top-level accounts that overlap.
• Define when to use A/R and A/P: if you invoice customers, use Accounts Receivable; if you receive vendor bills, use Accounts Payable. Don’t post those items directly to revenue/expense if you want accurate outstanding balances.

Step 5: Quick “posting test” to validate your COA

Run a simple test: for each common transaction, confirm there is an obvious account choice and that the result will appear on the right report.

Optional Variation: Small Retail COA (If You Sell Products)

If your business is retail, you still use the same five account types, but you typically add product-related accounts so the Income Statement can show gross profit.

• Revenue
  • Sales Revenue
• Expenses
  • Cost of Goods Sold (COGS)
  • Supplies Expense, Rent Expense, Wages Expense
• Assets (often)
  • Inventory (if you track inventory on hand)

Only add Inventory and Cost of Goods Sold if you plan to track product costs in a way that supports decision-making and reporting. If you do, define clear rules for what counts as inventory vs supplies to avoid overlap.