A chart of accounts is the master index of every ledger account a business uses to record its financial activity. Each account gets a unique number and captures one kind of transaction, and the accounts are grouped into five categories: assets, liabilities, equity, revenue, and expenses. Together they feed the balance sheet, the income statement, and the tax return, so a well-built chart is the difference between financial statements you can trust and numbers that mislead the people relying on them. Filing inaccurate returns can trigger IRS penalties and interest, which is why the accounts feeding those returns need to be right from the start.1Internal Revenue Service. Who Needs to File a Tax Return
How the Numbering Works
The standard convention assigns number ranges to each of the five categories:
- 1000–1999: Assets (what the business owns)
- 2000–2999: Liabilities (what the business owes)
- 3000–3999: Equity (the owners’ stake)
- 4000–4999: Revenue (money earned)
- 5000 and above: Expenses (costs of doing business)
Within each range, businesses add more specific numbers. A company might assign 1010 to its main checking account, 1020 to a savings account, and 1100 to accounts receivable. Larger organizations often build in department or location codes as sub-accounts, letting them track marketing expenses separately from warehouse expenses under the same parent account. The numbering itself is flexible. What matters is that it stays consistent so everyone entering data codes transactions the same way.
Asset Accounts
Assets are resources the business owns or controls that are expected to produce future value. They split into two groups based on timing: current assets that will convert to cash or get used up within a year, and non-current assets that stick around longer.
Current Assets
The most liquid account is Cash, covering physical currency, bank balances, and short-term cash equivalents like money market funds. Most businesses check this one first, because running out of cash can sink an otherwise profitable company.
Accounts Receivable tracks money customers owe you for goods or services already delivered on credit. Because not every customer pays, businesses typically pair this account with an Allowance for Doubtful Accounts, a contra-asset that reduces the reported receivable balance by the estimated amount that will never be collected. When a specific invoice is finally written off, it gets charged against that allowance rather than hitting the current period’s expenses all at once.
Inventory accounts hold the cost of goods waiting to be sold, from raw materials through finished products. How you value inventory affects both your balance sheet and your tax bill. The method chosen, whether First-In First-Out, Last-In First-Out, or another approach, must conform to accepted accounting practice for your industry and be applied consistently.2Internal Revenue Service. LB&I Concept Unit – Lower of Cost or Market Switching methods mid-stream creates comparison problems and may require IRS approval.
Prepaid Expenses capture payments made now for something you will use later, such as an insurance premium covering the next twelve months or rent paid in advance. The prepaid balance shrinks each month as the benefit is consumed and the cost shifts to an expense account.
Non-Current Assets
Non-current assets have useful lives stretching beyond one year. The most common group is Property, Plant, and Equipment, which includes land, buildings, machinery, vehicles, and similar physical assets used in operations. Rather than deducting the full purchase price in the year you buy them, you capitalize the cost and spread it over the asset’s useful life through depreciation.
For federal tax purposes, depreciation follows the Modified Accelerated Cost Recovery System, which assigns each type of asset a recovery period and depreciation method.3Internal Revenue Service. Publication 946 – How To Depreciate Property Businesses claiming depreciation on newly placed property, a Section 179 deduction, or depreciation on vehicles and other listed property report the details on Form 4562.4Internal Revenue Service. Instructions for Form 4562
Accumulated Depreciation is the contra-asset that tracks total depreciation recognized since each asset was placed in service. It pairs with the corresponding PP&E account so the balance sheet reflects net book value — original cost minus accumulated depreciation. If you bought a delivery van for $40,000 and have taken $15,000 in depreciation, the net book value is $25,000.
Other non-current assets include intangible items like patents, trademarks, and goodwill. These are written off through amortization rather than depreciation, typically over a 15-year period for assets that qualify under federal tax rules.5Office of the Law Revision Counsel. 26 U.S. Code 197 – Amortization of Goodwill and Certain Other Intangibles
Liability Accounts
Liabilities represent money the business owes to outside parties. Like assets, they divide into current obligations due within a year and non-current obligations that extend further out.
Current Liabilities
Accounts Payable is the mirror image of accounts receivable. It tracks what you owe suppliers for inventory, materials, or services purchased on credit. Wages Payable records compensation earned by employees but not yet paid, capturing the gap between the end of a pay period and the actual payday.
Unearned Revenue is a liability that often surprises new business owners. When a customer pays you in advance for work you have not yet performed, that cash is not revenue. It is an obligation to deliver. The balance sits in Unearned Revenue until you fulfill your end of the deal, at which point it moves to a revenue account.
Payroll tax accounts deserve their own attention because getting them wrong leads to steep penalties. Employers must track and deposit Social Security tax, Medicare tax, federal unemployment tax, and federal income tax withheld from employee paychecks. Each of these creates a liability account on your books from the moment wages are earned until the deposits are made.6Internal Revenue Service. Depositing and Reporting Employment Taxes Most states impose additional payroll obligations, so businesses operating in multiple states often maintain separate payroll tax liability accounts for each jurisdiction.
Businesses that collect sales tax face a similar situation: the collected tax is not income. It belongs to the taxing authority. A Sales Tax Payable account holds those funds until they are remitted.
