Whether you’re running your own business or trying to understand the inner workings of a business you want to invest in, you need to understand the language of business – accounting. Here are 8 basic accounting terms to help you get started:
An asset is anything your company owns that can bring an economic benefit. The simplest assets are things like cash, investments, receivable accounts you will collect later, or physical inventory you can sell. However, there are many other assets that are less tangible. For instance, things like copyrights, trademarks, and patents allow a company to earn money from its intellectual property. All of these are considered intangible assets.
Physical objects like equipment, vehicles, and even the buildings the company uses (if owned) are all considered assets.
Liabilities are opposite assets. Liabilities are what your company owes.
Loans and accounts payable are common examples of liabilities because they’ll cost you money in the future when you repay them.
In addition to accounts payable, there are a number of other things that can also be payable. For instance, interest, wages, or taxes can all have an accrued liability amount that you’ve accumulated but haven’t yet paid. In the meantime, these are liabilities.
While accounting these days is almost entirely done in computers, we still use terms like “ledger” and “journal entry” from the days of paper accounting.
Every journal entry impacts at least two accounts to show the effect of a transaction. Many entries are now automated by accounting software, but there are times when you’ll need to make a manual entry to adjust account balances. For example, you may use a depreciation journal entry to record the monthly depreciation on a fixed asset.
One of the three major financial statements you need to understand is the balance sheet. Financial statements give critical knowledge of the health of a business that’s useful both to business owners and investors.
Balance sheets show a company’s liabilities and assets (objects owned vs. objects owed) and the balance between the two. When you weigh assets against liabilities, you can see the amount of equity the owners have in the company.
Since the balance sheet deals with assets and liabilities, they offer a snapshot of a specific point in time. Typically, this occurs at day-end of the last day of the month or year and will be shown at the top of the balance sheet so you know what period you’re looking at.
Often called the product and loss — P&L — statement, the income statement shows revenue versus expenses over a specific period of time, giving you a clear picture of your profits (or losses). Unlike the balance sheet, the P&L covers a period rather than a specific point in time. Typically, a P&L will be run for a month or year.
The term “bottom line” comes from the income statement. After factoring in all the revenues and expenses for the period, the bottom line of the income statement arrives at the net income of the company.
Cash Flow Statement
Cash flow statements are the third and final major financial statement. Cash flow is crucial to the survival of a company, and it can be very different from profit. The cash flow statement starts from net income and works backward to filter out accrued income and expenses, leaving only the actual movement of cash in and out of the business.
For example, accounts receivable would be subtracted and accounts payable added back to zero in on only the actual cash transactions. Many other non-cash items like depreciation and amortization are also adjusted. The end result is a statement that shows exactly how much cash moved in and out of your company for the period in question.
The cash flow statement breaks these cash transactions down into three categories, dividing investing, operating, and financing activities. This gives a clearer picture of where cash is coming from and where it’s going.
In everyday language, we may think of depreciation as something decreasing in value. But in accounting, it’s a bit more complicated than that. Depreciation is the process of spreading out an asset’s cost over its estimated useful life. For instance, if you have a vehicle that’s likely to be replaced after 5 years, you’d spread its purchase price out over the full 60 months, even if you paid for it all at once.
While depreciation represents the using up of the asset, it doesn’t necessarily mean the asset is worth less. It simply means that you decrease the balance recorded on your books little by little until it reaches zero.
At the end of each month, the books need to be closed out in preparation for a new month. One of the most crucial steps of the monthly close is account reconciliation.
Account reconciliation involves matching your accounting records against an external source like a bank or mortgage statement. When opening and closing balances match up, you can be fairly confident that everything is recorded as it should be. If something is off, you can dive into the account line-by-line to find the discrepancy and correct it.
Use these 8 accounting terms to better understand your business or evaluate a business you may be thinking of investing in.
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