The general ledger is the core of your company’s financial
records. These constitute the central “books” of your system, and every
transaction flows through the general ledger. These records remain as a
permanent track of the history of all financial transactions since day one of
the life of your company.
Sub-ledgers and the GENERAL Ledger
Your accounting system will have a number of subsidiary ledgers
(called sub-ledgers) for items such as cash, accounts receivable, and accounts
payable. All the entries that are entered (called posted) to these sub-ledgers
will transact through the general ledger account. For example, when a credit
sale posted in the account receivable sub-ledger turns into cash due to a
payment, the transaction will be posted to the general ledger and the two (cash
and accounts receivable) sub-ledgers as well.
There are times when items will go directly to the general ledger
without any sub-ledger posting. These are primarily capital financial
transactions that have no operational sub-ledgers. These may include items such
as capital contributions, loan proceeds, loan repayments (principal), and
proceeds from sale of assets. These items will be linked to your balance sheet
but not to your profit and loss statement.
Setting up the General Ledger
There are two main issues to understand when setting up the
general ledger. One is their linkage to your financial reports, and the other
is the establishment of opening balances.
The two primary financial documents of any company are their
balance sheet and the profit and loss statement, and both of these are drawn
directly from the company’s general ledger. The order of how the numerical
balances appear is determined by the chart of accounts, but all entries that
are entered will appear. The general ledger accrues the balances that make up
the line items on these reports, and the changes are reflected in the profit
and loss statement as well.
The opening balances that are established on your general ledgers
may not always be zero as you might assume. On the asset side, you will have
all tangible assets (the value of all machinery, equipment, and inventory) that
is available as well as any cash that has been invested as working capital. On
the liability side, you will have any bank (or stockholder) loans that were
used, as well as trade credit or lease payments that you may have secured in
order to start the company. You will also increase your stockholder equity in
the amount you have invested, but not loaned to, the business.
Components of the Accounting System
Think of the accounting system as a wheel whose hub is the general
ledger (G/L). Feeding the hub information are the spokes of the wheel. These
include
1. Accounts receivable
2. Accounts payable
3. Order entry
4. Inventory control
5. Cost accounting
6. Payroll
7. Fixed assets accounting
These modules are ledgers themselves. We call them sub-ledgers.
Each contains the detailed entries of its specific field, such as accounts
receivable. The sub-ledgers summarize the entries, then sends the summary up to
the general ledger. For example, each day the receivables sub-ledger records
all credit sales and payments received. The transactions net together then go
up to the G/L to increase or decrease A/R, increase cash and decrease
inventory.
We'll always check to be sure that the balance of the sub-ledger
exactly equals the account balance for that sub-ledger account in the G/L. If
it doesn't, then there's a problem.
Differences between Manual and Automated Ledgers
Think of the G/L as a sheet of paper on which transactions from
all four categories of accounts-assets, liabilities, income, and expenses-are
recorded. Some of them flow up from various sub-ledgers, and some are entered
directly into the G/L through a general journal entry. An example of such a
direct entry would be the payment on a loan.
The same concept of a sheet of paper holds for each sub-ledger
that feeds the general ledger. A computerized accounting system works the same
way, except that the general ledger and sub-ledgers are computer files instead
of sheets of paper. Entries are posted to each and summarized, then the summary
is sent up to the G/L for posting.
Basic Terms and Concepts
There are a few (and only a few) things you need to understand in
order to make setting up your accounting system easier. They're basic (trust
me), and they will probably clear up any confusion you may have had in the past
when talking with your CPA or other technical accounting types.
Debits and Credits
These are the backbone of any accounting system. Understand how
debits and credits work and you'll understand the whole system. Every
accounting entry in the general ledger contains both a debit and a credit.
Further, all debits must equal all credits. If they don't, the entry is out of
balance. That's not good. Out-of-balance entries throw your balance sheet out
of balance.
Therefore, the accounting system must have a mechanism to ensure
that all entries balance. Indeed, most automated accounting systems won't let
you enter an out-of-balance entry-they'll just beep at you until you fix your
error.
Depending on what type of account you are dealing with, a debit or
credit will either increase or decrease the account balance. (Here comes the
hardest part of accounting for most beginners, so pay attention.) Figure 1
illustrates the entries that increase or decrease each type of account.
Debits and Credits vs. Account Types
Account Type Debit
Credit
Assets
Increases
Decreases
Liabilities
Decreases
Increases
Income
Decreases
Increases
Expenses Increases
Decreases
Notice that for every increase in one account, there is an
opposite (and equal) decrease in another. That's what keeps the entry in
balance. Also notice that debits always go on the left and credits on the
right.
Let's take a look at two sample entries and try out these debits
and credits:
In the first stage of the example we'll record a credit sale:
Accounts Receivable
$1,000
Sales Income
$1,000
If you looked at the general ledger right now, you would see that
receivables had a balance of $1,000 and income also had a balance of $1,000.