Non-Current Liabilities
Long-term debts like bank loans, equipment financing, and mortgages fall under non-current liabilities. Notes Payable and Mortgages Payable are the most common accounts here. These instruments often come with covenants — contractual restrictions on things like additional debt, financial ratios, or dividends — and violating a covenant can trigger a default even if you have not missed a payment.
Equity Accounts
Equity is what remains after you subtract all liabilities from all assets. The specific accounts depend on how the business is legally organized.
Sole proprietorships and partnerships use two primary equity accounts. Owner’s Capital tracks the owner’s investments into the business plus accumulated profits or losses. Owner’s Draws (sometimes called Distributions for partnerships) records money or property the owner pulls out for personal use. Draws reduce equity but are not expenses, a distinction that matters at tax time because draws are not deductible.
Corporations use a more layered structure. Common Stock represents the par value of issued shares, and Additional Paid-In Capital captures the amount investors paid above par value. Retained Earnings holds the cumulative net income the company has kept rather than distributing as dividends. When a corporation declares dividends, the payout reduces Retained Earnings. Together, these accounts tell shareholders how the company has been funded and how much profit has been reinvested.
Revenue Accounts
Revenue accounts measure the money a business earns from its core activities during a specific period. Sales Revenue records income from selling goods, while Service Revenue tracks fees earned by providing services.
Non-operating revenue accounts track income from side activities: interest earned on a bank account, gains from selling old equipment, or rental income from subleasing extra office space. Keeping operating and non-operating revenue in separate accounts makes it easier to evaluate whether the core business is healthy, independent of one-time windfalls.
The timing of when revenue hits the books matters. Under generally accepted accounting principles, revenue is recognized when the obligation to the customer is satisfied, meaning the goods have been delivered or the service performed, not simply when cash changes hands. A landscaping company that receives a $6,000 payment in March for six months of service recognizes $1,000 of revenue each month as the work is done, with the remainder sitting in Unearned Revenue.
Expense Accounts
Expense accounts capture every cost incurred while running the business during the period. For companies selling physical products, Cost of Goods Sold is usually the largest line item. COGS represents the direct cost of the inventory actually sold: the materials, labor, and overhead that went into producing what left the warehouse. This figure is directly tied to the inventory valuation method, so a change in method ripples through both accounts.
Other common expense accounts include:
- Salaries and Wages, covering gross compensation paid to employees, with the employer’s share of payroll taxes typically getting its own account.
- Rent, for leasing office space, retail locations, or equipment.
- Utilities, including electricity, water, gas, internet, and phone service.
- Depreciation Expense, the periodic charge that transfers a portion of an asset’s capitalized cost to the income statement.
- Insurance, for liability, property, workers’ compensation, and similar policies.
- Professional Fees, paid to accountants, attorneys, and consultants.
Most ordinary and necessary business expenses, including salaries, rent, and travel, are tax-deductible provided they are directly connected to carrying on the business.7Office of the Law Revision Counsel. 26 U.S. Code 162 – Trade or Business Expenses The key phrase is “ordinary and necessary”: the expense must be common in your industry and helpful to your business, even if not strictly indispensable.
The net effect of all revenue minus all expenses produces the period’s net income or net loss. That figure is the bridge between the income statement and the balance sheet. A profit increases Retained Earnings (or Owner’s Capital), and a loss decreases it.
How Temporary Accounts Reset Each Period
Revenue and expense accounts are called temporary accounts because their balances do not carry forward from one accounting period to the next. At the end of each period, whether monthly, quarterly, or annually, businesses run closing entries to zero out every revenue and expense account and transfer the net result to a permanent equity account.
The process follows a straightforward sequence. All revenue account balances are transferred into a summary account. All expense account balances move to the same summary. The difference — net income or net loss — then transfers to Retained Earnings for a corporation, or to Owner’s Capital for a sole proprietorship or partnership. Any draws or dividend accounts are closed to equity as well. After closing, every temporary account starts the new period with a zero balance.
Permanent accounts — assets, liabilities, and equity — are never closed. Their balances roll forward continuously, which is why the balance sheet is sometimes called a snapshot: it shows cumulative position at a single point in time, while the income statement measures activity over a span.
Records That Back Up Your Accounts
Setting up the right accounts is only half the job. You also need to hold on to the records that back them up. The IRS requires you to keep documentation supporting any item of income, deduction, or credit until the statute of limitations on that return expires.8Internal Revenue Service. How Long Should I Keep Records? The default retention period is three years from the filing date, extending to six years if you omitted more than 25 percent of your gross income, seven years for a worthless securities or bad debt deduction, and indefinitely if you did not file or filed a fraudulent return.
Employment tax records carry their own rule: keep them for at least four years after the tax is due or paid, whichever is later.8Internal Revenue Service. How Long Should I Keep Records? Under the Fair Labor Standards Act, payroll records require a three-year minimum, and supporting records like time cards, wage rate tables, and work schedules must be kept for at least two years.9U.S. Department of Labor. Fact Sheet 21 – Recordkeeping Requirements Under the Fair Labor Standards Act Records tied to property need to be kept until the statute of limitations expires for the year you dispose of the asset, which can push retention decades past the original purchase.