42 Common Accounting Terms Explained for Small Business Owners
Business owners need to know about important accounting terms. This is important so that they understand the financial statement prepared by outsourced bookkeeping providers.
Learning accounting terms should be high on the list of priorities, particularly for small business owners. Here are some of the common accounting terms that you should be aware of to understand the information provided by professional bookkeepers.
1. Bookkeeping
Bookkeeping refers to recording and reporting financial transactions. The bookkeeper generally records transactions using generally accepted accounting principles (GAAP). Most reliable bookkeepers use computer software that saves time and effort in recording financial transactions. The use of accounting software by bookkeepers also reduces the chances of errors.
2. Financial Statements
Financial statements are prepared to find out the financial position of a company. Lenders, investors, and business owners read the financial statements to gauge the financial health of a company.
3. Auditor’s Report
Auditor’s report refers to the report prepared by internal or independent qualified accounting. The auditor will review the financial statements prepared by the bookkeeper. Some of the financial documents that are reviewed by the accountant include:
- Financial Statements (Profit and Loss Report, Balance Sheet, Cash Flow Statement)
- Review reports
- Ledger report
- Attestation reports
- Review reports
- Procedure reports
The responsibility of the auditor is to verify that the financial statements are prepared as per the accepted rules. The auditor will also make sure that there are no anomalies in the reports. Getting the accounts reviewed by an external auditor is important to reduce the risk of fraud.
4. Accounts Receivable
Accounts receivable is the amount you owe from your customers. It is an asset that is shown on the balance sheet. The account receivable amount increases when you sell goods on credit. The amount decreases when the customer pays back the amount due.
The following accounts receivable journal entry is made at the time of credit sales.
Accounts Receivable (Debit) 5000
Sales (Credit) 5000
When customers who buy on credit pay back the amount due, the following journal entries are made.
Cash (Debit) 5000
Accounts Receivable (Credit) 5000
5. Accounts Payable
Accounts payable is the amount you owe to your vendors. It is shown in the balance sheet in the liability section. The account receivable payable increases when you buy goods on credit. The amount decreases when you pay back the amount due.
The following accounts payable journal entries are made at the time of credit sales.
Purchases (Debit) 5000
Accounts Payable (Credit) 5000
When you pay back the amount due to vendors, the following journal entries are made.
Accounts Payable (Debit) 5000
Cash (Credit) 5000
6. Accounting period
Financial statements are prepared for a particular accounting period. The accounting period of a company is generally one year.
In the US, the accounting period typically starts on January 1 and ends on December 31. But the accounting period of the US government begins on October 1 and ends on September 30. The accounting period of a company is also known as the fiscal year.
7. Cash-Based Accounting
Cash-based accounting is based on the concept of recognizing transactions when cash is paid or received. For instance, suppose that a company sells goods on credit on 21st July. The customer makes the payment for goods on 01st August. The company bookkeeper will record the expense on 01st August.
Now suppose that a company buys goods on 01st September. The company pays for the goods on 01st October. Under the cash-based accounting method, the transaction is recorded when the payment is made – i.e. 01 October.
8. Accrual-Based Accounting
Accrual-based accounting is based on the concept of recognition of transactions when they occur. The revenues are recognized when they are certain. In contrast, expenses are recognized when they are likely to occur.
Suppose that you sell goods on credit on 21st September. The customer makes the payment for goods on 01st October. As per the accrual-based accounting method, the transaction will be recorded on 21st September.
9. Balance Sheet
A Balance Sheet is a type of accounting statement that is prepared by the bookkeeper. The financial statement summarizes the assets, liabilities, and capital of the company. This statement is prepared based on the following formula.
Assets = Liabilities + Capital
The assets section of the balance sheet shows current and long-term assets. Current assets include assets that can be easily converted. Examples of current assets include cash, inventory, and accounts receivable.
In contrast, long-term assets are assets that cannot be readily converted to cash. Examples of long-term assets include buildings, furniture and fixtures, and computer equipment.
The other side of the balance sheet includes liabilities and capital. Liabilities can also be current or long-term. Current liabilities include the amount that is due within a year. Contrarily, current liabilities are amounts due more than one year.
Lastly, the balance sheet shows the capital invested in the business. The capital amount is increased when additional capital is invested in the company. This section also includes a retained earnings section. The profit that is not distributed to owners or shareholders increases the retained earnings amount.
10. Working Capital
Working capital refers to the amount available to meet business expenses. The amount is calculated by deducting current assets from current liabilities. The working capital represents the liquidity of the company. A company with a negative working capital will have to rely on external funding to meet business expenses.
11. Cash flow Statement
The cash flow statement reflects the inflow and outflow of cash. The cash flow can be from investments, financing, and operations.
The cash flow can be positive or negative during a month. A positive cash flow occurs when the cash inflow is greater than the cash outflow. A business with a positive cash flow won’t have to rely on lines of credit.
