No matter what industry you’re in, there are buzzwords. From chefs to health care professionals, web developers to booksellers, there’s a lot of jargon out there. Whatever your small business is, you’ve got a few words you likely use that no one else will understand unless explained.
The same goes for accounting, which is why we’re here to help. If you’re a small business and are jumping into working with an accountant or using accounting software (like us), there will be a few terms you’ll need to know.
We gathered some of the ones we thought everyone should have in their back pockets, so think of this as your own cheat sheet to understanding accounting jargon like a pro.
Accounting 101 Terms
When an accounting period ends, there is a series of steps that must be taken to prepare a business’ books for the next accounting period to start. This series of steps is called the accounting cycle, and it includes things like posting journal entries to the general ledger, creating trial balances, and making closing entries.
“Close the Books”
Accounting used to be done by hand in physical ledgers, or books. Today, when we say “closing the books,” we simply mean taking the final steps in the accounting cycle to prepare financial statements.
A general ledger is a total record of all of your business’ financial transactions, both debit and credit included. This document is required to prepare all financial statements.
Chart of Accounts
Your chart of accounts shows all the accounts that you might debit or credit when a transaction occurs. It’s like a key to reading your general ledger.
Cash Basis Accounting
There are two methods of accounting: cash accounting and accrual accounting. Cash accounting is the simpler method of the two, but it’s hard to get a clear picture of how your business is really doing using it. For that, you’d turn to accrual accounting.
Accrual Basis Accounting
This is the standard accounting method for most companies. The key difference between cash basis accounting and accrual is when revenue and expenses are recognized. Under the accrual accounting method, you must record expenses and revenue as you accrue them, regardless of when cash for the good or service is actually exchanged. Cash accounting records these transactions as soon as cash changes hands (hence the name).
In short, if you sell anything on credit using invoices, you should probably use accrual accounting.
Accounts Receivable (A/R)
Accounts receivable is the amount of money your customers or clients owe you for goods or services you’ve provided—but that they have not yet paid. Accounts receivable are legally enforceable claims and appear as assets on your balance sheet.
When you send an invoice for work you’ve done, that money you’re owed falls under accounts receivable until that amount has been paid. Then, it will simply be classified as cash.
Accounts Payable (A/P)
Accounts payable is defined as the money your business owes creditors or suppliers and is considered a liability. This liability is recorded on your company’s balance sheet (more on that below).
Commonly confused, the terms bookkeeping and accounting do not mean the same thing. Bookkeeping is the act of recording transactions properly in a business’ accounting file. This means posting transactions to the general ledger and to the proper accounts. This work is typically handled by a bookkeeper—not an accountant.
Get to Know the Basics of Bookkeeping
The hardest part is getting started. We’ll show you the way.
CPA stands for Certified Public Accountant. If you see this abbreviation after someone’s name, it means that they’re a trained and certified accountant and that they’ve passed rigorous tests to prove it.
Generally Accepted Accounting Principles, or GAAP, are a set of guidelines and rules that govern how businesses handle their accounting. It’s worth noting that the United States is one of the few countries to follow GAAP. Most other countries follow a similar method called the International Financial Reporting Standards, or IFRS.
As part of the process of “closing the books,” an accountant will create a trial balance to check their work. This essentially means making sure that all debits equal all credits. If not, a mistake was likely made somewhere and the accountant will make adjusting journal entries to remedy it.
Every time a transaction is made, whether money is spent or received, journal entries are made in the general ledger and corresponding accounts. Every journal entry should have two components: a debit and a credit. This means that every time a transaction takes place, at least one account will be debited and another will be credited.
Debits tend to increase the amount in a given account.
Credits tend to decrease the amount in a given account. Though this is a broad generalization.
Unearned revenue is money that your business has received, even though you haven’t done the work for it yet. When customers pay you in advance for work, that revenue is still “unearned” and is shown as a liability until the work is performed.
There are two types of costs: fixed and variable. A fixed cost is a cost that does not change regardless of how many sales your business generates. This includes things like salaries or rent.
A variable cost is a cost that does change depending on the volume of your sales. For instance, when the demand for your product increases, the cost of materials to meet that demand will go up, too.
Income Statement Terms
Reading and understanding your financial statements is one of the most useful weapons in a business owner’s arsenal. The income statement and balance sheet are the two primary financial statements, but the cash flow statement is often lumped in with them.
We’ve compiled all the terms that are typically associated with each statement here. Beware: there are many terms that mean the same things in this section.
Income Statement, or P&L Statement
Case in point: the income statement is a report that also goes by the profit and loss statement or P&L statement. All three mean the same thing, which is a report that shows the performance of your business over a set time period. The income statement shows all your revenue and costs compared to one another and how much profit was made in this time.
Cost of Goods Sold
Cost of Goods Sold, or COGS, is made up of the expenses required to create your business product or service. Things like the cost of your product’s materials or the labor required to provide your service are COGS.
