Accounting is the process of recording, assessing, and communicating financial transactions which helps individuals and organizations understand their financial health. This work is done by keeping track of expenses, profits, and losses. Effective accountants ensure clients understand their legal obligations, financial performance, and that they can develop budgets and plan for their future.
However, business owners need to also understand common accounting terms in order to fully grasp what their accountants are discussing. A broad understanding of the major principles of accounting can help business owners keep track of and analyze their business’s financial information. Below is a guide that includes some of the most basic accounting terms, their definitions, and industry acronyms. Business owners can use this accounting guide to better understand their accountant, financial records, and accounting software.
- Accounts Payable
Accounts payable refers to the money a business owes to its suppliers, vendors, or creditors for goods or services bought on credit. A short-term debt that must be paid back quickly to avoid default, accounts payable shows up as a liability on an organization’s balance sheet. The sum of all outstanding amounts owed to vendors is shown as the accounts payable balance on the company’s balance sheet.
- Accounts Receivable
Accounts receivable is opposite from accounts payable. Accounts receivable refers to the money owed to a business, typically by its customers, for goods or services delivered. For example, a distributor may buy a washing machine from a manufacturer, which creates an account payable to the manufacturer. The distributor then sells the washing machine to a customer on credit, which results in an account receivable from the customer.
- Assets
Assets are resources with economic value which companies expect to provide future benefits. These can reduce expenses, generate cash flow, or improve sales for businesses. Companies report assets on their balance sheets. Asset types include fixed, current, liquid, and prepaid expenses. Assets may include long-term resources like buildings and equipment. Current assets include all assets a company expects to use or sell within one year. Liquid assets can easily convert to cash in a short timeframe. Prepaid expenses include advance payments for goods or services a company will use in the future.
- Balance Sheet
Balance sheets are financial statements providing snapshots of organizations’ liabilities, assets, and shareholders’ equity at specific moments in time. Balance sheets represent one type of financial statement used to evaluate companies’ financial health and worth.
- Chart of Accounts (COA)
A COA provides a snapshot of all the financial transactions a company has conducted in a specific accounting period. COAs help companies organize their finances and provide insight into organizations’ financial health for investors and stakeholders. COAs can include assets, liabilities, and shareholders’ equity.
- Cash Basis Accounting
Cash basis accounting is an accounting method that does not incorporate transactions until the business receives or pays cash for goods and services. This method focuses on immediate revenues and expenses. This contrasts accrual accounting, which recognizes income at the time the revenue is earned and records expenses when liabilities are incurred regardless of when cash is received or paid.
- Gross Profit
Gross profit, also called gross income or sales profit, is the profit businesses make after subtracting the costs related to supplying their services or making and selling their products. Accountants calculate gross profit by subtracting the cost of goods sold from revenue. Gross profit considers variable costs, not fixed costs. Analysts can look at gross profit as indicative of a company’s efficiency at delivering services or producing goods.
- Profit and Loss Statement (P&L)
A profit and loss statement, also called an income statement, shows the expenses, costs and revenues for a company during a specific time period. This financial statement, along with the cash flow statement and the balance sheet, provides information about a business’s financial health and ability to generate profit.
- Net Income
Also called net earnings or net profit, net income is the amount an individual or business earns after subtracting deductions and taxes from gross income. To calculate the net income of a business, subtract all expenses and costs from revenue. Sometimes called the bottom line in business, net income appears as the last item in an income statement. Investors and shareholders look at net income to assess companies’ financial health and determine businesses’ loan eligibility.
- Retained Earnings
Retained earnings, also called an earnings surplus, refers to the amount of net income left for a business to use after paying dividends to its shareholders. A company’s management typically decides whether to keep the earnings or give them to shareholders. Retained earnings carry over from the previous year if they are not exhausted and continue to be added to retained earnings statements in the future.
While this accounting terminology guide barely touches the surface of accounting terms, this guide may assist business owners in understanding their financial information. We do encourage you to become familiar with more than these 10 terms as there are many more, but we hope this will be a good starting point for important information.
A preliminary understanding of accounting may assist business owners in realizing the necessity or benefit in hiring professional accountants to help them with their business’s finances. Understanding your company’s financial statements will allow you to feel comfortable working with accounting professionals and asking them questions. Being able to interpret your financials can also help operationally by identifying areas that may need changes.
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