Accounting Basics: What Is a General Ledger & Why You Need It
Before the advent of computers and accounting software, accountants and bookkeepers recorded all financial transactions in the general ledger by hand using the double-entry accounting method.
Now that accounting has gone digital, it is easier to automate your business financial transactions such as balance sheets, cash flow statements, and income statements with accounting software such as FreshBooks, QuickBooks, and other QuickBooks alternatives.
Although the way you record your business transactions has changed, the general ledger remains an important component of accounting.
In this article, you will learn what a general ledger is, an example of a general ledger, general ledger accounting categories, categorizing balance sheet and income statement accounts, and how a general ledger works.
You will also learn what a general ledger tells you, the differences between the general ledger and general journal, the differences between the general ledger and trial balance, and reasons why you need a general ledger.
Let’s get started.
What is a General Ledger?
A general ledger is a general accounting document in which all the transactions of a company are compiled and stored. When a transaction is made, it is posted into a journal and this journal entry is subsequently posted into a general ledger for adequate recording and account safekeeping.
Information about financial transactions is collected from every accounting document used by a company and stored for future reference. A general ledger remains a single document, the entire history of transactions made by a company since it started operations is recorded in it.
All transaction data recorded in a general ledger are needed and sufficient to produce the cash flow statements, income statement, and balance sheet, or other financial reports generated at the end of an accounting period. This transaction data is also used to update the trial balance, which is a very important report in accounting.
A trial balance contains the account balance information of every account used to create a general ledger, that is, every account from which a general ledger gets its transaction data. With it, accounting records are easily cross-checked for errors.
A general ledger is the master document that gives a company access to every single transactional information it needs. It is complemented by sub-ledger accounts that help to record individual transaction descriptions. These include ledgers for account receivables, account payables, inventory, fixed assets, purchases, sales, and cash.
Example of a General Ledger
|General Ledger – #1100 Cash Account (Partial – June 2021)|
The general ledger above includes transactions recorded from a journal.
- By June 1, the opening balance in the general ledger is $100,000, which is the same as the ending cash balance of the previous month. Debits and credits are recorded in separate columns and are defined by the type of transaction made.
- In the ledger, the description column shows that outward payments were made on June 5, June 12, and June 26. These payments decrease the cash account balance.
- Journal entry #1 indicates that rent was paid and the cash balance decreases by $60,000. However, this is recorded as a credit, signifying the alternate double-entry cash credit of it in the general journal.
- Entry #2 indicates the purchase of inventory for $20,000 which reduces the cash balance by the same amount. This is recorded as credit just as it is recorded in the inventory journal.
- Journal entry #3 shows that sales were made and revenue of $40,000 was generated on June 16. The cash account balance increased by the same $40,000.
- By the latest journal entry on the 26th of June, inventory was purchased for $10,000, with the account balance decreasing by this amount. The transaction is recorded on the credit side like in the reference journal.
- After the last journal entry, the general ledger account balance stays at $50,000. This amount represents the current balance of the cash account that is recorded into the general ledger. Sub-ledgers and reference journals contain more comprehensive information about all these transactions.
Note, the ending cash balance is posted on the 30th of June after all June activities are posted.
General Ledger Accounting Categories
Financial Accounts are divided into five categories within a general ledger: assets, liabilities, equity, revenue, and expenses.
An asset is any property owned or controlled by a company or business entity. It is anything that produces positive economic value when within favorable conditions.
When recording accounts on assets, the value which the property can produce when converted to cash is what is accounted for. It covers money and other valuables belonging to an individual or a business.
Assets can be split into two major types: tangible assets and intangible assets.
Tangible assets are properties that can be seen and touched with human senses. They are either current assets, which include inventory, accounts receivable, or fixed assets which include buildings and equipment.
Intangible assets are nonphysical resources and legal rights that are only mentally perceived and possess value to a company. They include certain rights like goodwill, copyrights, trademarks, patents, rights to financial investments, bonds, and stocks, among a whole lot others.
Generally speaking, a liability is anything owed to anyone. In accounting, liabilities are obligations that a company owes to other businesses or individuals. A liability also means a legal or regulatory risk or obligation.
Liabilities include burdens like payment of employee payroll including payroll taxes and repayment of bank loans, mortgages, or leases. In accounting, companies book liabilities in opposition to assets. This means that while an asset helps a company hold a value that could increase, liabilities depreciate the value of a company.
