Accounting Methods, Glossary, Financial Statements, & Fundamental Accounting Principles
Business owners take on many different responsibilities and every industry and business is unique. Owners may take care of the marketing, sales, management, staffing, customer service, daily operations, planning, and financial aspects of the business. Each industry and aspect of business has its own lingo that is necessary to effectively communicate. Sometimes accounting terms can be overwhelming but knowing the basics are essential for overall business success.
To assist business owners with financial operations, we have created a financial and accounting glossary which includes accounting methods, financial statements, important accounting terms, and fundamental accounting principles.
Accrual Basis Accounting
Public companies and many businesses and professional services in the United States are required by law to use accrual basis accounting. The main concept of accrual accounting is not when the money changes hands, but when the money is earned. Basically revenues are to be recorded when the customer is invoiced and expenses are to be recorded when they are incurred, rather than when the actual payments are made. Accrual basis accounting gives a more accurate picture of the long-term health of the business.
Cash Basis Accounting
Cash basis accounting is a simple method of keeping track of revenue and expenses. Many people use cash accounting in their daily lives when balancing a checkbook. The main concept of cash accounting is the actual flow of money. Revenue is recorded when the customer makes payment and expenses are recorded when paid out. This method is often used by sole proprietorships and small businesses that do not keep inventory. If the customer has credit terms, the revenue is not recorded until full payment is received, regardless of the invoice date. Similarly, if the business incurs an expense on credit, the expense is not recorded until the invoice is fully paid.
A balance sheet is a snapshot of a company’s financial position (assets, liabilities, and equity) at a particular point in time. This is the master record of a business’ finances and shows what your business owns and owes. It is organized into two main columns, with assets in one column and liabilities and equity in the other. The two sides always equal each other.
Assets = Liabilities + Equity
Cash Flow Statement
The cash flow statement measures whether your cash balance grew or shrank over the past period. It shows the movements of cash and cash equivalents in and out of the business. The cash flow statement is an important tool for evaluating business health, as it is possible to show a profit on the income statement while draining cash from the business.
The income statement (also known as a Profit and Loss Statement) shows your revenues, expenses, and profit for a particular period. It is a snapshot of your business that shows whether your business is profitable at that point in time (month, quarter, year, whichever time you pick).
The basic equation of the income statement: revenue minus expenses equals profit or loss.
Statement of Owner’s Equity
The statement of owner’s equity (also known as Statement of Retained Earnings or Equity Statement) explains the changes in retained earnings. Retained earnings are on the balance sheet and are most influenced by dividends and income
An accounting period is a specific period of time covered by financial statements. An accounting period can be one month, one quarter, or one year, depending on the business.
Accounts payable AP
This account is used to describe all unpaid expenses. AP represents the money that your business owes for goods and services. A/P can be anything from your utility bill to the rent on your office. You typically receive a bill from the vendor for these goods and services
Accounts receivable AR
This is the opposite of accounts payable. AR is money owed to your business for good and services that have been provided but that have not yet been paid. It can be considered an asset.
Accrual accounting records transactions when they occur rather than when payment is made or received. Most regular businesses use the accrual accounting method.
This is the practice of spreading the cost of an expense across multiple accounting periods on your balance sheet. A common example is depreciation. Suppose you purchase manufacturing equipment for your business. You can spread the cost of that equipment over several years.
The things a company owns in order to run the business and it has a monetary value. This can include buildings, cash, land, equipment, tools, vehicles, furniture, and inventory. Assets can have varying degrees of liquidity, how easy it is to spend, like cash. Other assets are harder to spend, like property, which first must be sold or liquidated.
This is the process by which you ensure that your general ledger (GL) accounts are in balance with your ending bank balance for a specific month.
Capital is the money that your company can use for operations and investment. It is calculated by subtracting liabilities from assets. It can include cash, but it can include non-cash assets that can be leveraged or liquidated for spending. Capital is not the measure of how much the company is spending, but rather the amount the company could spend.
Cash accounting records payments when they are received and expenses when they are paid, not when they’re incurred. Most sole proprietors and very small businesses use cash accounting, but if you have employees, you must use the accrual accounting method.
This is the amount of cash the company is expected to receive over a select time frame. Monthly cash flow is how much cash you anticipate receiving in a month.
A certified public accountant is a designation conferred by The American Institute of Certified Public Accountants. CPAs pass a uniform certified accountant exam and are licensed in their home state. The designation denotes a certain level of mastery in accounting to verify that an individual is properly qualified to work in this field.
