Accounting is key to understanding your business's financial health. It involves recording, communicating, and assessing financial transactions. However, it also comes with many accounting business terms or industry acronyms that can be tough to follow. Whether you have an accountant on your team or not, it's useful to have a basic understanding of the terminologies so you can assess your small business's financial situation.
To help you have a solid foundation on accounting terminology, here's a list of 30 accounting terms small business owners must know. Read on for definitions and practical, real-world examples so that you know how the term applies to your business practices.
Every accounting statement will have an accounting period, including balance sheets, income statements, and statements of cash flow. It represents the period covering the information you reported in the statements.
There are usually two accounting periods: calendar year and fiscal year. Whichever period your business chooses, you should stick to the same timeframe so that you can compare your accounting statements over different periods.
The calendar year accounting period starts January 1st and ends on December 31st. The fiscal year period starts on the first day of any other month during the year. You also don't need to have your accounting period be a full year. For example, your business can have a half-year accounting period that starts January 1st and ends June 30th. The next period will then start July 1st and end on December 31st.
Accounts payable (AP) are funds your business owes others on an invoice that is "payable" by your business. Basically, you will record any invoice your business receives as an AP. On the balance sheet, the AP will be listed under "current liabilities" since it's an amount you're still responsible for paying.
For example, if you order $200 worth of office supplies from a vendor, they will send you an invoice for this amount, typically due in 30 days. You will record $200 as the AP for that vendor and only close it out once you pay the invoice.
Examples of using this term in a sentence include:
● It's best to have an accounts payable system that ensures your business doesn't have liabilities on your books for an extended time.
● His job is to process all the accounts payable promptly.
Accounts receivable (AR) are funds that a third party owes your business. Typically, it's the money owed to you for services and goods used or delivered that a customer has not paid for yet. However, these funds can be from companies, banks, or anyone who borrowed money from your business. It will be recorded on your balance sheet or accounts chart under the "current assets" section.
For example, suppose your business provides website development services. Once you complete the project and deliver it to your customer, you will send them an invoice. The amount on the invoice is an account receivable for you until the invoice is paid.
Examples of using this term in a sentence include:
● Your business should manage how long it takes to collect accounts receivable from customers.
● The business improved its accounts receivable and increased its cash flow.
An accrued expense is another form of liability your business has and needs to pay. However, the difference between an accrued expense and AP is that you haven't received an invoice for these costs. You will record them on your balance sheet as a liability the moment you incur the expense. Sometimes they are also referred to as spontaneous liabilities or accrued liabilities.
Some examples of accrued expenses your business might have include:
● Employee vacation or sick days, which you owe the employee but they haven't used yet
● Utility expenses where you won't get a bill until the next month
● Cost of a customer submitting a future return or repair under warranty
Allocation, also called "cost allocation" in accounting, refers to the distribution of costs your business incurs across different departments or inventory items. It's a method used to control costs that are shared across the business.
For example, health care insurance costs for your employees can be allocated across different teams in your business. If your business has 50 employees and your sales team has five employees, you can allocate 10% of the insurance cost to the sales team. You might also hear this term used in reference to "budget allocations." This is the process of designating specific amounts of funding for an item, project, or program.
The allocation amount refers to the limit the person authorized to charge expenses to that budget line can't exceed. For example, suppose you allocate $2,000 to your marketing team's advertising budget for the quarter. The budget line item is advertising costs, and the team can't spend more than $2,000 on advertising for that quarter unless additional allocations are made.
Assets are any resource your business owns that is valuable and expected to provide future benefits. It can be tangible or intangible items and typically represents something you can convert into cash. However, cash is also an example of an asset.
Assets can be current or fixed. Current assets can easily turn into readily accessible cash, while fixed assets are there for the long-term and won't be converted within your next accounting period. For example, any equipment your business owns is a fixed asset that can take time to sell but still has the potential of offering you future benefits.
Examples of using this term in a sentence include:
● Purchasing land in this area is an asset that will increase in value over time.
● You must identify all your business assets and value them before selling the business.
A balance sheet is a common financial statement that provides an overview of your business's finances. You will report your business liabilities, assets, and shareholder equity on your balance sheet. Overall, it summarizes what your company owns and owes at a particular period and shows how much cash you will have if you sell all your assets and pay all your debts.
