A common way to set up a ledger is to have different accounts, each with its own balance. Typical accounts are Cash, Accounts Receivable, Inventory, Prepaid Expenses, Accounts Payable, and Equity.
These ledger accounts are not the same thing as the income statement categories of Cash, Accounts Receivable, Inventory, and so on. The income statement categories tell you what happened in your business during the period. The ledger-account balances tell you where things stand at the end of the period.
A ledger account is an accounting tool used to organize entries in a company’s books. A general ledger, which contains all the accounts of the company, is used to keep track of financial activity. Each type of activity has its own ledger account. For example, each transaction involving cash is kept in the cash account.
Where do the accounts come from? Generally, they are created by analyzing the profit and loss statements of the company. The account structure can be modified at any time to reflect changes in the business or the needs of the accountant.
The chart of accounts is an important tool for tracking transactions. When you set up a new bank account for your business, you will be asked to select a chart of accounts that corresponds to your company’s structure and activities.
Ledger accounts can also be used to track non-financial information, such as inventory or employee information.
There are several different types of ledger accounts:
Ledger Accounts: Assets and Liabilities
Assets and liabilities are two sides of the same coin. On one side is stuff that you own; on the other side is stuff that someone else owes you. How much money you have in a bank account, for example, is an asset because it’s money you own; how much money the bank owes you on the account is a liability, because it’s money the bank owes you.
In general, an asset is something that makes money for you, and a liability is something that costs you money. The most obvious exception to this rule occurs when what costs you money now will make you more money later. In that case a liability can actually be an asset. If I write a book, for example, advances from my publisher are a liability — they’re money I have to pay out now — but if the book becomes successful enough to earn royalties, those royalties will eventually exceed what I got from the publisher as an advance. In that case my publisher’s advances have been an asset.
A financial ledger is a record of transactions. It can be very simple or it can be very complex, but at its heart it is simply a list of things that happened, like an old-fashioned party guest register. A basic example might include three different accounts: one for money earned (or borrowed), one for money spent (or owed), and one for money invested.
These three accounts are the three sides of any transaction. If you earn some money, you now have it in your “money earned” account; you now owe it to someone else, who has placed it in their “money owed” account; and they have now invested it in something, so they have decreased the amount in their “money invested” account and increased the amount in your “money invested” account. It’s impossible to describe any transaction without referring to all three accounts.
A far more complicated ledger would include many more accounts, each with sub-accounts, and sub-sub-accounts, and so on. That is just good bookkeeping; if you want to keep track of how much money is tied up in an investment that takes several years to pay off, you will want sub-accounts for each year.
It is not a rule that companies shall have only one type of account. For example, a company may have a current account and a capital account.
The capital account is where the owner’s contribution to the company is recorded. It may also be used to record any loans from suppliers or from other companies. When the owner takes money out of the company it will be repaid from this account. The owner can make drawings from this account as he wishes, but he must leave enough money to cover his liability as an owner as well as making provision for interest on his capital, which must be added into the capital account each year.
It is quite usual for a business to have a capital account and a current account, even if it has no borrowing power beyond its overdraft facility. In this case, both accounts record transactions relating to the day-to-day running of the business and examples of these will be found in later chapters of this book.
In addition to recording transactions, accounts are used for preparing reports and calculating certain figures such as working capital and profit for the year. As explained more fully in later chapters, ledger accounts can be linked with subsidiary books by means of control accounts which enable all transactions pertaining to a particular subsidiary book to be recorded in one place.
The double-entry accounting system is the most powerful tool for business management. It’s also an extremely clever way to lose money, which is why you need to understand it well before you try it.
The basic principle of accounting is that every transaction has two aspects: it changes both the asset side and the liability side of your balance sheet. If you sell $1,000 worth of widgets, the liability side increases by $1,000, but so does the asset side. You have to show that in your books or your business will be broke even if everything else goes well. And that’s where the term “double-entry” comes from. Every transaction has to be recorded twice, once as a credit and once as a debit.
How do you know how much of each kind to record? The answer depends on why you are keeping track in the first place. If your purpose is to make money, then you want to enter every transaction as a credit. But if your purpose is simply to keep track of what happened, then every transaction should be entered as a debit.
Emil is a contributor at Accountant Log. We are committed to providing well-researched, accurate, and valuable content to our readers.
