Glossary of Accounting Terminology
Whether you're a seasoned professional or just starting your journey into the world of entrepreneurship, this comprehensive guide will help you navigate its intricate terminology with clarity and confidence.
Accounts Payable
The term accounts payable (AP) refers to the amount of money your company owes to its vendors or suppliers for goods or services that were purchased on short-term credit.
Accounts payable is also the name of a General Ledger Account listed as a Liability on the company's Balance Sheet. Its balance represents the vendor invoices that you’ve received but haven’t paid.
WHY: Accounts payable is an important indicator of a company's financial health because it represents its ability to meet its financial obligations.
A high level of accounts payable may indicate that the company is experiencing cash flow problems or is not managing its working capital effectively.
A low level of accounts payable may indicate that the company is paying its bills promptly and is maintaining good relationships with its suppliers.
Accounts Receivable
The term accounts receivable (AR) refers to the amount of money your company expects to collect from its clients or customers within a year or less.
Accounts receivable is also the name of a General Ledger Account listed as an Asset on the company's Balance Sheet. Its balance represents what is owed you for products or services for which you’ve invoiced but haven’t been paid.
WHY: Accounts receivable is an important indicator of a company's financial health, as it represents the company's ability to collect cash from its customers.
A high level of accounts receivable may indicate that the company is extending too much credit to its customers or that it is having difficulty collecting payments.
A low level of accounts receivable may indicate that the company is managing its cash flow effectively and is being paid promptly by its customers.
Accrual Accounting
Accrual accounting is an accounting method in which your business records revenue and expenses when they are earned or incurred, regardless of when cash is received or paid out. (The opposite of cash accounting.)
WHY: Accrual accounting provides a complete and accurate view of a business's profitability, financial position, and cash flow because it takes into account all of the economic activity of the business, including transactions that do not involve cash (e.g. depreciation of assets).
Accrual accounting is the standard method of accounting for most businesses and organizations, and it is required by generally accepted accounting principles (GAAP) in many countries.
Amortization
Amortization is the process of gradually reducing a financial obligation, such as a loan, or allocating the cost of an intangible asset, over its useful life.
For example, when you borrow money to buy a home or car, you typically make regular payments that consist of both principal and interest. Initially, a larger portion of your payment goes toward interest, but as you make payments, more of it goes toward reducing the loan balance. By the end of the loan term, you will have fully repaid both the principal and the interest. The process of amortization refers to the systematic reduction of the loan's principal amount over the life of the loan through these payments.
WHY: Amortization helps businesses and individuals ensure the cost or value of intangible items or loans is spread out over time, accurately reflecting their gradual decrease in value or their reduction of debt.
Assets
Business assets are the tangible (physical) or intangible (non-physical) resources your business owns that have a measurable monetary value and are expected to provide future economic benefits.
Assets are listed within the Assets section of the Balance Sheet according to their type:
Fixed Assets: Equipment and property.
Current* (Short-Term) Assets: Inventory and cash.
Investments: Stocks, bonds, and cryptocurrencies.
Intangible: Patents, trademarks, copyrights, and goodwill.
WHY: Assets can be used as collateral for loans or to secure other types of financing. Lenders and investors will use this information to assess the company's risk profile and potential for future growth. So, the value of a company’s assets is often used as a metric to determine the company's overall financial health.
*In accounting, the term “current” indicates that the asset has a useful life of a year or less.
Balance Sheet
The Balance Sheet is a financial statement that shows your company's assets, liabilities, and equity. It is called a balance sheet because it is based on the fundamental accounting equation:
Assets = Liabilities + Equity.
WHY: The balance sheet is a snapshot of the company's financial position at a specific point in time and is used by investors, creditors, and other stakeholders to assess the company's liquidity, solvency, and financial health, and inform financial decisions.
Capital
Capital refers to the financial resources that your company has available for both its short-term and long-term needs, to invest in its operations and fund its growth.
There are two main types of business capital: debt and equity.
Debt capital is the money that your business borrows, typically from banks or other financial institutions, and must pay back with interest over time.
Equity capital is the money that your business raises by selling ownership shares to investors, who then become part owners of the company.
WHY: Business capital is an important factor in a company's financial health because it indicates its ability to grow.
Having sufficient capital can allow a business to invest in new products, hire additional staff, expand into new markets, or purchase new equipment.
A lack of capital, on the other hand, can limit a company's ability to grow and can make it more difficult to navigate economic downturns or unexpected expenses.