Cost of goods sold COGS
Cost of goods sold is the direct cost of producing or purchasing the items you have for sale. This can include anything from materials and labor to the cost of a product you purchase for resale. It is important to keep track of your COGS to properly calculate your gross and net profit.
Credit is an accounting entry that is made on the right side of any accounting transaction. A credit increases a company’s liabilities or equity account and decrease its assets.
A debit is the inverse of a credit. A debit paid to a business increases its assets. A debit paid by the business decreases its liabilities. The double-entry accounting method pairs every debit and credit in the ledger.
Depreciation measures how much value an asset loses over time. A classic example is the depreciation of a company vehicle. Each year, the vehicle decreases in value. The process of lowering an asset value is depreciation.
Diversification is the process of spreading investments into varied assets. The goal is to minimize risk by reducing the percentage of assets that can lose value resulting from a single event or transaction.
Expenses are what your company pays. Generally, they are categorized as fixed, variable, accrued, or operation.
Fixed expenses (FE) are payments that are the same each period, like rent or mortgage.
Variable expenses (VE) change regularly. Labor or inventory replenishment are common examples.
Accrued expenses (AE) are expenses that have yet to be paid.
Operation expenses (OE) are indirect costs, such as advertising or taxes.
On a balance sheet, equity is determined by subtracting liabilities from assets. Owner’s equity is a different concept that describes how much of something is owned by a person or business. Property equity demonstrates how much of a mortgage is paid, while stock equity describes the percentage of a company that is owned via stock.
This is the complete record of a company’s financial transaction over the lifetime of the organization, including assets, liabilities, revenue, expenses, and equity.
Gross profit margin
Calculated by dividing a company’s gross profit by its net sales during the same period.
This is the company’s profit excluding overhead expenses. It is often used as part of the calculation to evaluate a company’s value.
Insolvency is what occurs when a company or individual cannot pay its debts. Insolvency is often projected by comparing all expenses to revenue. If revenue is insufficient to cover expenses, insolvency becomes inevitable.
Inventory is the list of sellable goods owned by a company. Inventory is usually classified as finished goods (which are ready for sale), work-in progress goods (that require assembly) and raw materials (that will become other goods in time).
liabilities are debts or money the business owes. Accounts payable, bonds, loans, taxes, unpaid bills, and accrued expenses are different types of liabilities
A limited liability company (LLC) is a business structure in which the owners are not personally accountable for company debts or liabilities.
Net profit and loss
Net profit is how much money the business has made after subtracting every single expense. Net loss is how much money the company lost after this same calculation if profit is negative.
This is the general cost of doing business, but it does not include the cost of goods that are sold. Utility payments, printing costs and property taxes are examples of overhead.
Payroll is the total compensation a firm pays its employees for a given time. It includes keeping track of hours worked, distributing payments, and dividing money for Social Security and Medicare taxes are all part of the payroll process.
Also called an earnings surplus, retained earnings are a company’s net income left over for the company to spend after paying dividends to shareholders. The management of a business usually determines whether to keep the profits or distribute them to shareholders.
Return on investment is a calculation that demonstrates how much money is made from an investment relative to its cost. An ROI can be calculated for money spent on advertising and marketing. To determine ROI, the benefit of the investment is divided by the cost of the investment.
Revenue is the total amount of money earned by the business. It is used to calculate gross and net profit.
This type of bookkeeping system tracks a company’s financial activities by recording cash, taxable income and tax-deductible costs coming in and out of the firm as one entry per transaction. Single-entry bookkeeping can be performed through accounting software or simple tables. It is far less complicated than double-entry bookkeeping, which necessitates two entries for each transaction.
Variable costs are defined as a company’s costs pertaining to the number of goods or services it produces. Variable costs increase as output goes up and decrease as output declines. In contrast to variable cost, fixed cost refers to a company’s costs that remain constant regardless of production, such as rent and insurance.
Fundamental Accounting Principles
Economic entity assumption
A business is an entity unto itself and should be treated as such.
Monetary unit assumption
All financial transactions should be recorded in the same currency.
Specific time period assumption
Financial reports should show results over a distinct period of time.
The cost of an item doesn’t change in financial reporting.
Full disclosure principle
All information that relates to the function of a business’s financial statements must be disclosed in notes accompanying the statements.
Going concern principle
A business will continue to exist and function with no defined end date.
Businesses should use the accrual basis of accounting and report all financial information using this method.
Revenue recognition principle
Revenue is reported when it’s earned, regardless of when payment is received.
When an accountant finds a transactional error, they can use their professional judgment to determine if the error is immaterial to the business.
When there is more than one acceptable way to record a transaction, expenses and liabilities should be recorded as soon as possible, and revenues and gains should only be recorded when they occur.