“Keeping the books.” It’s a common phrase that refers to maintaining the general ledger. But what exactly is a ledger, and why do you need one?
Traditionally, accountants recorded financial transactions in the ledger by hand, using the double-entry accounting method.
With the advent of computers, recording transactions became simpler. No longer did you have to record in books; you could use excel sheets and sophisticated accounting software.
While the way you record transactions has changed, the importance of the ledger remains. It’s an essential accounting record for creating financial reports which are crucial for evaluating business health.
We’ll explore what a general ledger is, how it works, and why you need one.
An Overview of the General Ledger And How it Works
The general ledger is a master accounting document providing a complete record of all the financial transactions of your business. It helps you look at the bigger picture. Accounts include assets (fixed and current), liabilities, revenues, expenses, gains and losses.
Before we continue, let’s look at a few key concepts that will help you better understand the ledger and how it works. These are double-entry accounting, the basic accounting equation, and journals. It may seem overwhelming, but really, it isn’t.
If I – someone who switches off at the mere mention of accounting terminology, can understand it, you can too! I’ve broken it down step-by-step.
1. Double-Entry Accounting
There are two primary types of accounting methods. The single-account method works just fine if you’re a solopreneur. But, the double-entry accounting method makes it easier to prepare financial statements and improves accountability. So, switching to the double-entry accounting method may be wise.
Regardless of what you decide works for you and your small business, general ledgers use the double entry accounting method: An entry to one account requires an opposite entry to another account. Rephrased: every debit on one account has a credit on another.
A debit is an accounting entry that increases an asset or expense account and decreases a liabilities or owner’s equity account. A “credit” is the inverse.
Because credits and debits lead to the formation of an account that resembles the letter “T,” ledger accounts are also known as T accounts. You find debits on the left and credit on the right.
We’ll look at a few ledger examples shortly, but first, let’s review journals and the accounting equation.
Transactions are first recorded in journals before they’re transferred to ledgers. If ledgers are the master document for looking at the bigger picture, journals are the documents for analyzing the finer details of your business.
These transactions are usually recorded on a daily basis and, as with ledgers, you’ll have a credit and a debit for each entry.
While there are 7 types of journals, the four common ones are the sales journal, purchase journal, cash receipts journal and cash payment journal. I explain them below.
- The Sales Journal is for recording credit sales. For example, customers (debtors) who bought on credit or account.
- The Purchase Journal is for recording credit purchases by your business. Examples are supplies and equipment.
- The Cash Receipts Journal is for recording all cash inflows, such as cash for services rendered.
- The Cash Payments Journal is for recording all cash outflows.
3. The Basic Accounting Equation
The purpose of double entry accounting is to make sure basic accounting equation balances. The equation (Assets = Owner’s Equity + Liabilities) is the foundation of double-entry bookkeeping.
If at any time the sum of debits for all accounts does not equal the sum of credits, the equation will not balance. You’ll know you’ve made a mistake.
Let’s look at three examples and how to record the transactions:
Example 1: You pay an expense of $300
Debit “expense” and credit “cash” in BOTH the journal and the ledger.
Example 2: You receive $400 cash
Debit “cash” and credit “accounts receivable” in BOTH the journal and the ledger
Example 3: You owe $600
Debit “accounts payable” and credit “cash” in BOTH the journal and the ledger.
These are the basics, but you may be thinking, “So what? Do I even need a ledger?
Reasons Why You Need a General Ledger
Obviously, it’s always up to you (and your financial advisor) to decide what is right for your small business. You may be doing just fine without a General Ledger, in which case you may not want to boil the ocean! But in case you’re wondering, there are seven compelling reasons why you may want to use a General Ledger for your small business:
- It provides an accurate record of all financial transactions
- It helps you compile a trial balance, so your books balance
- It makes filing tax returns easy because you have expenses and income is in one place
- It reports real revenue and expenses so that you can stay on top of spending
- It helps you spot unusual transactions immediately
- It helps you identify (and stop) fraud
- It aids in compiling key financial statements which are crucial for evaluating your profitability, liquidity, and overall financial health. These include the cash flow statement, income statement and balance sheet.
The general ledger is your master document for all the financial transactions of your business. Understanding how it works can be daunting at first, but it doesn’t have to be.
You just need to understand the fundamental principles of double-entry accounting, the basic accounting equation, and how to transfer journal entries to the ledger.
Once you understand and start using the general ledger, you’ll realize how powerful it is. It offers several compelling benefits for your business. Arguably, the most important is that it’s the foundation for creating financial statements that are critical for evaluating your financial affairs.