Liabilities are divided into two: current liabilities and non-current liabilities. Current liabilities are the short-term financial obligations of a company that is due within one year or a normal operating cycle. Non-current liabilities are obligations that are not due to be repaid within a year.
Equity is the difference between your total assets and total liabilities. When you sell off your assets for cash value and pay off all your liabilities, equity is the amount of cash value you are left with.
For shareholders in a company, equity represents the value that would be gotten if all of the assets are liquidated and all of the company's debts are paid off.
A company does not need to be sold off for its equity to be determined. It also represents the value of an owner's or shareholders’ stake in a company, excluding liabilities.
Revenue, which is also referred to as sales, is the income received from business operations, investments, and other business activities. It is the amount of cash, or its equivalent, accrued from a company's business and financial activities.
The generated revenue is divided into operating income and non-operating income. Operating income is the revenue generated from normal business operations like sales of goods or services.
Non-operating income refers to secondary sources of revenue that are not consistent or part of business operations. These include income from lawsuits or external monetary grants.
An expense is the outflow of cash or other valuable assets from an individual or company. This outflow of cash represents an occasion where an asset is used up or a liability is incurred. Expenses reduce the equity of owners or shareholders.
Categorizing Balance Sheet and Income Statement Accounts
The transaction data contained in a general ledger are used to generate subsequent reports at the end of a period. However, the reports generated from a general ledger have different uses for these categories of accounts.
A general ledger records all the accounting transactions of a company and this transaction data is used to construct the balance sheet and income statement. The categories of accounts stay in place regardless of a company's accounting method, but the balance sheet and income statements make use of differing categories.
The balance sheet uses accounts in the asset, liabilities, and equity categories. Balance sheet accounts are permanent, long-term accounts whose balances always carry over from one financial period to the next.
Balance sheet accounts help a company to evaluate its rate of return (RoR) on investments and also review its capital structure. These accounts include records of cash, accounts receivables, accounts payable, loans payable, and various equity accounts.
Income statement accounts are temporary accounts whose balances are usually refreshed at the end of each month. The next month begins with a zero balance as it contains temporary transactional activities that occur repeatedly within a month.
Income statements make use of accounts in the revenue and expense categories. This means that income statement accounts make use of records of sales income, investment income, salaries expense, rent expense, interest expense, among a whole lot others.
With income statements, a company has records of how it came about its net profit from its various business activities.
How Does a General Ledger Work
The whole system of creating a general ledger makes use of the double-entry accounting method. It is one of the small business bookkeeping basics that every business should know. Sub-ledgers complement general ledgers and also contain transactional data about various types of transactions.
Transaction data is first recorded in journals using the double-entry method. Records of double-entry transactions are called “journal entries,” and are posted in two columns; debit and credit. The debit column is usually on the left while the credit column is placed on the right.
Businesses that employ the double-entry bookkeeping method record financial transactions in at least two sub-ledger accounts. Each entry also has at least one debit and one credit transaction.
For example, where a purchase of an item is made, a debit would be made for purchase in the cash account and a credit of the same amount would be made for cash for the same account in a general journal. A debit is also made in the sales sub-ledger and a credit is made into the purchases sub-ledger.
Double-entry accounting is a method that helps companies to ensure accountability and that all accounts are accurate.
The total of all debit and credit entries must be the same. If the total of both columns does not balance, then there may be a mistake while entering data into the journal.
After the journal and sub-ledgers are updated, transactions are then inputted into the general ledger. The general ledger contains all the summarized data from journals.
An accountant then generates a trial balance. A trial balance is a report that contains the balance of each ledger and accounts. The trial balance is updated regularly by posting recent account balances and, by the end of a financial period, it is used as a cross-check while generating financial statements and reports.
Summarily, double-entry bookkeeping is the main accounting method used in creating general ledgers. Journals and sub-ledgers are updated with this method and a general ledger gets its data from journals.
Transaction data kept in general ledgers are then used to create trial balances used to create necessary financial reports and statements at the end of a financial period. The updated balance of accounts recorded in trial balances is used as a means to cross-check figures and make sure they are accurate.
What Does a General Ledger Tell You?
For every business, it is crucial to maintain accurate financial records to generate credible financial statements.
The general ledger exists to facilitate the generation of financial statements at the end of a financial period. These financial statements are necessary for companies to satisfy external stakeholders like investors, creditors, and industry regulators.
The transaction data recorded in a general ledger is split into five different categories: assets, liabilities, equity, expense, and revenue. All these represent different elements affecting the overall value of a company.
The categorized transactional data presented to you by a general journal helps you generate a trial balance, income statement, balance sheet, statement of cash flows, and a lot of other important financial reports.
