Analyzing Transactions

General Ledger and Chart of Accounts

General Ledger and General Journal

All account transactions are stored in the general ledger. The general journal shows economic events in the order in which they were recorded.

An accounting system is a way of keeping track and telling the story of economic events that occurred to an individual or an organization. Accountants use the double-entry accounting system as part of the system to keep track of events. The creation of financial statements begins with transactions as the starting point of an accounting system, and the financial statements are the end. Transactions will be recorded in the accounting books of a person or organization. Even though they are databases today, think of an accounting book as a book with many pages. Each page is for a separate account. The book with the accounts on separate pages for each account is called the general ledger. The general journal is a book or database where economic events are recorded. A transaction entry in the general journal, called a journal entry, is made using double-entry accounting. Finally, these are all the pieces needed to create financial reports. This is a basic accounting system.

Jim has earned $299 in wages. To create an entry for his wages earned, he needs a debit and a credit. Jim recorded his wages earned as credits. To make his entries balance, he needs a debit, likely to cash.

Wages Earned Log

Date Description Debit Credit
2018-04-18 Worked 5 hours for Bob @ $20/hr $100.00
2018-04-19 Worked 8 hours at store @ $14.5/hr $116.00
2018-04-20 Worked 4 hours at store @ $14.5/hr $58.00
2018-04-20 Mowed lawn for Mr. Simpson $25.00
Wages for week $299.00

Cash Paid for Wages Earned Log

Date Description Debit Credit
2018-04-18 Worked 5 hours for Bob @ $20/hr $100.00
2018-04-19 Worked 8 hours at store @ $14.5/hr $116.00
2018-04-20 Worked 4 hours at store @ $14.5/hr $58.00
2018-04-20 Mowed lawn for Mr. Simpson $25.00
Wages for week $299.00

Chart of Accounts

A list of all the different accounts, called the chart of accounts, is set up for keeping track of them in the general ledger.

The chart of accounts is a list of all accounts including assets, liabilities, revenues, expenses, and equity, as a means of keeping track in the general ledger. To set up the pages of the general ledger, some educated guesses will need to be made in order to determine what groupings of economic events need to be tracked. For example, a company that will make improved mousetraps will need to create a series of accounts. All businesses have cash, so that account should be created. Hopefully, the company sells some mousetraps, so the sales account would be required. The company would also need an account to track the mousetraps, so the inventory account would be necessary. Some of the sales will be on credit, so the business would need to track how much money to collect. This account is called receivables.

The following is an example of the accounts to consider:

  • Cash
  • Sales
  • Cost of goods sold
  • Inventory
  • Receivables
  • Common stock
  • Bank loan
  • Interest expenses
  • Bank charges
  • Land
  • Buildings
  • Machinery
  • Marketing expenses
  • Salary expenses
  • Benefits expenses
  • Administration expenses
  • Accounts payable
  • Tax expenses
  • Taxes payable

A common form of business is the corporation, and ownership of a corporation is through shares or common stock. An account is needed for that. There may be a bank loan on which to pay interest, which means there will be bank charges to pay on the bank account. The bank loan will be put into the cash account to buy land, buildings, and machinery to make mousetraps.

To sell the mousetraps, money will be spent on marketing. Employees will be paid a salary and may be provided with health benefits, as well. There will be other administrative expenses, and not all expenses may be paid in cash. Especially if granting credit to customers, it makes sense for the company to buy from its suppliers on account, so the amount due to each supplier will be listed. Those are called accounts payable.
Of course there will also be taxes. It will be necessary to keep track of tax expenses and how much tax is still payable. As a business grows and new things need to be tracked, new accounts can be added. However, a business should not have too many accounts. Having too many accounts makes it harder to see the big picture and also tends to take a lot of time to maintain.

There is one more step to take to finish generating a journal entry, and that is to decide whether a normal entry to an account will be a debit or a credit. To do this, cash is the starting point. An addition of cash is a debit.

The initial source of cash was issuing common stock, so to make the double entry work, if cash is a debit, then common stock would be a credit. This can be visualized by using T accounts. Entries to common stock must normally be credits.

Cash and Common Stock T Account Example

Using a T account format, cash is a debit, and purchasing common stock is a credit.
In the same way, the bank loan also increases cash. Increases to cash are debits, so when the business obtains the cash from the bank, it debits, or increases, cash. On the other side, the business will eventually need to repay the bank, so it has a liability to the bank and will increase its account Bank Loan with a credit. Cash is then decreased to buy land, buildings, and equipment. If increases to cash are debits, then decreases to cash must be credits. That means when cash is spent to buy land, cash is credited, which requires land to be debited. The business decreased its cash with a credit and increased its land account with a debit since it used cash to obtain land. For example, if mouse traps were sold for cash, cash would increase (a debit).

