Like it or not, accounting is one of the tasks that every business owner has to deal with. And whether you intend to do your own bookkeeping or hire professionals, you will need to become familiar with some basic accounting terms.
The Two Main Methods of Accounting
Accrual Basis Accounting: Public companies and most businesses and professionals in the United States and Canada are required by law to use accrual basis accounting, which requires revenue to be recorded when the customer is invoiced and expenses 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––revenue is recorded when the customer makes payment and expenses are recorded when paid out. It is most often used by sole proprietorships and small businesses that don't maintain 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.
Balance Sheet: A balance sheet is a snapshot of a company’s financial status at a particular point in time. 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 (in other words, assets = equity minus liabilities).
Cash Flow Statement: The cash flow statement 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's possible to show a profit on the income statement while draining cash from the business. Most companies that fail do so due to chronic cash flow problems.
General Ledger: The general ledger is the complete recording of a company’s financial transactions over the lifetime of the organization, including assets, liabilities, revenue, expenses, and equity.
Income Statement: The income statement (also known as a profit and loss statement) shows your revenues, expenses, and profit for a particular period. It's a snapshot of your business that shows whether or not your business is profitable at that point in time. The basic equation of the income statement is: revenue minus expenses equals profit or loss.
Accounting Terms Used on Financial Statements
Accounts Payable (AP): Accounts payable are amounts owed by the business to vendors, suppliers, landlords, and other service providers. These are recorded as a liability on the balance sheet.
Accounts Receivable (AR): Accounts receivable are amounts of money owed to the business by customers or clients for goods and services rendered. Because the clients have a legal obligation to pay, the amounts are entered as an asset on the balance sheet.
Accruals: Accruals are revenues that are earned but not yet formally entered into the books (such as completed but not invoiced sales) or expenses that are incoming but not received (such as goods purchased but not yet invoiced).
Assets: Assets are anything of monetary value owned by the business. Typical tangible business assets include land, buildings, equipment, cash, vehicles, accounts receivable, etc. Intangible assets include client lists, franchise agreements, favorable finance or lease agreements, brand names, patents, copyrights, etc. Assets are expressed in terms of their cash value on balance sheets.
Bad Debt Expense: Bad debts are incurred when customers do not pay amounts owed. They are recorded as an expense on financial statements.
Capital (Also Known as Working Capital): Working capital is money that a company has available to pay bills or reinvest. It is equal to the value of all current assets minus current liabilities and is considered a key measure of the health of a business.
Depreciation: Depreciation occurs as business assets such as vehicles and equipment decline in value over time due to use or obsolescence. Depreciation is an important tax deduction––a percentage of the original value of the asset can be written off every year based on the rate of depreciation.
Dividends: Dividends are distributions of a portion of company earnings to owners (shareholders) of the business. Dividends can be issued on a regular or non-regular basis and may consist of cash or additional shares in the business. For tax purposes, a business owner may prefer dividends to salary.
Equity (Also Known as Owner's or Shareholder's Equity): Equity is the amount of money invested in the company by the owners (shareholders) plus any earnings retained (not paid out to owners) minus any liabilities or any money taken out in the form of draws.
Expenses: Expenses are costs incurred by a business to generate income. Expenses can be fixed (such as rents or salaries) or variable—those that fluctuate depending on sales or production cycles.
Fiscal Year: A fiscal year is the 12-month period that constitutes the start and end of the annual financial records for a business. It does not necessarily correspond to the calendar year. For example, seasonal businesses such as farming often use a fiscal year that ends in the fall.
Liabilities: Liabilities are financial obligations owed by the company, including salaries, income taxes, rents, utilities, interest payments, and amounts owed to suppliers. Liabilities can be short or long term and are grouped on balance sheets in order of classification.
Revenue: A business' gross revenue is the sum of all monies generated through the sale of goods and services, interest charged, royalties, sale of assets, rental property, and more, before subtracting expenses.
Accounting Made Easy
If you decide to do some or all of your own accounting, there are a number of inexpensive, easy-to-learn, cloud-based accounting packages available for small businesses that can help you do some or all of the following:
- Create invoices
- Record expenses
- Be used as POS (point of sale) systems
- Make it easier to calculate, charge, and keep track of taxes
- Generate financial statements
Software is no substitute for having a solid understanding of accounting basics, though. If you're unfamiliar with these terms, be sure to study up or consult with an accounting professional to ensure you can adequately assess the financial health of your business.