With this data, important administrative stakeholders within and outside a company can continually assess the company’s performance.
A general ledger does not present you with detailed information about a transaction. For example, if revenues increase, a general ledger does not tell you why it increased. It only summarizes all the transactions inputted into journals.
Where accounting errors occur, a general ledger has enough summarized transaction data for you to use as a reference in locating the cause.
General Ledger vs General Journal
A general journal is a record of every transaction made by a company in chronological order. It is the first point of entry into the company’s accounts before a general ledger is updated. A general journal is also a great document to use in reviewing all transactions.
In a general journal, extended information about every business transaction is recorded. The source documents for these pieces of information are typically journal vouchers, copies of management reports, and invoices, among others.
General ledgers and general journals are similar. Both serve as great records to refer to while looking for all business transactions and are both generated through the double-entry accounting method. The information recorded in both the general journal and general ledger can also be used for creating financial statements.
They are only differentiated by which comes first in the whole accounting process and the amount of information they provide.
A transaction is recorded in a general journal before it is recorded in a general ledger. The general ledger serves as the second point of entry for recording every transaction. Transaction data recorded in a general ledger are also gotten from the information provided in a general journal. The general ledger is only a summary of every transaction a company makes.
General Ledger vs Trial Balance
A trial balance is a bookkeeping document in which the account balance of all sub-ledgers is recorded. Only the balance of sub-ledgers is compiled and updated using the double-entry accounting method.
Ledger account balances are recorded into debit and credit account columns, with the totals of these columns being equal. A trial balance is updated periodically, typically at the end of every reporting period, and also used for cross-checking purposes.
The general-purpose a trial balance serves is to ensure that general entries in a company's accounting system add up mathematically.
General ledgers and trial balances are differentiated by the amount and nature of the information they provide as well as what they are used for.
A general ledger contains a multitude of summary transactions compiled from various accounts while the trial balance only contains the updated balance of each of these accounts. With this, a general ledger may be several hundred pages long while a trial balance only a few pages due to the amount of information they present.
While a general ledger serves as a database of data about accounting transactions, the trial balance is a report derived and generated from data stored on the general ledger.
Furthermore, a general ledger is also one of the main sources of information used by financial accountants to investigate accounts and create financial statements. A trial balance is limited to just being used to compare all debits and credits to make sure they are balanced.
Reasons Why You Need a General Ledger
A general ledger is not a compulsory aspect of running a business. Your business accounts can be highly accurate without a general ledger, but why choose not to have it?
A general ledger, even though not compulsory kept, acts as a backup or point of reference if you have problems with your accounts. Having a solution without a problem is better than having problems without a solution and this is where general ledgers are relevant in accounting.
There are several reasons why a general ledger should be part of your accounting framework.
Reason #1. You Easily Create Important Financial Statements
If properly kept, a general ledger contains accurate summary information about every single financial transaction you have made during your financial operations or since when you started keeping records.
An accurate general ledger makes it easy for you to create important financial statements required by investors, creditors, or industry regulatory bodies.
Apart from the satisfaction of external stakeholders in your company, creating financial statements also helps you evaluate your profitability, liquidity, and overall financial health.
A general ledger also serves as one of many financial documents required for efficient managerial accounting. It helps you easily and accurately create crucial reports like cash flow statements, income statements, trial balances, and balance sheets, among others.
Reason #2. General Ledgers Keep You Organized
A general ledger compartmentalizes transactions into different categories. These categories define the nature of transactions recorded under them and this proves to be very useful.
The organized nature of general ledgers makes it very easy to find transactions. Errors or unusual transactions are immediately spotted and financial statements can be made as accurate and balanced as they need to be in the shortest possible time.
With this, you steer clear of bigger problems that may arise from inaccurate financial reports such as reduced creditworthiness, regulatory penalties, and inaccurate tax filings. Every external stakeholder has access to records that give them an accurate picture of your business’s finances.
Reason #3. Fraud Is Easily Identified
A general ledger contains all the history of transactions made by a company. The double-entry method employed in recording data before it is inputted into a general ledger also makes the whole process rigid.
This chronological, rigid, and highly accurate process makes account tampering very difficult. Where a general ledger is given confidential access, individuals who have tampered with other accounting records do not have access to the general ledger to replicate their changes. Apart from all these, a general ledger also makes filing tax returns easy as revenues and expenses are recorded in one place. You can also study patterns in income and expenses to stay on top of your business cash flow.