All financial transactions occurring in the day to day operations of a business are tracked by the business’ accounting department and recorded to provide the business owners an accurate assessment of the financial performance of the company. Transactions are recorded by the company in books called journals that are summarized on a monthly basis, and then the totals are posted to the company’s General Ledger. A General Ledger is a mandatory component of any business’ accounting system as it is a historical record summarizing all of the financial balances of a business.
To keep this explanation simple, we will avoid using terms such as debit and credit and will assume that all of the business’ transactions are directly recorded into the company’s General Ledger (vs. being initially recorded in a journal and then summarized in the journal prior to posting in the General Ledger). To easily understand how a General Ledger is used, it can be explained in a visual sense by looking at a non-computerized, i.e. manual accounting system. Picture a big book. That book contains several lined pages. Each lined page is assigned to each account of the business and is labeled as such with the name of the account at the top of the page. Each line on the page would then be filled with the individual financial transactions that have occurred for that particular account. The lines of the page are then totaled together to determine the balance in that particular account as of a certain date. The cumulative balances of the profit and loss type accounts are then added together to determine the business’ profit or loss through a certain date.
The General Ledger accounts of the business are created to track the company’s assets, liabilities, owner’s net equity, sales, and expenses. Each General Ledger account is “labeled” quite simply to describe what it is. The asset accounts, for example, would include such items as the company’s cash accounts, equipment accounts, and other items that the company physically owns. The liability accounts (or “amounts owed” accounts) are labeled with descriptions matching what the liability is for, such as wages payable which represents the amount of wages that are due or payable by the company to their employees for the time period reflected as of a certain date in time. The revenue accounts are assigned labels to describe the type of revenue generated by the business. For example, a company that sells four different products might want to label four different accounts to allow the company to track the sales generated from each of the different products as: Sales-Product A, Sales-Product B, Sales-Product C, and Sales-Product D. The expense accounts of a business are labeled in the same manner with a name that describes the expense that was incurred by the business. For example, to enable the business to track the amount that they have spent on office supplies during the year, they set up a General Ledger account titled “Office Supplies”. Any purchase recorded during the year for paper, print cartridges, pens, etc. would then be tracked by the business on the General Ledger page titled “Office Supplies” and then the total of all of the purchases would be added together to determine how much the company spent on office supplies for that year.
To illustrate a portion of the accounting process, let’s look at how a company would record the purchase of a piece of equipment that they needed to acquire for their manufacturing process. Let’s assume the company places an order for the equipment with their equipment vendor that costs $1,000.00. After the equipment is delivered to the company, the company is required to pay the vendor $1,000 for the cost of the equipment. The equipment vendor sends the company an invoice requesting payment in the amount of the cost of the equipment ordered for $1,000. The vendor’s invoice states the terms of payment, such as the due date of the invoice, the amount due, and also the address of where the payment should be sent. To record the purchase in the company’s financial system, a clerk would need to assign labels or accounts to the transaction. In order to maximize a business’ cash flow, businesses use the account titled “Accounts Payable” to track all of the vendor invoices owed at any point in time for the business. This allows the business a tracking mechanism for all of their bills and the ability to time their payments to their vendors. In our example then, two accounts would be needed to account for the purchase. Since equipment was purchased, the “Equipment” account would be increased by the cost listed on the invoice for the equipment, which was $1,000 in our example. The second account needed would be the “Accounts Payable” account which is a liability account used to hold the invoice until payment on the invoice is due. The “Accounts Payable” account would then be increased by the $1,000 invoice. When the payment is due to the vendor, a check would be cut in the amount of $1,000 made payable to the vendor. In order to properly account for the payment transaction, the balance would be decreased in the company’s “Accounts Payable” account by $1,000 and also in the company’s “Cash” account by $1,000.00. This entire transaction properly records exactly what occurs when a company acquires a new piece of equipment. The piece of equipment is then added to the company’s “Equipment” account and the cash used to acquire the equipment is recorded by reducing the amount of cash that the company has on hand.
Assigning proper “labels” to a company’s General Ledger accounts is the first step in accurately describing and recording the day to day financial transactions of a business. The detailed information it provides allows those interested in the financial results of the company to have a clearer understanding of exactly what transpired for the period under review.