Accounting and Bookkeeping Basics Part 2

The Ledger
A ledger is just another book but with each page devoted to a single account. It is simply an alternative view of your journal entries - the journal entries are in date order, the ledger is a re-arrangement of the journal in account order.

The important thing to remember is that all your transactions are entered in the journal first. The ledger merely contains copies of them re-arranged by account.

Just like the journal, most businesses will use more than one ledger, each devoted to a certain aspect of the business and each given a different name to reflect this (e.g. 'Sales Ledger' and 'Purchase Ledger'), but whatever the case, a single general ledger will always be opened. This is called the Nominal Ledger (called the General Ledger in the USA).

Although it is termed 'nominal' for reasons which will become clear later, it is nevertheless important to realise that it is the main ledger of a business (i.e. where other ledgers are also in use, the final balance of those ledgers will also be held in the nominal ledger). Therefore, the nominal ledger will hold the full picture of a business however many other ledgers are used.

In order to post (i.e. make copies of) the entries from the journal we must draw up a list of the accounts used so far and give each one its own page in the ledger.

We need three accounts at this stage: a cash account, a petrol account and a sales account.

The layout of each account in the ledger is identical to the journal with the exception that the 'account' column is no longer required - we are looking at the entries of just one account so it can be included as the title of the page instead.

Once we have posted our entries into the ledger we can then begin to see how the business is doing.

Posted entries are exact copies of the original. If the entry was a debit entry in the journal then it is also a debit entry in the ledger. Although we can now see the relevant entries we don't yet know what the balance is; furthermore we don't know whether that balance means we have a surplus or a deficit of cash. To find out, follow this procedure:

1. Start by adding up the debit and credit columns and show the totals on a new line.
2. Subtract one from the other to get the balance using the following rules:
a) If the debit total is greater: the balance=debits-credits and the result is put in the debit column.
b) If the credit total is greater: the balance=credits-debits and the result is put in the credit column.
c) In other words, we are always going to get a positive balance, and it will always be placed under the highest total (this is the reason the columns were totalled first).

Because the balance of every account is always expressed as a positive value it doesn't tell us where we stand in relation to it (e.g. do we have a surplus of cash or is it overdrawn?).

We can overcome this by applying our from/to guide again (from=credit and to=debit). If the balance is in the debit column, then we have a positive cash balance (more money has gone to it than from it). If it shows a credit balance then it is overdrawn.

How does it apply to the sales account? If it has a credit balance, then we have positive sales. Where has the money come from? sales. And finally, look at the petrol account. Where has the money gone to? petrol.

The next step is to check that all the journal entries have been posted correctly to the ledger. This is called a trial balance.

The Trial Balance
The trial balance is a complete list of your account balances from the ledger. The layout is similar to the ledger except that only three columns are required: the account name and a debit and credit column.

Just the final balance line of each account is copied into the trial balance using the debit column if the account has a debit balance, or the credit column if the account has a credit balance.

The debit and credit columns are then totalled and checked that they match each other to satisfy the first rule of accounting (all the debits must equal the credits).

If they are not equal to each other it is proof that a mistake has been made. An audit is then carried out to find the error.

An audit simply means going through each entry in the journal to check that it matches the original paperwork (this is called an audit trail). If no error is found then it must be due to a mistake when posting the entries to the ledger. The audit then continues by checking each journal entry against the ledger entries.

OK, so lets discover if the business is making a profit or a loss.

The Profit and Loss Account
The Profit and Loss account (aka P&L), as its name implies, tells us whether we are making a profit or a loss: are we earning more money than we are spending? (a profit), or vice-versa (a loss).

The layout of the P&L account is just like any other account. To compile the P&L account copy the balances of the sales and expense accounts into it. We can then use our from/to guide on the resulting balance to determine if a profit or loss has been made. If more money has come from sales than has gone to expenses, we have made a profit. That is, if the credit side is greater than the debit side we have made a profit.

Having established the P&L account we must do one more thing: take a look at the business as a whole. For this we need to prepare the balance sheet.

The Balance Sheet
We can now look at the main equation of a double-entry system which will show that the first rule of accounting (the debits must equal the credits) not only applies to each transaction but continues right up to the main financial statement of the business; the balance sheet.

The P&L account reflects the balance of a specific area of your business over a particular period of time. The balance sheet reflects the current balance of everything since the business began.

The ledger holds this information, so like the trial balance we can compile the balance sheet by copying all the account balances into a report. The only difference is that the accounts are re-arranged to show what the business owns and what it owes. These are broken down into 3 groups:

Assets
These are the things the business owns. They are usually broken down into two groups: Current Assets and Fixed Assets.
Current assets include money in the bank, petty cash, and money owed to the business by its customers.
Fixed assets include capital items like business premises (assuming they are not rented), company cars and office equipment.

Liabilities
These are the things the business owes to third parties. They too are usually broken down into 2 groups: Current Liabilities (e.g. overdraft at the bank) and Fixed Liabilities (e.g. Long Term Loans).

Equity
Equity represents what the business owes to the owner of the business. This includes money paid for shares or capital introduced, any profits (or losses) brought forward from previous years as well as the current balance from this year's P&L.

These three groups make up what is known as the accounting equation:

Assets = Liabilities + Equity

Easily remembered by those who like a pint with the acronym: ALE.

Just like any mathematical equation a balance sheet can be re-arranged in any order you like:

Equity = Assets - Liabilities
Liabilities = Assets - Equity

Probably the most useful view is Equity. Since equity is what the business owes its owners, it represents the value of the business from the owners point of view. If this were your personal accounts, it would be your net worth.

Compiling a balance sheet is just more of what we have been doing so far; rearranging account balances by copying them into a different order. Assets first (bank balances, cash balances, debtors, unsold stock, buildings and company vehicles), then Liabilities (overdrafts, creditors, loans, mortgages), then Equity (P&L, Paid-up share capital, profit or losses brought forward from previous years). The Assets will have a debit balance, the liabilities (including equity) will have a credit balance. Add the two resulting columns up and they should both have the same balance.

Although this is a very simplified view of accounting from an initial transaction right through to its effect on a balance sheet, it shows just how simple the process really is. Before computers came along, the whole process was carried out manually exactly as above. Early software emulated this process, making things only marginally quicker by automatically adding columns. Modern software takes things a stage further by eliminating the need to post anything. All you need to enter are the original transactions.