Cash Accounting
Cash accounting is an accounting method in which your business records transactions based on the actual inflow and outflow of cash. This means that revenue is recognized when cash is received, and expenses are recorded when cash is paid out, regardless of when the underlying activity took place. (The opposite of accrual accounting.)
WHY: Cash accounting is a straightforward method of accounting that is commonly used by small businesses and self-employed individuals. It is simple to understand and can provide a clear picture of a business's cash position. However, it may not accurately reflect a business's financial performance, as it does not take into account non-cash transactions, such as the depreciation of assets, which can have a significant impact on a company's profitability.
In some countries, cash accounting is an allowable method of accounting for small businesses that meet certain criteria. However, larger businesses and corporations are generally required to use the accrual method of accounting, which records transactions when they are incurred or earned, regardless of when cash is received or paid out.
Cash Flow
Cash flow refers to the movement of cash in and out of your business over a specific period of time, typically a month or a year, and is a metric that reflects the amount of cash your business has available to meet its financial obligations, pay its bills, and make investments.
WHY: Effective management of cash flow is essential for the financial health and sustainability of a business.
Positive cash flow indicates that a company is generating more cash than it is spending.
Negative cash flow indicates that a company is spending more cash than it is generating.
Cash Flow Statement
A cash flow statement is a financial statement that shows the sources and uses/inflows and outflows of cash and cash equivalents over a specific period of time.
It is divided into three sections based on activity type:
Operating: Cash received from customers (revenue) and paid for expenses.
Investing: Cash received from the sale, or paid for the purchase, of new assets.
Financing: Cash received from issuing debt or equity or paid for debt repayment.
WHY: The cash flow statement is an essential tool for assessing a company's financial health as it provides valuable information about a company's liquidity, solvency, and financial flexibility. By analyzing the cash flow statement, investors and creditors can make informed decisions that impact a company's ability to meet its financial obligations, pay dividends, and invest in future growth opportunities.
Cost of Goods Sold (COGS)
Cost of goods sold (COGS) is an expense type and critical financial metric that refers to the direct costs associated with the manufacturing, production, or purchase of the goods that your company sells, including
Cost of materials,
Non-payroll labor (e.g. freelancers and contractors), and
Any other expenses directly related to the production or purchase of those goods, such as shipping costs or import duties.
WHY: Knowing the cost of goods sold is crucial for proper financial management, tax compliance, pricing strategies, and profitability analysis. It provides valuable insights into a company's financial health and helps stakeholders make informed choices to optimize performance and profitability.
Credits & Debits
Credits and debits are part of the double-entry accounting system, which ensures that your company's accounting records remain in balance.
Here's how credits and debits work:
Debit
Debits are used to record increases in assets and expenses and decreases in liabilities, equity, and revenue.
Debits are often associated with actions like:
Receiving cash or assets.
Incurring expenses.
Reducing liabilities.
Credit
Credits are used to record increases in liabilities, equity, and revenue, and decreases in assets and expenses.
Credits are often associated with actions like:
Borrowing money (increasing liabilities).
Receiving payments from customers (increasing revenue).
Depreciation
Most assets lose value over time due to factors like wear and tear, obsolescence, or aging. Depreciation is an accounting method that recognizes this and distributes the cost of your tangible assets over their estimated useful lives.
As an asset loses value, the monetary equivalent of that loss is recognized as an expense on an income statement. The asset’s book value (carrying amount) on the balance sheet is decreased by the same amount.
It's important to note that depreciation is a non-cash expense. It represents the allocation of a cost already incurred when the asset was acquired; no actual cash is exchanged when depreciation is recorded.
WHY: Depreciation allows a business to match the cost of acquiring assets with the revenue they generate over their useful lives. Plus, many tax authorities allow businesses to deduct depreciation expenses for tax purposes, reducing a company's reported profit and, consequently, tax liabilities.
Dividends
Dividends are payments made by a corporation to its shareholders as a distribution of the company's profits or earnings. Dividends are typically paid out in cash, but they can also be in the form of additional shares of stock or other property.
The decision to pay dividends is typically made by the company's board of directors, and the amount and timing of the payments are determined by the company's dividend policy. Some companies may choose to pay dividends regularly, such as quarterly or annually, while others may pay dividends only in certain circumstances, such as when the company has excess cash or when profits have exceeded a certain threshold.
WHY: Dividends are an important factor in a company's financial health, as they provide a return on investment for shareholders and can help to attract and retain investors. Companies that pay regular dividends are often seen as stable and reliable investments, while those that do not may be viewed as more speculative. However, paying dividends can also limit the company's ability to reinvest profits in the business, which could affect its growth potential over the long term.