Now we'll record the collection of the receivable:
Cash
$1,000
Accounts Receivable
$1,000
Notice how both parts of each entry balance? See how in the end,
the receivables balance is back to zero? That's as it should be once the
balance is paid. The net result is the same as if we conducted the whole
transaction in cash:
Cash
$1,000
Sales Income
$1,000
Of course, there would probably be a period of time between the
recording of the receivable and its collection.
That's it. Accounting doesn't really get much harder. Everything
else is just a variation on the same theme. Make sure you understand debits and
credits and how they increase and decrease each type of account.
Assets and Liabilities
Balance sheet accounts are the assets and liabilities. When we set
up your chart of accounts, there will be separate sections and numbering
schemes for the assets and liabilities that make up the balance sheet.
A quick reminder: Increase assets with
a debit and decrease them with a credit. Increase liabilities with a credit and
decrease them with a debit.
Identifying assets
Simply stated, assets are those things of value that your company
owns. The cash in your bank account is an asset. So is the company car you
drive. Assets are the objects, rights and claims owned by and having value for
the firm.
Since your company has a right to the future collection of money,
accounts receivable are an asset-probably a major asset, at that. The machinery
on your production floor is also an asset. If your firm owns real estate or
other tangible property, those are considered assets as well. If you were a
bank, the loans you make would be considered assets since they represent a
right of future collection.
There may also be intangible assets owned by your company.
Patents, the exclusive right to use a trademark, and goodwill from the
acquisition of another company are such intangible assets. Their value can be
somewhat hazy.
Generally, the value of intangible assets is whatever both parties
agree to when the assets are created. In the case of a patent, the value is
often linked to its development costs. Goodwill is often the difference between
the purchase price of a company and the value of the assets acquired (net of
accumulated depreciation).
Identifying liabilities
Think of liabilities as the opposite of assets. These are the
obligations of one company to another. Accounts payable are liabilities, since
they represent your company's future duty to pay a vendor. So is the loan you
took from your bank. If you were a bank, your customer's deposits would be a
liability, since they represent future claims against the bank.
We segregate liabilities into short-term and long-term categories
on the balance sheet. This division is nothing more than separating those
liabilities scheduled for payment within the next accounting period (usually
the next twelve months) from those not to be paid until later. We often
separate debt like this. It gives readers a clearer picture of how much the
company owes and when.
Owners' equity
After the liability section in both the chart of accounts and the
balance sheet comes owners' equity. This is the difference between assets and
liabilities. Hopefully, its positive-assets exceed liabilities and we have a
positive owners' equity. In this section we'll put in things like
1. Partners' capital accounts
2. Stock
3. Retained earnings
Another quick reminder: Owners' equity is
increased and decreased just like a liability:
1. Debits decrease
2. Credits increase
Most automated accounting systems require identification of the
retained earnings account. Many of them will beep at you if you don't do so.
By the way, retained earnings are the accumulated profits from
prior years. At the end of one accounting year, all the income and expense
accounts are netted against one another, and a single number (profit or loss
for the year) is moved into the retained earnings account. This is what belongs
to the company's owners-that's why it's in the owners' equity section. The
income and expense accounts go to zero. That's how we're able to begin the new
year with a clean slate against which to track income and expense.
The balance sheet, on the other hand, does not get zeroed out at
year-end. The balance in each asset, liability, and owners' equity accounts
rolls into the next year. So the ending balance of one year becomes the
beginning balance of the next.
Think of the balance sheet as today's snapshot of the assets and
liabilities the company has acquired since the first day of business. The
income statement, in contrast, is a summation of the income and expenses from
the first day of this accounting period (probably from the beginning of this
fiscal year).
Income and Expenses
Further down in the chart of accounts (usually after the owners'
equity section) come the income and expense accounts. Most companies want to
keep track of just where they get income and where it goes, and these accounts
tell you.
A final reminder: For income accounts, use credits to increase
them and debits to decrease them. For expense accounts, use debits to increase
them and credits to decrease them.
Income accounts
If you have several lines of business, you'll probably want to
establish an income account for each. In that way, you can identify exactly
where your income is coming from. Adding them together yields total revenue.
- Typical
income accounts would be
- Sales
revenue from product A
- Sales
revenue from product B (and so on for each product you want to track)
- Income
from sale of assets
- Consulting
income
Most companies have only a few income accounts. That's really the
way you want it. Too many accounts are a burden for the accounting department
and probably don't tell management what it wants to know. Nevertheless, if
there's a source of income you want to track, create an account for it in the
chart of accounts and use it.
Expense accounts
Most companies have a separate account for each type of expense
they incur. Your company probably incurs pretty much the same expenses month
after month, so once they are established, the expense accounts won't vary much
from month to month. Typical expense accounts include
- Salaries
and wages
- Telephone
- Electric
utilities
- Repairs
- Maintenance
- Depreciation
- Amortization
- Interest
- Rent
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