Business Accounting Series - Part I: Basic Concepts

Learn the basics of double entry accounting.

November 02, 2022


Part I
Introduction to Double Entry Accounting (General Ledger)

1 Definitions of terms and basic principles

1.1 Debits and credits (transactions)

Debits and credits are balanced financial transactions. Balanced means that their sum equals zero. Debits have a positive sign and credits have a negative sign. An example of a balanced set of debits and credits looks like this:

Debits Credits
$50.00 -$50.00
$100.00 -$4.00

The debits column adds up to $150.00 and the credits column adds up to -$150.00. The sum of $150.00 plus -$150.00 is zero.

1.2 Financial statement

A financial statement is a snapshot of the finances of the business. It shows both the value of the business as well as the performance of the business. It does so in two parts: the balance sheet and the income statement.

1.2.1 Balance sheet

The balance sheet portion of a financial statement describes the value of the business. It consists of two major sections. The first of these lists all assets and the second major section lists all liabilities and equity. Assets are generally entered with a postive sign and liabilities and equity with a negative sign. The sum of these two sections is always zero.

Assets typically include things such as:

  • Cash
  • Invoices due from customers
  • Inventory
  • Buildings
  • Vehicles
  • Manufacturing equipment
  • Furniture

Liabilities typically include things such as:

  • Payments owed to vendors
  • Taxes due
  • Loans

Equity typically includes things such as:

  • Investments made by business owners
  • Current earnings
  • Year over year retained earnings

1.2.2 Income statement

The income statement portion of the financial statement shows how a business is performing. This indicates if a business is currently making or losing money. The total of the income statement is included in the equity portion of the balance sheet as current earnings. An income statement is typically organized as follows:

  1. Sales
  2. Cost of sales
  3. Cost of overhead

Within sales there might be many subcategories, such as inventory, labor, departments, or any grouping that warrants special tracking. Cost of sales, typically called cost of goods sold, includes payroll labor expenses, cost of sold inventory items, cost of manufacturing, and any other costs directly related to producing whatever products are sold. Overhead costs are generally everything else.

1.3 Fiscal years and periods

A fiscal year is a period of time equal to one year that is used as a basis for valuation and performance measurement. A fiscal year does not have to begin and end on the same date as the calendar year, but can be chosen to begin and end on any date that assists the business in developing an accurate picture of performance. Once a fiscal year beginning date has been chosen, it is very rarely if ever changed.

A fiscal period is a time period typically roughly corresponding to a calendar month. Often calendar months are used, but this is not a requirement. As with the fiscal year, the fiscal periods are chosen in such a way as to help accurately view financial performance. Because there are many cycles (both concerning expenses and income) that are monthly in nature, a calendar fiscal period is the most common. However, some businesses have other cyclical data points that work better with fiscal periods aligned to an equal number of whole weeks or always starting after the weekend.

1.4 Accounting methods

1.4.1 Cash accounting

Cash accounting means that expenses and sales are recorded in the same fiscal year and period as those of any cash transaction. With cash accounting the movement of money through the bank accounts rules the timing of all general ledger entries. Note that this refers to the date of a deposit or, in the case of paying a vendor or employee, the date of the check written. The fiscal period and year of the transaction is the date of when the cash sent or received.

1.4.2 Accrual accounting

Accrual accounting means that expenses and sales are recorded in the fiscal year and period in which they apply and not necessarily the fiscal year and period of the related cash transactions. An expense which is not paid for immediately can be recorded as happening immediately even though the payment for that expense does not happen for some time. Fiscal period and year of the transaction is that of the invoice (whether a vendor invoice or an invoice sent to a customer).

1.5 General Ledger framework

General Ledger account numbers are grouped into ranges based on the type of thing being tracked. This grouping of accounts by type determines where on the financial statement the accounts appear and how they function. The General Ledger framework is generally structured as follows:

  • Assets
  • Liabilities and equity
  • Sales
  • Cost of goods sold
  • Overhead

Notice that the first two parts of the framework are part of the balance sheet and the last three are part of the income statement.

The framework can define any number of sub-groupings of accounts. Typical sub-groups are assets that can be easily converted to cash, long term assets such as buildings and land, liabilities that are usually paid immediately, long term loans, owner investments and earnings, sales, cost of goods sold, and overhead.

1.6 General Ledger accounts

A General Ledger account is simply an identifier for something that the business wants to track. For example, tracking the amount of money in a bank account or the amount of money that customers owe. The identifier is typically a number, often divided into two parts called an account number and a sub-account number.