When you subtract COGS from your total revenue, you’ll find gross income. Gross income is often referred to as gross profit.
Unlike COGS, which centers on how much it cost to make a product, operating expenses show the costs associated with running your business on a day-to-day basis. Things like rent and payroll would be considered operating expenses.
Net income is found by subtracting all expenses from all revenues. This means subtracting both COGS and operating expenses, along with any tax payments. It’s found at the bottom of the income statement, which is where it gets one of its more popular names: “the bottom line.”
Net income also goes by:
- Net profit
- Net Earnings
Balance Sheet Terms
Unlike the income statement, which measures performance over time, the balance sheet simply shows the current state of the business at a single moment in time. In short, it shows a summary of everything that a business possesses, owes, and owns.
The balance sheet is made up of three main categories—assets, liabilities, and equity—and relies on the accounting equation, which says that assets must equal liabilities plus equity.
Accounting Equation: Assets = Liabilities + Equity
An asset is a resource, like equipment or inventory, that will provide a future benefit to your company. You don’t have to own an asset outright, but a company’s assets are things that it possesses. For example, you may be making loan payments on a piece of equipment. Even though you don’t own it outright, you would consider the value of the equipment as an asset.
As a small business owner, it’s important to understand two types of assets: current and fixed.
- A current asset is an economic resource that is expected to convert into cash in one year. Things like cash, inventory, and accounts receivable are all examples of current assets.
- A fixed asset is a long-term economic resource, such as equipment or real estate properties that are not as easily converted into cash.
If assets are all the things your company possesses, the other side of the accounting equation shows who owns those things—you or someone else. If someone else owns it, it belongs in the liabilities section.
Liabilities are cash or goods your business owes somebody else, also known as financial debts. This can be things like loans, mortgages, and accounts payable.
Equity, or owner’s equity, describes the portion of your company that is owned by you and your investors. If you subtract your assets from your liabilities, you’re left with your business’ equity.
Retained earnings is a line within the equity section of the balance sheet that shows your company’s cumulative profits over time. If last month’s income statement showed a net income of $50,000, you would close that accounting period by moving that amount to your retained earnings account. You might then dip into this account later to finance a big purchase or pay investors.
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Cash Flow Statement Terms
Before we talk about what’s included in the cash flow statement, let’s first understand cash flow as a concept.
Cash flow describes the inflows and outflows of cash to and from your business. Ideally, you want to have a positive cash flow. The reason cash flow is tricky for business owners to understand is because accrual accounting means that transactions are recognized when incurred—not when money changes hands. This means that the income statement isn’t a useful tool for keeping track of cash. For that, we need a cash flow statement.
Cash Flow Statement
The cash flow statement, or statement of cash flows, summarizes all the cash that changed hands over a given period of time. It lumps these cash movements into three categories:
- Cash Flow from Operating Activities
- Cash Flow from Financing Activities
- Cash Flow from Investing Activities
Operating Cash Flow
Operating cash flow, or OCF, shows the cash left over after operating expenses have been subtracted. Businesses can make money in a variety of ways, but OCF is a measure of how successful a business is at bringing in revenue through their primary activities.
Managerial Accounting Terms
Most of the accounting terms listed above don’t help business owners analyze their business much. While they are useful to know to ensure clear communication with an accountant, there are other items that do a better job helping business owners measure success.
In fact, all of the terms above fall into the umbrella of “financial accounting.” The goal of financial accounting is to follow GAAP regulations and produce accurate financial reports. Managerial accounting, on the other hand, includes all the efforts made to use financial information to guide decision making.
Liquidity is a company’s ability to meet its short-term debt obligations, or any debt that will be paid back within 12 months.
Solvency is a company’s ability to meet its long-term debt obligations, or any financing or borrowed monies that will be paid back after 12 months.
To understand the differences between liquidity and solvency, check out this post.
Burn rate is a measure of how quickly your business is “burning” through its cash reserves. In other words, how much money are you spending on average?
Want to calculate your business’ burn rate? Try out our handy calculator.
If burn rate is how much you’re spending, your cash runway shows how long you can continue to spend at that level before running out of cash. These are both particularly helpful metrics for (non-profitable) startups that have received funding and need to manage how they spend it.
Return on Investment (ROI) is a measurement of the financial return on a particular investment relative to its cost. The ROI formula is:
ROI = (Current Value of Investment – Cost of Investment) / Cost of Investment
Tackling Your Small Business’ Accounting and Bookkeeping
Understanding accounting terminology can feel overwhelming for anyone, but having a solid foundation is crucial for any small business owner looking to manage their business’ books themselves. Once your business has surpassed the point in which you have the capacity or knowledge to take on accounting tasks, consider outsourcing your accounting and bookkeeping services to a comprehensive online provider, such as ScaleFactor. Request a free demo to learn how ScaleFactor can best help your business reach its financial goals.