Double-Entry Accounting
Double-entry accounting is a fundamental accounting method that is widely used in business and finance to record and track financial transactions. It is based on the concept that every financial transaction has at least two equal and opposite entries, known as "debits" and "credits."
The primary purpose of double-entry accounting is to ensure that a company's accounting records remain in balance and that the accounting equation is maintained:
Assets = Liabilities + Equity
Here's how double-entry accounting works:
Each financial transaction is recorded with at least one debit entry and one credit entry.
Debits and credits are used to record increases or decreases in various accounts on the company's general ledger.
Debits are typically recorded on the left side of the ledger account, while credits are recorded on the right side.
Debits increase assets and expenses but decrease liabilities, equity, and revenue.
Credits increase liabilities, equity, and revenue but decrease assets and expenses.
The total debits must always equal the total credits. This balance ensures the accuracy and integrity of financial records.
WHY: The data from the general ledger, including debits and credits, are used to prepare financial statements such as the income statement, balance sheet, and cash flow statement. These financial statements provide a comprehensive view of a company's financial performance and position.
Double-entry accounting offers several advantages, including accuracy, transparency, and the ability to track and analyze financial transactions effectively. It is the foundation of modern accounting and is used by businesses, organizations, and accountants worldwide to maintain reliable financial records and make informed financial decisions.
EBITDA (Earnings Before Interest, Taxes, Depreciation, & Amortization)
As its name implies, EBITDA represents your company’s earnings or profit before factoring in certain non-operating expenses and financial factors (e.g. interest, taxes, depreciation, and amortization).
WHY: EBITDA is often used by analysts, investors, and lenders to evaluate a company's operational efficiency and profitability because it provides a clear view of how the company's core business is performing. It can be particularly useful when comparing companies in the same industry, as it eliminates some of the variations that may arise due to differences in financing, tax strategies, or accounting methods.
Equity
Equity refers to the ownership interest or residual value that the owners or shareholders of your company have in the business. This includes the initial investment made by the owners or shareholders, as well as any additional capital contributions made over time, retained earnings, and any other adjustments to the equity account.
Also known as shareholders' equity or owner's equity, it is reported on the balance sheet of a company's financial statements. Its total amount represents the net assets of the company, which is the difference between the company's total assets and its total liabilities. (This number can be either positive or negative.)
WHY: Business equity is an important financial metric, as it represents the value of the company and is used to calculate financial ratios such as return on equity (ROE).
A high level of equity can indicate a healthy financial position for the company.
A low or negative level of equity can indicate financial distress or other issues that may require attention from management.
Expenses
In the accounting world, the term “expenses” refers to the costs that your business incurs as a result of its operations.
Some common examples of business expenses include office lease payments, employee salaries and benefits, utilities, office supplies, travel and entertainment expenses, advertising and marketing expenses, insurance premiums, and legal and professional fees.
WHY: In general, a business can deduct its allowable expenses from its revenue to calculate its taxable income, thereby reducing the amount of taxes that it owes to the government.
However, not all expenses are deductible, and the rules regarding deductibility can vary depending on the type of expense and the tax laws in the jurisdiction where the business operates.
General Ledger
A general ledger is a comprehensive record-keeping system that serves as the central repository for your company’s financial data.
The general ledger is organized into individual accounts, each representing a specific category of transactions. Common accounts include cash, accounts receivable, accounts payable, revenue, and expenses.
Every time a financial transaction occurs within your business (sales, purchases, loans, and other financial activities), it is recorded in the general ledger.
WHY: The data in the general ledger is used to generate financial statements, including the balance sheet, income statement (profit and loss statement), and cash flow statement. These statements provide a snapshot of the company's financial health and performance.
The general ledger also plays a crucial role in audits and financial compliance as it provides a comprehensive and transparent record of all financial activities, making it easier for auditors to verify the accuracy of financial statements.
General Ledger Account
A general ledger account, often simply referred to as an "account," is a specific record within your company's general ledger that tracks the financial transactions related to a particular type of activity or financial item.
With each transaction entered, the balance of the account is either increased or decreased. This running balance reflects the current financial status of the account.
WHY: These accounts are the building blocks of a company's accounting system and are essential for tracking, managing, and reporting a company's financial activities accurately. When combined, they make up the general ledger, which is used to generate financial statements and provide a snapshot of the company’s financial health and performance.
Gross Profit / Gross Income
Gross profit, also called gross income, is the difference between the revenue earned from the sale of goods and the cost of producing or acquiring those goods (COGS).