Some examples of General Ledger account numbers follow:

Account Number Account Name Purpose
101-0 Cash in bank Tracks money kept in a bank account
120-0 Accounts receivable Tracks money owed from customers
151-0 Store building Tracks the value of the building owned by the business
151-1 Land Tracks the value of land owned by the business
201-0 Accounts payable Tracks the total money owed to vendors
210-0 Bank loan Tracks the money owed on a loan
291-0 Current earnings Tracks the money made or lost this year
292-0 Retained earnings Tracks the money made or lost in all previous years
301-0 Sales Tracks sales

2 General Ledger functions

2.1 General Ledger transactions

As alluded to earlier, General Ledger transactions are balanced sets of debits and credits. All sets of transactions must always sum to zero. This means that every set of transactions must consist of at least two entries. Returning to our example of debits and credits, this time with account information:

Account Debit Credit
101-0 Cash 50.00
301-0 Sales -50.00
201-0 Accounts payable 100.00
101-0 Cash -4.00
101-0 Cash -6.00
101-0 Cash -90.00

Notice that a sale is positive when entered into the cash account but negative when recorded in the sales account. Similarly, when vendors are paid the amount owed is paid down using a positive number and the cash is reduced using negative numbers.

2.2 Audits

The General Ledger system enables fine-grained audits to be performed on all business activity. Every bank account transaction, every bill from a vendor, every invoice to a customer, and every asset must be tied to a General Ledger transaction.

2.3 Examples

Understanding how General Ledger entries work is sometimes most easily understood by examples. Following are examples typical of some major business functions. In all of these examples the business uses accrual accounting.

2.3.1 Accounts Payable

Accounts Payable is the business function dedicated to paying bills and tracking expenses. In this example, vendor Acme Incorporated is used to obtain office supplies and the business has an account with the vendor (i.e. this is not a walk-in cash sale). The invoice from Acme Incorporated looks like this:

Item Amount
Printer toner 150.00
Printer paper 50.00
USB hard drive 200.00
Total 400.00

In order to pay this invoice from Acme Incorporated we first must allocate each item purchased to a General Ledger account. Printer toner and paper in this example are consumables that constitute overhead expenses for the business. For this example we will use 601-0 “Office supplies” as the General Ledger account for both the toner and the paper. The USB hard drive is not a consumable, but rather computer equipment used in the generation of the business’ product. In that role it is a part of inventory and, when sold, will become a cost of goods sold. So we will use account 130-0 “Inventory” as the General Ledger account number. The business uses General Ledger account 201-0 “Accounts payable” for tracking payables and account 101-0 “Cash in bank” for tracking cash. We will suppose that the supplies are purchased in fiscal period 8 and paid for in fiscal period 9.

The expense transactions will all occur in fiscal period 8 and look like this:

Item Amount General Ledger Account Debit Credit
Printer toner 150.00 601-0 Office supplies 150.00
Printer paper 50.00 601-0 Office supplies 50.00
USB hard drive 200.00 130-0 Inventory 200.00
Total 400.00 201-0 Accounts payable -400.00

Notice that the sum of the debits and credits is zero as required. Also take note that expenses are recorded as debits and the amount owed as a credit. Remember that liabilities are “things you owe” and offset assets, so liabilities are credits. In order to make a balanced entry, the expense entries must be debits.

When paying the vendor invoice the entries occur in fiscal period 9 and are rather simple:

General Ledger Account Debit Credit
201-0 Accounts payable 400.00
101-0 Cash in bank -400.00

Again the entries balance to zero as required. Since cash is disbursed, a credit entry is made to the cash account. At the same time, the amount of money owed to vendors is reduced, so a debit is made to the payable account.

2.3.2 Accounts Receivable

For this example we will use General Ledger account 120-0 “Accounts Receivable” for tracking money owed to the business by the customers. Account 301-0 “Sales” will be the account for sales of products. As in the previous example we will use 101-0 “Cash in Bank” for tracking cash. We will suppose that this invoice is dated in the eighth fiscal period.

Suppose the business sells goods to customer SuperTech. The invoice to SuperTech looks like this:

Item Amount
CoolProduct 500.00
Sales tax 10.00
Total 510.00

As in the previous example we first assign each line to a General Ledger account. The sale of CoolProduct will go to account 301-0 “Sales”, the sales tax to account 213-0 “Sales tax payable”, and the total to account 110-0 “Accounts receivable”. Note that sales tax is not included in 301-0 “Sales” because it is not something that a business sells, but rather a charge that is passed on to the customer. This charge becomes an amount owed to the taxing authority, and is thus a payable. Accounts receivable tracks the total due from the customer, and thus the total of the invoice goes there.

Looking at this invoice with the corresponding debits and credits makes this more clear. All transactions here are in fiscal period 8.

Item Amount General Ledger Account Debit Credit
CoolProduct 500.00 301-0 Sales -500.00
Sales tax 10.00 213-0 Sales tax -10.00
Total 510.00 110-0 Accounts receivable 510.00

An important point to notice here is that sales are negative. Negative sales are a good thing! The sales tax owed to the tax collector is appropriately shown as negative since it is a liability. Finally, the accounts receivable amount is positive as it should be, since it is increasing an asset.