In contrast, a negative cash flow occurs when the cash outflow is more than the cash inflow. A business with a negative cash flow will be forced to rely on a bank loan. This will result in a high cost of operations that cannot be sustained for a long time.
12. Profit and Loss Statement
The profit and Loss Statement shows the net profit or loss sustained by a company during a particular period. The statement shows the income and expenses of a company during a particular period.
The income section consists of sales revenue and additional income earned by the company. The expenses section includes all the expenses incurred during a period that include rent expenses, utility expenses, depreciation expenses, and others.
13. Depreciation
All assets of a company are depreciated based on their useful life. Companies use different methods to calculate depreciation expenses.
The depreciation expense is deducted from the sales revenue. The IRS allows companies to depreciate equipment, machinery, vehicle, furniture, and building.
Companies are allowed to use the modified accelerated cost recovery system (MACRS) for determining depreciation expenses. Under this system, companies can use either the straight-line method or the double-declining method.
The most common method is the straight-line method. The depreciation expenses can be calculated by dividing the book value of the asset by the estimated useful life. It is called a straight-line method as the depreciation expense remains the same each period.
The double declining method involves calculating the depreciation rate, and then multiplying double the depreciation rate with the net asset value each year. This method results in a higher depreciation expense during the initial years.
14. Cost of Goods Sold (COGS)
Cost of Goods Sold (COGS) refers to the expenses required to make items ready for sale. The cost is a direct cost that is subtracted from the revenue to arrive at the gross profit figure. The nature of the cost depends on the type of business.
COGS for manufacturing companies typically include labor and raw material used in producing the goods. Service companies generally don’t mention COGS in the profit and loss statement.
15. Dividends
Dividends are issued by registered companies to shareholders of the company. Shareholders are investors who have purchased shares of a company. The dividends are announced during the annual general meeting (AGM) of the company.
Companies issue dividends in different forms. The dividends are commonly issued as stock shares and cash payments. Some companies also offer dividends in the form of a property to attract investors.
16. Single Entry Bookkeeping
The single-entry bookkeeping technique is generally used by small businesses. The method involves a single debit or credit entry for each transaction.
17. Double-entry bookkeeping
Double-entry bookkeeping involves making debit and credit entries for every transaction. The method involves the use of an accounting equation.
18. Accounting Equation
The accounting equation is the foundation of the double-entry accounting system. The following is the simplified version of the accounting equation.
Assets = Liabilities + Capital
In the above equation, assets are items of significant value owned by a company. The liabilities refer to debts owed by a company, and capital is the amount invested in the company.
19. Fixed and Variable Costs
Variable costs are one of the two important methods used by companies to determine cost. These are important accounting terms that you need to understand. The fixed cost refers to the cost that remains fixed regardless of the production volume. Examples of fixed costs include rent, utility costs, and salaries.
On the other hand, variable costs vary depending on the volume of production. The variable cost will be higher when the production volume is higher.
20. Gross Profit/Gross Margins
Gross profit or gross margins are also important accounting terms that you need to understand. The gross profit amount is calculated by deducting the cost of goods sold from revenues. The overhead expenses are not included in calculating the gross profit or margins.
Gross profit refers to the amount that is left after subtracting the cost of manufacturing an item or providing a service.
21. Liquidity Ratio
The liquidity ratio determines the financial position of the company. The ratio gauges the ability of the company to meet its financial obligations. The liquidity ratio is typically calculated by dividing the current assets by current liabilities. A company must improve its liquidity ratio to avoid bankruptcy.
22. Customer Invoice
Customer invoice refers to the invoice issued to customers. The invoice contains information about the goods sold. It shows the value of the goods and the payment terms. Generally, invoices are issued in B2B transactions. In contrast, receipts are issued in B2C transactions.
23. Generally Accepted Accounting Principles (GAAP)
GAAP is the accounting standard that is set by the Financial Accounting Standards Board (FASB). All registered companies are required to enter financial transactions in the books using the GAAP.
GAAP includes accounting principles, procedures, and standards issued by the FASB. All registered companies in the US must comply with the GAAP when preparing accounting statements. Make sure that your bookkeeper knows how to make accounting entries in compliance with the standards and principles.
The accounting standards influence the method used by companies to record expenses. The standards also specify the approach to recording expenses. For instance, the conservatism principle specifies that revenues should be recognized as soon as they become certain while expenses should be recognized when they are likely to occur.
The materiality principle specifies that companies disclose all significant income and expenses. There is no hard and fast rule for implementing the principle. But most bookkeepers consider income or expense as immaterial if they are less than 2 to 3 percent of the net revenues.
24. Return on Investment (ROI)
Return on Investment (ROI) refers to the expected return from an investment. The ROI is calculated by deducting the initial investment value from the returns received during a period. Investors look for projects with a positive ROI.
25. Taxable Income
Taxable income refers to the income of a company that is taxable. The taxable income rate is specified by the IRS. The taxable income is multiplied by the tax rate to calculate the tax due during a period.
