Accounting can seem like a foreign language to those without experience in the field. However, having a grasp of some basic accounting terminology and concepts is crucial for any entrepreneur, small business owner, or even personal finance. This guide will explain 30 fundamental accounting terms using clear, beginner-friendly definitions and real-world examples.
Introduction to Accounting Concepts
Before diving into specific terms, let‘s quickly cover what accounting actually entails. Accounting is the process of recording, summarizing and reporting a business‘s financial transactions. The end goal is to paint an accurate picture of a company‘s financial health and performance over time.
Some key functions of an accounting system include:
- Tracking income, expenses, assets, liabilities
- Preparing financial statements like balance sheets and income statements
- Calculating costs, profits, cash flow
- Filing tax returns
- Facilitating business analysis and planning
Now let‘s break down some must-know vocabulary. We‘ll start with the accounting equation that underpins everything else:
The Accounting Equation
Assets = Liabilities + Equity
This simple formula sums up the foundation of accounting. It shows that what a business owns (assets) is purchased by either what it owes (liabilities) or the owner‘s investment (equity). Keep this relationship in mind as you learn other key terms.
Key Accounting Terms and Definitions
Below are 30 fundamental accounting terms explained simply with examples for context.
Assets
Anything of value owned by a company, which can be further divided into current assets and fixed assets.
- Current assets – Cash or resources that can be converted to cash within a year, like accounts receivable, inventory, marketable securities
- Fixed assets – Illiquid assets with long-term useful lives like property, plants, equipment
Example: A bakery‘s ovens, delivery vans and cash balances are assets.
Liabilities
Money that a business owes to outside parties, like loans, unpaid bills, bonds, mortgages. Liabilities are settled over time through the transfer of financial resources.
Example: A shoe retailer‘s debts to suppliers for inventory purchases are liabilities.
Equity
Also called owner's equity. It encompasses a business owner‘s investment of capital into the company, retained earnings, and additional ownership rights.
Example: A florist‘s financial investment into starting up her shop represents her equity.
Revenue
Income earned from the business‘s main operations, like sales of products or services to customers. Also referred to as sales or turnover.
Example: An automobile manufacturer‘s annual vehicle sales represent its revenue stream.
Expenses
The costs associated with running daily business operations, from wages to utilities to supplies and more. Together, revenues and expenses impact profitability over a period of time.
Example: A medical clinic‘s utility bills, medical tools and staff salaries are common expenses.
Profit
The amount by which revenues exceed expenses in a given reporting period. This is a key metric reflecting a company‘s financial success and growth potential.
Example: If a consulting firm earns $500K in revenue and has $300K in expenses one year, the annual profit is $200K.
Loss
The opposite of profit – when expenses exceed revenues for a business over a reporting period. Indicates an unprofitable venture but can sometimes occur even in successful companies.
Example: A SaaS startup has $800K in expenses but just $700K in annual recurring revenue, signalling a $100K loss.
Cost of Goods Sold (COGS)
The direct expenses related to producing or purchasing the products and services sold by a company to customers. Determining COGS is crucial for setting prices and production budgets.
Example: For a furniture maker, the timber and labor costs tied to manufacturing sofas are included in its COGS.
Gross Profit Margin
A ratio showing the profitability from sales after accounting for COGS. Higher ratio = greater profitability.
Gross Profit / Revenue x 100
Example: If a jewellery business has $1.5M in revenue and $750K in COGS, gross margin is 50%.
Accounts Receivable
Outstanding invoices and money owed by customers and clients for goods or services received on credit. Getting paid on these outstanding dues is key for cash flow.
Example: Product sales made on Net 30 terms lead to accounts receivable that are expected to be collected in full within 30 days per contract.
Accounts Payable
Conversely, this represents money a business owes to its own vendors and suppliers for inventory, supplies other goods and services received on credit.
Example: A retailer buying electronics from vendors on Net 60 payment terms will list this as accounts payable for 60 days.
Cash Flow
The movement of incoming and outgoing cash in a business over a period. Analyzing cash flow patterns helps firms maintain adequate cash balances.