Cash T Account Example

If a company sells mouse traps for $250 cash, cash increases as a debit in the T account.

Sales T Account Example

Increases to cash are debits, but decreases to cash are credits using a T account.
If the customer said they would pay later, receivables would be debited instead of cash. Receivables are increased by a debit. Later, when the customer pays cash for the amount they owe, the company's cash is debited, which increases the cash balance. Receivables are credited, which reduces the receivables balance.

Receivables T Account Example

If a company sells mouse traps on account (on credit) instead of for cash, receivables is debited, increasing the receivables balance (debit subtotal). When the amount owed is collected from the customer, the receivables amount is credited, and the balance in account is zero.
Inventory can be difficult to understand, It may be easier to think of it in terms of a company that buys inventory from manufacturers and sells it to consumers. Walmart is an example. Walmart has to spend money to acquire the inventory, which is a decrease in cash.

Grouping Accounts

Ledger accounts can be classified and numbered in different ways for easy identification—by assets, operating assets, credits, debits, longevity, and other codes.

There are different ways to classify and number general ledger accounts. For example, numbers can be grouped to represent assets or similar expense codes such as operating assets. Accounts should be grouped into useful classifications, making it easier to identify account codes and what type of account they are (asset, liability, expense, equity, etc.). Some accounts are normally credits, and some are normally debits, which is one way to group accounts. Also, cash is there until it is spent and payables are there until they are paid. Once the goods have been transferred to the buyer, the basic sales process is complete. Another way to group accounts may be by longevity. For example, assets are grouped by how long they will be used. Assets used for only a short time are called current assets. Assets that will be used for a long period are called noncurrent assets. Liabilities are also grouped by longevity based on when they must be paid. Liabilities that must be paid soon are called current liabilities. Liabilities that don't need to be repaid soon are called noncurrent liabilities.

It makes sense to reorder accounts to match financial reports, making it easier to create those reports later. The balance sheet represents the value, ownership, and obligations of a company. Within the balance sheet, accountants group accounts that are normally debits together as assets. Accounts that are normally credits are grouped as either liabilities or as equity if the accounts record ownership interests. A liability is an obligation or amount owed to another individual or entity as a result of a past transaction, such as a sale or loan.

The income statement represents the operations of a period that then add to or subtract from the earnings of the company. The income statement is split between sales (also called revenues) and costs (also called expenses). Revenue is money or resources received or expected to be received by the company in exchange for goods or services rendered. An expense is the cost of buying materials, paying employees, or any other type or purchase in order to generate revenue. In short, expenses are the cost of doing business.

Chart of Accounts Part 1

Better Mousetraps Corporation: Basic Chart of Accounts
Balance Sheet of Accounts Assets Current Assets Cash Debit
Receivables Debit
Inventory Debit
Long Term Assets Land Debit
Buildings Debit
Machinery Debit
Liabilities Current Accounts payable Credit
Taxes payable Credit
Long Term Bank loan Credit
Equity Common stock Credit

Chart of Accounts Part 2

Income Statement Accounts Revenue Sales Credit
Expenses Product Cost of goods sold Debit
Operating Salaries Debit
Benefits Debit
Marketing expenses Debit
Administration expenses Debit
Finance Interest expense Debit
Bank charges Debit
Tax Tax expense Debit

It is important to note that the accounts should be kept in the order intended, which can be difficult as new accounts are added. The easiest way to keep things in order is to number them, leaving space in between the existing accounts to allow space for future accounts that may be added. For example, one could start numbering Account #1000 and Account #1001, but just in case a new account is needed, the next number after 1000 could be 1010. If Account #1200 is set to be "Receivables from Customers"—more commonly called "Trade Accounts Receivable" or simply "Accounts Receivable"—there is still room for another type of receivable, say "Employee Travel Advances" at Account #1230. Accounts receivable are outstanding invoices from previous sales on credit that are due to be paid to the company. The account number is like an index number in a database. Most modern computerized accounting systems are specialized databases. Account numbers can be very complex, but using specialized databases makes maintaining order of accounts easier.

Account Types and Ranges

The easiest way to keep accounts in the correct order is to number them in ranges.
There is no limit on the range of account numbers. Large organizations will use a five-digit number. Most companies will be fine with four digits, especially if the codes are combined with subcodes. For example, Account #4000-01-31 may mean "Mousetrap Sales-Pest Control Division-California Region."

Remember: the structure of the accounts supports the accounting equation: Assets = Liabilities + Equity.