General Ledger
The general ledger is the core of your company’s financial records. It acts as the central repository for every financial transaction since the company's inception, providing a permanent history of all activity.
Sub-ledgers and the General Ledger
Your accounting system includes various subsidiary ledgers (sub-ledgers) for tracking items such as cash, accounts receivable, and accounts payable. Every entry you post to these sub-ledgers eventually flows through the general ledger account. For example, when a credit sale recorded in the accounts receivable sub-ledger converts into cash through a customer payment, the transaction is posted to both the general ledger and the respective sub-ledgers (cash and accounts receivable).
Occasionally, transactions will bypass sub-ledgers and be recorded directly in the general ledger. These entries typically involve capital financial transactions with no corresponding operational sub-ledger. Examples include:
- Capital contributions
- Loan proceeds
- Principal repayments on loans
- Proceeds from the sale of assets
Such transactions affect your balance sheet but do not appear on your profit and loss statement.
Setting up the General Ledger
When establishing your general ledger, there are two main considerations:
- Linkage to Financial Reports: The balance sheet and profit and loss statement are generated directly from the general ledger. The sequence of numerical balances is determined by the chart of accounts, but every entry forms part of the overall financial reports. The general ledger accumulates the balances that constitute the line items on these reports, and changes are subsequently reflected in the profit and loss statement.
- Establishment of Opening Balances: Opening balances are not always zero. On the asset side, opening balances include the value of tangible assets (machinery, equipment, inventory) and any cash invested as working capital. On the liability side, you will record any bank or shareholder loans, trade credits, or lease payments that were necessary to start the company. Additionally, stockholder equity increases by the amount invested (as equity rather than debt).
Components of the Accounting System
View your accounting system as a wheel:
- Hub: The general ledger (G/L)
- Spokes: The various sub-ledgers that feed detailed information into the general ledger.
The primary sub-ledgers include:
- Accounts receivable
- Accounts payable
- Order entry
- Inventory control
- Cost accounting
- Payroll
- Fixed assets accounting
Each of these modules functions as a sub-ledger, recording detailed entries within its specific domain. The sub-ledgers summarize these entries and then transmit the summary to the general ledger. For example, the accounts receivable sub-ledger captures all credit sales and cash receipts daily, and the net transactions are posted to the G/L to adjust the accounts receivable, cash, and inventory balances.
The system verifies that the sub-ledger balance equals the corresponding general ledger account balance. Any discrepancy indicates an error that must be resolved.
Differences between Manual and Automated Ledgers
Imagine the general ledger as a sheet of paper recording all transactions across four primary account categories: assets, liabilities, income, and expenses. Some transactions are transferred from sub-ledgers, while others are entered directly via a general journal entry (for example, a loan payment).
Similarly, each sub-ledger functions as its own record. In a computerized accounting system, both the general ledger and sub-ledgers exist as digital files. Entries are posted and summarized automatically—after which the summary is sent to the general ledger.
Basic Terms and Concepts
Understanding a few key concepts can simplify the setup of your accounting system and clarify discussions with your CPA or other technical accounting professionals.
Debits and Credits
Debits and credits are the fundamental elements of any accounting entry. Every entry in the general ledger includes both a debit and a credit, and the total debits must equal total credits to maintain balance. Automated systems typically enforce this rule, preventing any out-of-balance entries.
Changes in account balances are determined by the following:
| Account Type | Debit | Credit |
|---|---|---|
| Assets | Increases | Decreases |
| Liabilities | Decreases | Increases |
| Income | Decreases | Increases |
| Expenses | Increases | Decreases |
Every increase in one account corresponds to an equal and opposite decrease in another, ensuring balance. It is important to remember that debits are recorded on the left side and credits on the right side of an entry.
Sample Entries
- Recording a Credit Sale:
- Debit: Accounts Receivable $1,000
- Credit: Sales Income $1,000
After posting this entry, the general ledger shows a balance of $1,000 for both accounts receivable and sales income.
- Recording the Collection of a Receivable:
- Debit: Cash $1,000
- Credit: Accounts Receivable $1,000
The accounts receivable balance returns to zero after collection. The net effect is equivalent to recording a cash sale directly:
-
- Debit: Cash $1,000
- Credit: Sales Income $1,000
Even if there is a delay between recording the sale and collecting the payment, the overall accounting effect remains consistent.
Understanding how debits and credits affect various account types is critical. Once mastered, the rest of the accounting process becomes a variation on this fundamental concept.
Assets and Liabilities
Balance sheet accounts are categorized as either assets or liabilities. When setting up your chart of accounts, use separate sections and numbering schemes for these categories.
Reminder:
- Assets: Increase with a debit and decrease with a credit.
- Liabilities: Increase with a credit and decrease with a debit.
Identifying assets
Assets include valuable items owned by your company. Examples include the cash in your bank account, company vehicles, machinery, production equipment, inventory, and tangible properties. Additionally, intangible assets such as patents, trademark rights, and goodwill (often arising from an acquisition) are included. The value of intangible assets is generally determined by mutual agreement when the asset is created, or linked to development cost, as in the case of patents, and reflects any premium paid in an acquisition for goodwill.
Identifying liabilities
Liabilities represent your company's obligations to external parties. Examples include accounts payable, bank loans, or any payables owed to vendors. In the case of banks, customer deposits are considered liabilities because they represent future claims against the bank.
Liabilities are typically split into short-term (due within the next 12 months) and long-term (due after 12 months) categories, providing a clearer picture of when obligations are scheduled for payment.
Owners' equity
Owners' equity is calculated as the difference between assets and liabilities. It appears on the balance sheet immediately after the liabilities section and includes components such as:
- Partners' capital accounts
- Stock
- Retained earnings
Reminder:
- Debits decrease owners' equity.
- Credits increase owners' equity.
Many automated accounting systems require you to designate a retained earnings account. Retained earnings represent the accumulated profits from prior years. At the end of an accounting period, income and expense accounts are closed against each other, and the resulting profit or loss is transferred to the retained earnings account. This resets income and expense accounts to zero for the new period while the ending balances of balance sheet accounts become the opening balances of the next period.
Income and Expenses
Income and expense accounts detail where your company’s money comes from and where it goes. These accounts are typically listed immediately after the owners' equity section in the chart of accounts.
Reminder:
- Income Accounts: Increase with credits and decrease with debits.
- Expense Accounts: Increase with debits and decrease with credits.
Income accounts
If your company operates multiple lines of business, consider establishing a separate income account for each revenue stream. This segregation helps in tracking and analyzing where your income originates. Common income accounts might include:
- Sales revenue for Product A
- Sales revenue for Product B
- Income from asset sales
- Consulting income
Maintaining a limited number of income accounts is generally advisable, as an excessive number can complicate reporting without providing additional operational insight.
Expense accounts
Expense accounts are typically set up for the recurring costs your company incurs. Once these accounts are established, they usually remain consistent from month to month. Common expense accounts include:
- Salaries and wages
- Telephone expenses
- Electric utilities
- Repairs and maintenance
- Depreciation
- Amortization
- Interest expenses
- Rent
These accounts help you track your business’s operational efficiency and manage costs effectively.