How to set up a chart of accounts

business.gov.au defines a chart of accounts as an index: the list of accounts a business sorts its transactions into. Each account stands for one type, which is asset, liability, owner's equity, income or expense.

Every entry in the general ledger is recorded against accounts on that list, and those accounts form the main lines of your financial statements. Choose accounts for the figures you need to see separately, and check what your software can already report from transaction details before adding more accounts.

Section 286 of the Corporations Act 2001 requires a company's written financial records to explain its transactions, and its financial position and performance, correctly, and to be detailed enough that true and fair financial statements could be prepared from them. A consistent chart of accounts supports that work, because each kind of transaction is recorded in the same place every time.

Within the balance sheet types, business.gov.au separates current from longer-term items. It treats an asset as current if it is cash or can be turned into cash within 12 months, and a liability as current if payment is due within 12 months. Grouping your asset and liability accounts the same way makes the balance sheet easier to read.

Which equity accounts you need depends on the business structure, such as sole trader, partnership, company or trust. Ask your accountant which ones fit yours before you create them.

Before you name any accounts, decide what your reports need to tell you. These questions shape most of the list:

• Which kinds of income do you want to see separately, such as product sales and service fees?
• Which costs do you watch most closely, and want on their own line?
• Do you sell goods? In business.gov.au's terms, cost of goods sold is the full direct cost of making the goods or providing the services you sell. Keeping those costs in their own accounts lets the profit and loss statement show gross profit: sales less those direct costs.
• Which bank accounts, cards and loans does the business have?
• If you keep a budget, which lines does it use? Matching your income and expense accounts to those lines lets you compare the two directly.

If your accounting system came with a ready-made list, go through it with the same questions rather than accepting it as it is. Then show the draft to your accountant, who may want particular accounts kept separate for their year-end work.

Where an asset or liability has a statement from outside the business, give it its own account in the chart: one for each bank account, one for each credit card and one for each loan. Petty cash gets its own account too.

Give each account a name that says what goes in it, such as "Advertising and marketing" rather than "Sundry". You can also give each account a code. A simple pattern gives each type its own block of numbers, in the order assets, liabilities, equity, income and expenses, and leaves gaps so a new account can sit next to related ones.

Too few accounts and unlike costs get lumped together. Too many and the same kind of transaction ends up in different places. A few rules help:

• Create accounts for kinds of transaction, not for individual suppliers or customers. Who was paid belongs in the transaction's details; the account says what the money was for.
• Open a new account when it will hold regular transactions or a figure you want to watch. A one-off cost can go in the closest existing account.
• Keep a general account for small costs that fit nowhere else, and look through it now and then. If one kind of cost keeps turning up there, give it an account of its own.
• If you use a holding account for transactions you can't yet identify, clear it every month so it doesn't become permanent.
• Keep personal spending out of business expense accounts. How money moving between the owners and the business is recorded depends on the structure and the arrangement, so ask your accountant which account fits.

• Add accounts as the business changes, such as when you start holding stock or take out a loan.
• Don't delete an account that already has transactions in it. Stop using it instead, so earlier reports still show what happened.
• Where you can, make bigger changes at the start of a financial year, so one year's figures sit in one set of accounts.
• Keep a dated note of each change and the reason for it, so anyone reading older reports can follow what moved where.
• Tell your accountant about changes before the year end.

The ATO's record-keeping rules say you must be able to rebuild your original data after your record-keeping system changes, and must keep information about how that system works.

Once a month of transactions is recorded, run the profit and loss statement and the balance sheet and ask:

• Are the figures where you expected to find them?
• Is the general or holding account bigger than it should be?
• Can each balance sheet account be checked against something outside it, such as a bank statement or a list of unpaid invoices?

Unexpected figures, an oversized holding account or unsupported balances are easier to investigate now than after a year of transactions.