Gross Profit = Revenue – Cost of Goods Sold
WHY: Knowing your company’s gross profit margin can provide insight into the efficiency and profitability of its operations.
Liabilities
Liabilities are the obligations or debts that your business owes to others as a result of its operations.
Liabilities are reported on your company’s balance sheet. Business liabilities can be short-term, such as accounts payable or payroll expenses, or long-term, such as mortgages or loans with extended payment terms.
WHY: Liabilities represent the amount of money that the business owes to others and can impact the company's overall financial health, as well as its creditworthiness. A business with high levels of debt or outstanding liabilities may be seen as higher risk by lenders and investors, which could affect its ability to secure financing or negotiate favorable terms.
Overhead
Overhead, a more specific term for expenses, refers to the ongoing expenses that your business incurs as a result of its operations but which are not directly tied to the production of a specific product or service.
Overhead costs can include expenses such as rent, utilities, salaries for administrative staff, insurance, and office supplies, among others. These costs are typically fixed, meaning they remain relatively constant regardless of the level of production or sales.
Overhead costs are distinct from direct costs, or cost of goods sold, which are expenses that can be specifically attributed to the production of a product or service, such as materials and contract labor costs.
WHY: In general, a business can deduct its overhead expenses from its revenue to calculate its taxable income, thereby reducing the amount of taxes that it owes to the government.
Profit / Net Profit / Net Income
Net profit, also known as net income, is the amount of money your business made after accounting for its expenses. This is how it’s calculated:
Net Profit = Revenue – COGS – Overhead – Taxes – Other (Depr., Amort., etc.)
It is reported on your company's income statement and is used to calculate financial ratios such as return on investment (ROI) and earnings per share (EPS).
WHY: Net profit tells your creditors more about your business health and available cash than gross profit does. When investors want to invest in your company, they will refer to the net profit of your business to check whether it is worth investing their money.
Profit & Loss Statement (P&L) / Income Statement
A profit and loss statement, also known as an income statement, is a financial document that shows your company's revenues, expenses, and net income (or net loss) over a specific period of time.
WHY: This document is used by investors, lenders, and other stakeholders to determine the company's profitability, its ability to generate cash flow, and its overall financial health.
Retained Earnings
Retained earnings refers to the portion of your company's profits that has been kept by the company instead of being given to you or any of its shareholders.
Retained earnings are reported on the balance sheet of your company's financial statements, and represents the cumulative total of earnings that have been retained for all time.
WHY: This accumulation of profits is often seen as a sign of financial stability and success. By reinvesting a portion of its profits back into the business, a company can fund various activities, such as research and development, expansion, debt reduction, and capital investments, without the need to raise external capital. This gives the company flexibility and independence in pursuing strategic opportunities and indicates a commitment to long-term sustainability.
Revenue
Revenue refers to the total amount of money generated by your business or organization from the sale of its products or services, as well as any other income earned from its operations, such as interest earned on investments or rent received from property owned by the business.
WHY: Understanding your business’s revenue is vital for assessing financial performance, making informed decisions, attracting investment, managing taxes, and planning for the future. It serves as a cornerstone of financial management and guides your business toward sustainable growth and profitability.
Taxable Income
Taxable income is the portion of your business’s revenue that is subject to taxation by the government.
More than just sales, taxable income can include various sources of income, such as:
Salary and wages
Rental income
Interest and dividends from investments
Business profits
Capital gains from the sale of assets
Pension and retirement income
Certain government benefits
Taxable income is divided into different tax brackets, each with its own tax rate. As income increases, the tax rate may increase as well. Tax brackets vary by country and tax system, and they may also vary based on filing status (e.g., single, married, head of household).
WHY: Taxable income is the amount of income that is used to calculate tax liability. Knowing your taxable income allows you to accurately estimate your tax liability and plan for your financial future.
Working Capital
Working capital, a subset of capital, refers to the money your company has to fund its day-to-day operations, pay bills, purchase inventory, and handle unexpected expenses.
More specifically, it represents the difference between your business’s current assets (such as cash, accounts receivable, and inventory) and its current liabilities (such as accounts payable and short-term debt). The formula for calculating working capital is:
Working Capital = Current Assets − Current Liabilities
WHY: Working capital measures the company's short-term liquidity and its ability to cover its short-term financial obligations.
A positive working capital indicates that the company has enough to cover its current debts and could continue its operations without interruption should something unexpected occur.
A negative working capital is a sign of financial stress or inefficiency in managing cash flow and indicates that the company is having difficulty paying its bills.
Accounting not your forté? No problem. We’ll count the beans.
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