26. Inventory Turnover
Inventory turnover is an accounting terminology that refers to the number of times the goods purchased for sales are sold during a particular period. In other words, it is the rate at which the company sells goods compared to the inventory at hand.
27. Accounts Receivable Turnover
Accounts receivable turnover reflects how quickly a company can collect the amount due from customers.
28. General Ledger
The general ledger contains a record of all the accounting transactions. The ledger is a type of repository of all transactions. The ledger can be maintained manually or using accounting software.
The balance amount in the ledgers at the end of a period is transferred to the next period by making an appropriate accounting entry. Bookkeepers prepare financial statements using the balance amount in the ledgers.
29. Inventory
Inventory refers to the number of goods for sale held by the company. The inventory of a company can be in three stages.
- Raw material
- Work-in-progress
- Finished products
You need to manage the inventory using the appropriate inventory control methods. The three important inventory control methods include ABC Analysis, Economic Order Quantity, and Inventory Production Quantity.
30. Economic Order Quantity (EOQ)
EOQ is one of the most popular methods of determining the optimum quantity of goods to order. This method is suitable when the unit inventory price, order cost, and demand rates don’t change significantly.
Companies can use the method to determine the number of goods that results in minimum ordering and holding costs. The optimum inventory order under this method is calculated by taking the square root of two times the cost of order and demand rate and dividing the figure by the holding cost.
31. Inventory Production Quantity (IPQ)
Inventory production quantity (IPQ) specifies the optimum number of items you should order in a batch to reduce the order and holding costs. The method assumes that the supplier delivers the order in installments instead of a single batch.
32. ABC Method
ABC method allows determining optimum order based on the level of importance. This inventory management model categorizes items to be ordered into A, B, or C, depending on how important they are in the production process.
33. Just in Time Method
Just in Time Method involves ordering goods whenever they are required. The method results in minimum holding costs since items are ordered only when they are needed during production. The con of this method is that it increases the ordering cost.
34. Journal Entries
Bookkeepers make entries in the journal to record transactions. Each journal record is dated and contains debit and credit entries. The journal entries are transferred to the corresponding ledgers.
35. Inventory Costing Methods
Accountants use different methods to value inventories. The three most common methods for valuing inventories include the Last in First Out (LIFO), First in First Out (FIFO), and Weighted Average Costing (WACO) methods.
The LIFO method assumes that the last item bought is the first to be sold. The cost of the latest product bought in the inventory is reported as the cost of goods sold.
The FIFO method assumes that the first item bought is the first to be sold. The oldest cost is used to calculate the cost of goods sold.
The weighted average is the most common method used to value inventories. The method involves assigning values to inventory based on the average weighted cost of items bought. This method is generally used when the items sold by a company are similar. Bookkeepers calculate the inventory value using this method by dividing the cost of units available for sale by the number of units on the shelf. The resulting average per unit cost is used to value the cost of goods sold and ending inventory.
36. Overhead
Overhead refers to the indirect cost incurred in running the business. Examples of overhead costs of a company include utilities, rent, office supplies, and administrative expenses. Depreciation expenses are also a type of overhead expense.
The overhead costs are deducted from the gross profit figure to determine the taxable income. The tax rate is applied to the taxable income to determine the tax due to the IRS.
37. Amortization
The amortization concept is similar to the accounting concept of depreciation. The only difference is that amortization applies to non-tangible assets such as goodwill and patents. The method to calculate amortization is similar to the method of calculating depreciation.
38. Bank Reconciliation
Bank reconciliation is a method of reconciling bank statements with the company ledger account. Accountants compare the bank statement sent by the bank with the general ledger. It involves tallying each entry on the bank statement and the ledger to ensure that no transaction is unrecorded.
39. Book Value
Book value refers to the value of the asset recorded in the ledger. The value refers to the original cost of the asset. The book value can be different from the market value of the asset.
40. Market Value
Market value refers to the value of the asset at which it will be sold in the market. The market value can be higher or lower than the book value.
41. Equity
Equity refers to the stake of the owner or shareholders in the business. The equity in a business can also be determined using the accounting equation. Bookkeepers can determine the equity of a business by deducting liabilities from assets.
The equity of a business must be positive. Negative equity is a major danger sign. It means that the company will not be able to meet the business liabilities and default on loans.
42. High-low method
The high-low method is used by companies to determine the efficiency of operations. The method involves comparing the highest and the lowest costs at different activity levels. The method allows a company to know whether it is operating efficiently.
Conclusion
The above accounting terms define the basics of bookkeeping. Understanding the accounting terms is important so that business owners know how to make the most of the bookkeeping records. A solid understanding of these terms is important to make an informed decision based on financial statements.
Maxim Liberty is a professional outsourced bookkeeping service provider. Our accountants can prepare accounting statements based on GAAP standards. Contact us today to know how we can streamline the bookkeeping process for your company.