Example: Monthly invoices paid immediately reduce cash flow, while long-term product sales boost it.
Depreciation
The method of allocating an asset‘s cost over its expected lifecycle rather than expensing the entire cost upfront. This accounts for wear and tear over time.
Example: Rather than deduct the full $10K cost of a delivery truck in Year 1, it gets depreciated over 5 years to more accurately reflect usage.
Amortization
Works like depreciation but for intangible assets like patents and intellectual property, spreading out costs.
Example: A custom software application worth $500K may get amortized over 4 years on financial statements rather than expensed upfront.
P&L Statement
Abbreviation for profit and loss statement. A financial statement summarizing the revenue, costs, and expenses incurred over a specific period of time.
Example: Many businesses generate P&L statements monthly and yearly to monitor profitability.
Balance Sheet
A snapshot of a company‘s financial standing at a given point, outlining assets = liabilities + equity to assess solvency and net worth.
Example: Analyzing year-end balance sheets over time helps identify growth trends.
General Ledger
The master account where totals from subsidiary ledgers and business transactions are accumulated by accountants to prepare financial statements.
Example: Journals compile daily sales and purchases data that get aggregated into the general ledger.
Trial Balance
A listing of all accounts and balances in the general ledger to verify that debits match credits prior to financial reporting. Helps spot discrepancies.
Example: Accountants generate trial balances at key monthly and year-end dates to confirm accuracy.
Credit
A bookkeeping entry that increases liabilities and equity while decreasing assets. Business transactions can involve a credit, debit or both to maintain the balanced accounting equation.
Example: Recording a new loan taken would involve a credit to the liabilities section of the balance sheet.
Debit
A bookkeeping entry that increases assets and expenses while decreasing liabilities and equity. Pairs with credits in a Double-entry accounting system.
Example: Purchasing inventory for cash involves debiting your inventory assets account.
Chart of Accounts
The complete listing of every account tracked, assigned a name and number. Allows accountants to categorize transactions correctly.
Example: Codes like 100-990 can represent different assets, income sources, debts accounts in the CoA.
Accounts Receivable Turnover
A ratio showing how well a company is collecting payment owed by clients over time. Higher ratio = better credit and collection policies.
Net Credit Sales / Average Accounts Receivable
Example: $700K in net credit sales and average A/R balance of $70K indicates a 10x turnover ratio.
Inventory Turnover
A ratio gauging a company‘s efficiency in managing inventory, calculated by dividing COGS by average inventory. A higher number indicates well-managed stock levels.
COGS / Average Inventory
Example: With $500K in COGS and average stock of $100K, a manufacturer has 5x inventory turnover.
Return on Assets (ROA)
A metric tracking how profitably a company is using its assets, calculated by dividing net income by average assets. Higher ROA signals effective asset usage.
Net Income / Average Total Assets
Example: $1.5M in net income over average assets of $15M gives an attractive ROA of 10%.
Break-Even Point
The sales threshold where total revenues equal total expenses. Companies strive to surpass this point to turn a profit.
Example: If a small bakery has fixed costs of $5K monthly plus variable product costs, the unit sales BE point can be calculated.
As demonstrated above, bookkeeping involves continually categorizing transactions across these different accounts to derive actionable insights over term.
Key Takeaways as an Accounting Beginner
Grasping fundamentals is the first step in deeper finance and accounting mastery. From the accounting equation through to turnover ratios, use this guide as a reference point for common terms.
Some key learnings include:
- The balanced accounting equation helps quantify a business‘s assets = liabilities + equity at any point
- Key elements of the income statement like revenues, expenses and profit metrics are vital health indicators
- The balance sheet provides a snapshot of business health combining short and long-term assets and debts
- Statements like the P&L and balance sheet help track financial KPIs used to make strategic decisions
- Ratios like ROA and inventory turnover assess how well firms manage assets and stock respectively
Use these building blocks to have productive conversations with accountants and bankers. Over time, continue self-educating through online learning, books and real-world practice to sharpen skills. Accounting doesn‘t have to be confusing – learning core concepts like these can help demystify it for any entrepreneur.
