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Opening the Kimono π of Business: the General Ledger
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This π is an incredible post from last year by one of my favorite RETwit accounts, Bethany. And one that proves the point that being able to read a general ledger is a superpower not reserved just for accountants. There's a reason that getting the general ledger is one of the most powerful components of due diligence - it tells you both sides of every transaction recorded for that year. And it can help you see things that you'll miss just looking at the financials. β What Is It?Every accounting system is based on "double entry accounting" - or the concept that business financial statements are really an equation. Assets = Liabilities + Equity (Equity includes previously retained earnings and the net income or loss of the current period) That means that if you receive cash, the other side of the equation must be recorded to keep everything in balance. So you'll either record an increase in income (like Sales) or an increase in liabilities (like Deposits). Over the course of a year, there forms a "log" or "ledger" of these transactions. When you group each side of the transaction by the account it was recorded to, you arrive at a general ledger. You will also have a beginning balance (last year's ending for balance sheet accounts, $0 for income statement accounts) and ending balance sub totals. And with the magic of the accounting equation, you'll be able to tell if you have a complete set of books by seeing if all the debits (left hand side) equals credits (right hand side). It's kind of like having your wife's credit card statement π instead of just the amount due - painful sometimes but necessary. β How to Use It?Revenue Analysis Bethany does a killer job explaining one way to use it - by looking for unusual activity in the income (rent) accounts. To do this same exercise, navigate to the "income" or "rental income" account grouping in the general ledger report. You'll be able to quickly see the dates, amounts, and descriptions of income (rental) activity. You'll also be able to see if there were charge-offs or write-offs of income that represent bad debt. π If the company just reversed the entry instead of recording full bad debt expense, you'll be able to see it here. Journal Entries Another great use is to check on the quality of the accounting. A firm I was at previously once assigned the audit partner responsibility over the firm's financials. By the next month, everything was recorded with manual journal entries because he couldn't figure out how to use the system. You'll be able to search by manual entries or journal entries and see what "overrides" are being made by the accounting team. This indicates possible weakness in controls or accounting ability to record transactions naturally. The worst ones are seeing manual journal entries hitting the cash account. Equity Activity I'm a big fan of the Statement of Cash Flows - but it's not always done right by small accounting systems. So another general ledger hack is to skim down to the equity section (retained earnings, partner's capital, shareholder's equity, owner's equity, contributions, distributions, etc.) and look at the activity posted in those accounts. π It should show any distributions made and the timing of those distributions - e.g. did they miss Q1 and Q2 distributions and only make Q3? It would also show any contributions made by ownership - did they need to make equity infusions to keep the business afloat? If so, how often? As Bethany pointed out in her review, this would show if ownership was contributing "rent" to cover tenants missed or late rent. Lastly, this section is another good indicator of quality of financials. If you see a lot of manual journal entries posted here, it could be a sign that accounting is not on the same page with their auditors. P&L Netting You can bury a lot of one-off transactions you don't want to explain by coding it right. π₯ We use the general ledger to review for any "negative" income or "negative" expense items that are buried in the details. These are transactions that are small enough to get "absorbed" by the total of transactions in any given account - but may indicate something unique that needs more attention. This could be like a settlement payment coded to revenue, legal fees picked up a costs of good sold, or interest income coded against interest expense. You'd be surprised how many of these little transactions we found during an audit that ended up requiring significant disclosure and footnotes. Subledgers and Overrides An accounting system should tie to itself. That's a confusing statement if you've never been knee-deep in it. But it can happen pretty easily. For example, if I pull up the balance sheet and find my accounts receivable amount, I should be able to pull an AR Aging that ties to that same amount. The AR Aging is an example of what we call a subledger. It's a supporting report of the amount you see on the balance sheet and it should tie (or agree). It can get out of balance when "top line" entries - or manual entries βοΈ - adjust these amounts without updated the subledger activity. A common time this happens is when accounts receivable are written off with a journal entry but the invoice isn't credited in the system. This will result in a lower accounts receivable balance on the balance sheet but the AR Aging will show the original amount without the adjustment. When these don't tie, it's indicative of a subpar accounting process. β Reading a general ledger for alpha is not a skill limited to accountants. Like the tweet at the top, it is a critical part of due diligence and can save headaches and pain down the road. π«‘ π₯ Hottest Finance Posts This Week π₯β
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