Disclosure: This guest post was contributed by FLoQast, an accounting workflow automation tool designed to make accountants’ lives easier.
Here’s the short answer: The general ledger is the master listing of all the transactions recorded in an organization’s accounting system. The chart of accounts is a listing of the various accounts to be used in the accounting system to sort those transactions into meaningful categories.
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What is the General Ledger?
Until we got computers, the general ledger was literally a paper ledger book where all the transactions were recorded by hand. Today, a general ledger is a database of transactions entered using accounting software. For even a relatively small company, that database may contain thousands of entries, so making sense of that flood of transactions requires a method of sorting the data into meaningful categories.
The general ledger itself may be split into subsidiary ledgers or subledgers that contain all the detail for transaction-heavy areas such as accounts receivable or payroll. Periodically, the totals for these subledgers are posted to the general ledger. Depending on the accounting software you’re using, these subledgers may be completely invisible, or they may be modules within a program.
How Does the Chart of Accounts Help to Create Financial Statements?
Without the sorting mechanism of the chart of accounts, the general ledger would essentially be a mass of meaningless data. As science fiction writer Daniel Keys Moran said, “You can have data without information, but you cannot have information without data.” The chart of accounts is what transforms the raw data of accounting transactions in the general ledger into useful and usable information.
By sorting similar transactions into accounts, you can see what was spent on Office Supplies versus what was spent on Wages. You can verify that bank loans are being paid off and you can monitor the balances in the cash accounts. The goal is to structure the data in the general ledger into categories that help a company make decisions. The individual accounts are further aggregated into groups that appear as line items on financial statements. Office Supplies may be grouped with other overhead expenses, and Wages may be grouped under cost of goods sold or with administrative expenses, depending on the nature of the underlying labor. Those line items are then further aggregated into the broad categories of the financial statements: Assets, Liabilities, Equity, Revenue and Expenses.
What’s in the Chart of Accounts?
In general, the chart of accounts will hold three basic types of information for every account that a company uses: an account number, account detail, and the name of the account.
Account Number:
It’s optional to assign each account a unique number, but as an organization grows, it’s helpful for making sure that transactions are going into the correct buckets. Account numbers — which may also include letters — commonly follow a standard order of numbering, with initial digits designating the following categories:
1 – Assets
2 – Liabilities
3 – Equity
4 – Income or Revenue
5 – Cost of Goods Sold
6 – Overhead Costs or Expenses
7 – Other Revenue
8 – Other Expenses
Very small companies may only need three- or four-digit account numbers to cover all the accounts they need, but large companies may use account numbers with six or more digits, and possibly a three- or four-digit extension to designate a location or other information.
Some organizations use their account numbering system as an additional layer of information to help sort, identify, and categorize accounts. A well-designed numbering system makes it easy to slot in new accounts as the need arises.
Account Detail
This identifies where in the financial statements a particular account should be categorized. For example, within the assets category, cash accounts will be reported on a separate line from accounts receivable and from fixed assets. The account detail also ensures that Income statement accounts don’t end up on the balance sheet, and vice versa. Making sure each account goes into the correct type is crucial for creating accurate and useful financial statements. Most accounting software has options for setting these up so that every account ends up in the right place.
Account Name
This should be specific enough so you can easily identify which transactions should be entered in that account, but not so granular that there are too few transactions to be helpful for decision making. As a company grows, you may need to add additional accounts to break transactions into smaller, more meaningful categories. Keep in mind that your accounting system may provide additional ways to track data with tags or other identifiers, so your chart of accounts may not need to do all the heavy lifting.
How to Design a Chart of Accounts
When designing a chart of accounts, consider meaningful levels for making decisions. Each company will develop its own, unique chart of accounts that will provide information in categories that are relevant for that company and its industry.
For example, let’s consider Lisa’s Luscious Lemonade, which makes and sells various kinds of lemonade at the local farmer’s market: Traditional, Extra-Sweet, Sugarfree, Raspberry, and Blueberry. If Lisa wants to see which kinds are the biggest sellers, and which should perhaps be discontinued, she may want accounts for each of those categories. If Lisa expands her operation beyond the farmer’s market, she may want additional accounts to track her sales to various outlets. A well-designed chart of accounts will provide Lisa with as much — or as little — detail as she needs. It will also be helpful for the accountants and bookkeepers so that they know exactly where each transaction needs to be recorded.
Transforming Data into Information
The chart of accounts is the key to sorting the flood of transactions in the general ledger into financial statements and reports for management. It transforms data into information. It helps decision makers see what’s working in their business so they can course correct as needed. It’s also crucial for meeting the requirements of regulatory compliance.
Without a chart of accounts to transform the data in the general ledger into information, we would not be able to perform the basic function of accounting: to provide useful information for making business decisions.
Summing It All Up
If the general ledger paints the picture of how your business operated during the period, then the general ledger is the canvas onto which everything rests. For more advice and answers to your accounting questions, check out our other articles throughout this website and follow FloQast.