Sometimes, balance sheets are called "statements of financial positions." A properly recorded balance sheet can help you secure investors and loans by portraying your financial health. It's also a useful financial statement for small businesses to:
● Evaluate your risks and returns
● Make business decisions and avoid overspending
● Figure out why your business isn't showing increasing equity
● Help with tax preparation
Examples of using this term in a sentence include:
● The business is financially healthy as evident by a strong balance sheet
● Irregularities in the balance sheet bring up evidence of theft.
Book value (BV) refers to the value of an asset recorded on your balance sheet. It helps determine your company's value by presenting the difference between your total assets and total liabilities. There are different ways to calculate it, including:
● BV = Total assets - intangible assets - liabilities
● BV = historical cost - accumulated depreciation
For example, suppose your business purchases a piece of equipment costing $2,000. If it's estimated to have a 5-year useful life, the equipment will depreciate by $400. So, at the end of the year, the book value of the equipment will be $1,600, i.e., $1,600 = $2,000 - $400
In accounting, cash flow (CF) is used to describe the amount of cash your business generates or uses within a period. It balances your incoming and outgoing cash, including any cash equivalents. When you have "positive cash flow," it means the money your business generates is greater than the money you have going out. You will typically see this recording on a cash flow statement.
There are different types of cash flows, including operating, financing, and investing cash flow. You may also hear people mention a cash flow forecast. This is calculated by looking at the beginning cash your business has, adding the projected income minus the projected outflows.
For example, if your business has $1,000 and expects to earn $2,000 and pay $500 in costs, the ending cash of your cash flow forecast will be: $2,500 = $1,000 + $2,000 - $500.
The cost of goods sold (COGS) helps your business determine the "true cost" of a service or product you sell. It looks at all the direct costs required to produce a product or deliver a service. This includes material and labor costs. COGS will not include any indirect costs, such as marketing, sales, or overhead costs.
You will record your COGS as a business expense on your income statement since it's the "cost of doing business." Generally, when your COGS increase, your net income decreases. Therefore, you want to try and keep your COGS low, so your net profits are higher.
For example, if your business provides cleaning services. The COGS to clean one house will include the cost of:
● Cleaning supplies
● Transportation to customer
● Employee wages
While you may assume credit means the ability to purchase something on your credit card and pay it later, the term is defined differently in accounting. Credit refers to any record of money that is flowing out of an account.
Credits are recorded on the right side of an accounting journal that tracks all financial transactions your business makes. Credits will typically increase numbers on your revenue account on your income statement and your liability and equity accounts on your balance sheet.
For example, suppose you have an account ledger for your marketing budget. If you purchase a Google Ad, the cost of the ad will be recorded as a credit to this budget account.
Debit and credit come hand-in-hand in accounting terms. A debit is the opposite of credit. It refers to any record of money that is flowing into an account. A debit can also be a record of any asset your business receives.
Debits are recorded on the left-hand side of your accounting journal. You will reflect debits on an asset account on your balance sheet and the expense account on your income statement. By accurately recording your debits and credits, you can ensure your books are balanced at the end of each accounting period.
For example, suppose you purchase a new computer. You can enter this additional office equipment as a debit in your asset account since it's an asset gained. Whereas the money used to buy the computer will also be recorded as a credit that reduces your expense account.
Depreciation refers to a method in accounting that allows your business to allocate the cost of a physical asset over its life expectancy. By calculating depreciation, your business can determine how much of an asset's value is used up.
For example, suppose your business purchases a vehicle for $40,000. Instead of writing off the entire cost within the first year of purchase, you can allocate the vehicle cost over its useful lifetime. If you expect the vehicle to last ten years, the depreciation would be $4,000 each year, and you can expense it as $4,000 for your current calendar accounting period.
Diversification helps your business manage risk, letting you allocate capital across various assets. That way, one asset's performance doesn't dictate the performance of all your assets. Basically, you're spreading your investments over different industries and fields. The term diversification is used most in investment portfolios.
For example, if you have a portfolio of stocks in one company only, your entire portfolio will be negatively impacted if that stock does badly. In contrast, having diversification in your portfolio means you have multiple stocks from different companies as well as bond options. If stock prices fall and bond prices rise, it won't impact your diverse portfolio as negatively.
Equity in accounting refers to the portion of your company that the owners and investors own. You can calculate this by subtracting your liabilities from your assets, i.e., Equity = Assets - Liabilities
For example, suppose you're paying a mortgage for your business property. You submit the final payment, so there are no more liabilities to the bank. In this case, you can say, "with this final payment, we now own 100% of the equity in our business property."
