There are dozens of essential accounting words or phrases, which, if not described in layman’s terms, would leave you feeling confused – because it’s not your expertise. You might as well be reading Chinese or Arabic because that’s what it sounds like to you.
You’re in luck because we’ve used our secret decoder ring and compiled a handy list that’ll help you understand what the terms mean so you can properly manage your business and finances.
3 financial statements you’ll need to understand
Balance sheet
A balance sheet illustrates your company’s current financial health. It shows a summary of:
- Assets: What you possess
- Liabilities: What you owe
- Equity: What you own
Income statement (AKA Profit & loss)
Your income statement or P&L shows your business’s performance and profitability over a set period.
It begins with sales and ends with net income or loss. You can also see the cost of goods sold, taxes, gross profit, depreciation, and other financial gains and expenses.
Statement of cash flow
The statement of cash flow is the last of the three financial statement musketeers. It takes information from the balance sheet and P&L and helps you figure out where your cash went.
Specifically, the cash flow statement shows you how your cash was used in your operating, financing, and investing activities.
Balance sheet terms
Accrual vs. cash accounting
There are two methods of accounting: accrual and cash. But what’s the difference?
- Accrual accounting records revenue when it’s earned and expenses when they’re incurred regardless of when payment happens.
For example, assume you sell $1,000 of product in February, but your customer pays you in April. Under the accrual method, you’ll record the $1,000 of revenue in February.
- Cash accounting is straightforward because you recognize and record payments each time you make or receive them.
Using the same example from above, you would record the $1,000 of revenue in April when your customer paid you.
Current vs. non-current assets and current vs. long-term liabilities
Current assets are valuable items like cash, inventory, and accounts receivable that you can convert into cash quickly, usually within a year, to pay everyday expenses and fund ongoing operations.
Non-current assets aren’t easily converted into cash and include real estate, goodwill, and intellectual property. These assets help you avoid huge losses in the years when capital expansion occurs because their costs hit your income statement over several years.
Current liabilities are financial obligations like accounts payable or payroll liabilities that are due within a year. Current liabilities are paid with current assets, and if current liabilities exceed current assets, there is a liquidity problem.
Non-current (long-term) liabilities include bonds payable, long-term loans, and mortgages that aren’t due within one year. Comparing long-term liabilities against total assets will give you an idea of your company’s solvency.
Equity
Equity is the amount of capital invested in or owned by you and your investors. And it is generally broken down into two main categories: stock/owner contributions and retained earnings.
- Stock or owner contributions are the amounts you’ve invested in the company.
- Retained earnings are the accumulation of profits over time. They are the portion of your net income that isn’t paid out as dividends and remains in the business for future use.
Income statement terms
Cost of goods sold (COGS)
The cost of goods sold is the direct cost of producing your business’s products or services, such as paint, screws, wood, and direct labor. COGS doesn’t include indirect costs like shipping fees, marketing expenses, or utilities.
Depreciation
Depreciation — noted by a depreciation journal entry — is the loss of value of a tangible asset like buildings, machinery, vehicles, and furniture over time.
Recalling back to our discussion about non-current assets, the cost of these assets hit your income statement over time via depreciation. So if you buy a building for $100,000, you don’t recognize the entire cost in the year of purchase. Instead, you spread out that cost over the expected life of the building, which can be up to 20 years.
Profit margin
When you want to know how profitable your products are, check your profit margin.
It represents the percentage of your sales that has turned into profits after all expenses are taken out of your revenue. For example, if you report a 40% profit margin, $0.40 of each $1.00 of sales is income.
Net income
After removing taxes, costs, expenses, and other deductions from gross sales revenue, you’re left with net income, which is the amount your business earns and will be taxed on.
Other accounting terms you should know
Debit vs. credit
Debit and credit can be confusing depending on how they’re explained to you.
In short, debits generally represent all inflows of money to your business, and credits are the outflows.
CPA vs. EA
Still need support with accounting? Professional help is available. You can reach out to an enrolled agent (EA) or a Certified Public Accountant (CPA).
Both are knowledgeable and experienced financial experts, but they differ in their scope of work and where they’re licensed.
- The EA is licensed by the Internal Revenue Service (IRS) and specializes in taxation.
- The CPA is licensed by their applicable state boards of accountancy and can specialize in tax, auditing, accounting, financial planning, and more.
Tax credit vs. tax deduction
Nobody likes taxes. Thankfully, there are ways to reduce the tax burden on your business.
- A tax credit reduces your tax bill.
If your tax bill is $10,000, for example, a $2,000 tax credit would lower your final tax bill to $8,000. - A tax deduction reduces your taxable income for the year – not the tax bill itself.
So, if your taxable income is $50,000, a $2,000 business tax deduction would drop your taxable income to $48,000. However, the $2,000 business tax deduction won’t lower your tax bill by $2,000.
Conclusion
This isn’t a definitive list of all the business accounting terms available. Think of it as a personal cheat sheet you keep in your back pocket to help you understand accounting jargon and set you up for future success.