Suppose now that the customer pays the invoice in fiscal period 10. The General Ledger transactions would all be in that period and look like this:

General Ledger Account Debit Credit
101-0 Cash in bank 510.00
110-0 Accounts receivable -510.00

In this example, money is received, so the asset account for cash in the bank account is increased. The amount of money owed the business from customers is reduced in the same amount.

The paying of sales tax to the tax authority is the same as the Accounts Payable example above and is an exercise left to the reader.

2.3.3 Inventory

There are many possible examples dealing with inventory. We will provide two: receiving inventory and sales of inventory.

First, it is worthwhile to note that ordering inventory (i.e. via a purchase order) does not necessitate any General Ledger entries.1 The simple act of ordering inventory does not (yet) cause any money to change hands and thus no General Ledger entries are made for purchase orders. It is when the inventory or invoices from the vendor are actually received that General Ledger entries are required.

To consider receipt of inventory, let’s use an example purchase order. A packing list may be included with the received inventory, but that would typically not include prices. For this example we will ignore any issues related to partial or substituted shipments. Also, we are interested in the dollar amounts, not the quantities received, so we will ignore such quantities.

Item Price
Megawidget 100.00
SuperPart 50.00
Total 150.00

Once again, we need to consider what General Ledger accounts correspond to each line. Megawidget and SuperPart are both items we will be adding to inventory for later sale, so both of these will go to account 130-0 “Inventory”.

But what about the total? We haven’t received an invoice from the vendor yet, so the total cannot go to Accounts Payable. Yet the act of receiving inventory means that the business now owes the vendor something.

The answer to this is that the total constitutes another kind of liability - one that we know is owed but does not have a formal invoice to go with it. So for this we will use account 202-0 “Inventory received but not invoiced” and put the total there.

Examining our receiving with the General Ledger accounts looks like this:

Item Price General Ledger Account Debit Credit
Megawidget 100.00 130-0 Inventory 100.00
SuperPart 50.00 130-0 Inventory 50.00
Total 150.00 202-0 Inventory received but not invoiced -150.00

The fiscal period of these transaction would be that of the period in which the inventory was received.

When the vendor invoice is received and entered in Accounts Payable, it must offset the transactions above for that inventory. Those entries would look like this:

General Ledger Account Debit Credit
202-0 Inventory received but not invoiced 150.00
201-0 Accounts payable -150.00

When the vendor invoice is paid it follows the same process as the example in 2.3.1.

When inventory is sold it has an effect on the value of inventory and on the cost of goods sold. Using the prior Accounts Receivable example, suppose that CoolProduct is an item that is created using both Megawidget and SuperPart. The General Ledger information now has more data:

Item Amount General Ledger Account Debit Credit
CoolProduct 500.00 301-0 Sales -500.00
Megawidget 100.00 130-0 Inventory -100.00
Megawidget 100.00 401-0 Cost of goods sold 100.00
SuperPart 50.00 130-0 Inventory -50.00
SuperPart 50.00 401-0 Cost of goods sold 50.00
Sales tax 10.00 213-0 Sales tax -10.00
Invoice Total 510.00 110-0 Accounts receivable 510.00

Once again the entries sum to zero. Inventory is depleted and the cost of goods sold increases.

2.3.4 Payroll

Payroll has many components: cost of labor, taxes withheld from the employee’s pay, taxes paid by the business, any voluntary payroll deductions or garnishments, and of course the disbursement of actual pay. The cost of labor itself requires considering whether or not that labor is used in creating products that are sold or if it is an overhead expense. In addition, payroll benefits such as available vacation pay may be accrued.

This example supposes that the cost of labor is an overhead expense. We will use a simplified case with no deductions other than payroll taxes and no accrual of vacation or other benefit pay.

Item Amount
Gross pay 1000.00
Taxes withheld from employee 200.00
Employer taxes 50.00
Net pay 800.00

Note that the net pay is not the gross pay minus all the taxes. The employer taxes are not subtracted from the employee’s pay but are expenses on the business itself. Assigning the General Ledger accounts results in:

Item Amount General Ledger Account Debit Credit
Gross pay 1000.00 501-0 Labor 1000.00
Taxes withheld from employee 200.00 212-0 Withholding tax -200.00
Employer taxes 50.00 212-50 Employer tax payable -50.00
Employer taxes 50.00 601-0 Employer tax expense 50.00
Net pay 800.00 101-0 Cash in bank -800.00

As always, the transactions sum to zero. Just like the inventory received example, we have created payable (liability) accounts to track something that the business owes. When the taxes are paid, those payables will be reduced.