Although the expense and cost of the terms are sometimes used interchangeably, there's a specific difference in accounting. An expense is a type of cost your business incurs to create revenue. It's also a cost that your business regularly spends to pay for something and directly impacts your business profitability. Expenses will typically show up on your profit and loss statement.
Although a cost can be a purchase of an asset, an expense is anything paid for that your business needs to earn revenue. For example, expenses include:
● Any fixed amount you must pay monthly even if you make no sales, such as utility costs
● Raw materials required to create a product
● Employee wages to keep your business open
A fixed cost (FC) is a cost your business has that doesn't change depending on the decrease or increase in the number of services provided or goods produced and sold. Your business needs to pay FC regardless of what is going on with your business activities that generate revenue.
Examples of fixed costs your business might have include:
● Employees who have salaries (as opposed to hourly wages)
● Rent costs or mortgage payments
● Property taxes
● Some utilities not directly associated with producing goods or providing services
Gross margin (GM) refers to the ratio or percentage of revenue that exceeds your business's costs of goods sold (COGS). It shows how well your business generates revenue compared to the costs involved in producing or providing a product or service. A high GM indicates your business is effectively managing revenue for every dollar of cost.
The formula to calculate gross profit margin is: GM = (Revenue - COGS) / Revenue
For example, if your business provided landscaping services that gave you a total revenue of $1,000 and the COGS for providing those services was $400, your GM will be 60%, as shown in the formula below. This result means your business is earning $0.6 for every dollar of revenue earned.
0.6 (or 60%) = (1,000 - 400) / 1,000
Gross profit (GP) shows the amount of money your business earns after subtracting the costs associated with producing or providing your products or services. Although gross GP is sometimes used interchangeably with gross margin (GM), the terms are different.
Both are determined from your business income statement. However, GP is an absolute amount, whereas GM is a percentage or ratio.
The formula for GP is: GP = Net sales - Cost of goods sold (COGS)
Net sales are like revenue, which is the total amount of money your business generates from sales. However, it can also include deductions or discounts from returned products. If your net sales amounts to $1,000 and your COGS is $400, your GP will be $600.
Your income statement is sometimes called a profit and loss (P&L) statement. This financial statement shows your expenses, revenues, and profits over a specific accounting period. The statement typically earns revenue at the top, and all your costs are subtracted from this total until you reach a result: your net income.
It's used to track your revenues and expenses to see how well your business is operating. You can also use your IS to determine areas in your business that are over or under budget.
Income statements are usually generated monthly or quarterly. Suppose your total revenue for a particular month is $5,000, and your expenses are $1,000. A typical single-step income statement for this scenario will have your company name, the month the statement is covering, and data presented as follows:
● Revenue: $5,000
● Expenses: $1,000
● Net Income: $4,000
Interest is any amount of money you pay on a line of credit or loan that is in addition to the principal balance. The principal balance is the original loan amount or line of credit that is still unpaid. Therefore, the interest is the cost the lender is charging for you to have the line of credit or loan.
For example, if you take out a small business loan of $20,000 and pay off $5,000 of this amount, your principal balance is $15,000. The interest rate is typically determined when you take out the loan. If your interest rate is 5%, this means you must pay an extra 5% of the principal balance as a fee for having the loan.
Inventory refers to anything held or owned by a business that can be sold to earn a profit. It's considered an asset for your business, so it's good to understand how much inventory you have. Any inventory purchases made will be recorded in your operating account and reported as a current asset on your balance sheet.
Inventory can include goods, material items, merchandise, or stocks. In the service industry, inventory can refer to intangible things required for completing a sale. For example, if your business is in the hotel industry, any vacant rooms are considered inventory. Since inventory is often a commodity you haven't sold, this potential income can also be a loss if you have too much inventory and can't sell it all.
To use this term in a sentence, you might say:
● The shoe inventory shows that some of the shoes included in the record are missing from the store.
● The department released an inventory list detailing the number of furniture available for sale in the store.
Any debt that your business hasn't paid off is considered a liability. Liabilities will typically be reported on your balance sheet and listed on the right side to indicate the money that your business owes. Examples of liabilities include:
● Wages owed
● Principal balance of loans
● Accounts payable
● Taxes owed
● Mortgage debt
The following is an example of how liability may be used in a sentence: "After looking at the business financials, Mary realized the business could not afford the liability of buying upgraded equipment."
Your business's net income (NI) is the dollar amount of the profits earned.
The formula for your NI is as follows: NI = (Total revenue + gains) - (total expenses + losses)
Revenue is the money your business makes, including active and passive income sources. It can be interest income, royalty payments, advertising income, or revenue earned from selling a service or product.
The gains are any money you earn from selling a long-term asset. Losses include money you lose from selling a long-term asset as well as any loss from non-operating activities such as unusual one-time costs or lawsuit payments.
Examples of expenses you will report when calculating your NI include:
● Costs of goods sold (COGS)
● Administrative expenses
● Employee wages
● Rent or mortgage payment
● Interest paid
For example, suppose your total revenue is $5,000, and your total expenses are $2,000. Additionally, your business sold an asset for $1,000 today when you purchased it for $900 five years ago. Your gain is $100.
If you also sold a piece of equipment for $200 when you bought it for $500 five years ago, then your loss is $300. Using these numbers, your NI will be $2,800, as shown in the formula below: $2,800 = ($5,000 + $100) - ($2,000 + $300)
While net income is an absolute number, net margin is a ratio or percentage. It measures the amount of profit or net income your business generated as a percentage of your revenue. It helps your business understand whether you're gaining enough profits from sales and determine if your overhead and operating costs are contained.
Net margin is an important indicator of how financially healthy your business is.
You will want to divide net income by revenue and convert it into a percentage to calculate net profit. For example, if your business has a revenue of $20,000 and a net income of $12,000, your net profit will be 0.6 or 60%. This number means that your business earns 60 cents in profit for every dollar collected.
Sometimes described as "on credit," on account indicates a partial payment of money owed. When customers buy something on account, they pay nothing or part of the cost up front and will pay the rest later. On-account purchases will be recorded as accounts payable.
Once the money is paid, it's called "paid on account." Usually, these purchases are those made on credit or as part of payment installations.
For example, if your business purchases a new computer worth $2,000 and sets up four payment installations with $500 required up front, the remaining $1,500 will be on account for the computer store. An example of using this term in a sentence is: "The customer made a payment on account for the provided services worth $100."
Overhead is any ongoing business expenses you have that are not directly related to creating a product or providing a service. They will be listed as a current liability on your balance sheet since they are usually paid quarterly, monthly, or weekly.
There are typically two types of business overheads: administrative or manufacturing. They can also be variable costs, semi-variable costs, or fixed costs.
Examples of overhead costs your business might have include:
● Legal fees
● Accounting fees
● Office supplies
● Travel costs
● Telephone bills
Return on investment (ROI) is a common business term used to help you understand how profitable an investment is.
Originally it meant the profit your business is making, divided by the investment you put in. This produces the following formula: ROI = Net profit / Cost of Investment
Today, you will hear people use ROI for returns on various objectives and projects within a business. For example, suppose your business spent $1,500 on Google Ads that led to increased sales and $3,000 worth of profit. In this case, you can state that your ROI on Google Ads spending is 50%.
By understanding the ROI of the projects or strategies your business uses, you can better determine if something is worth spending more money on in the future.
You can think of revenue as any income an organization or business makes. It's the money earned from sales or other regular business operations. You can calculate revenue by multiplying the average sales price of a product or service with the number of units sold or services provided.
For example, if you sell ice cream at $5 per tub and sell a total of 20 tubs, your revenue is $100. Examples of how this term can be used in a sentence include:
● The government's main revenue is from taxes.
● After closing for a week, the restaurant lost revenue due to emergency kitchen repairs.
● My business is looking for an additional source of revenue.
Variable cost (VC) can be seen as the opposite of fixed cost since it will increase or decrease depending on the change in the number of services provided or goods produced and sold. Typically, the more services you provide or products you produce, the higher your VC will be.
For example, suppose your business produces vinyl signs, and each sign uses $2 worth of materials. When you make 100 signs, your variable cost will be $200. However, if you produce 500 signs, your variable cost will increase to $1,000.
Examples of variable costs besides raw materials include:
● Packaging costs for products
● Commissions on goods or services sold
● Hourly wages of employees
● Utilities directly related to providing goods or services, such as gas used to travel to customers
● Costs of goods sold (COGS)
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