Basic Accounting Terms Quick Guide
The language of accounting can seem perplexing at first, especially when some words that we use in everyday transactions take on different meanings in a financial context. By understanding a few dozen foundational terms, you will be on track to talk about, and manage, money with confidence.
Whether you are studying to enter an accounting career or just want to keep your personal finances in order, here are some of the most common accounting terms everyone should know. (You’ll find alternate terminology in parentheses.)
The accounting vocabulary provided here is intended for general reference and centered on US-based accounting practices. If you are seeking financial advice, we recommend talking with an accounting professional—or consider becoming an accounting expert yourself.
The process of tracking and organizing activities that involve money. You are accounting for every transaction—a monetary event—that happens. Accurate accounting results in data and reports that can be used to make informed business decisions.
The two most common methods are accrual accounting and cash accounting. The IRS does not require any particular method, but it does require that an organization use the same method from year to year.
Accrual Accounting (Accrual Basis)
An accounting method in which revenues are recorded when earned and expenses recorded as incurred, as opposed to recorded when the money involved in those transactions is received or paid (see cash accounting for the inverse).
For example: in January, Organization A provides a service for which it expects to receive payment in February. Under the accrual method, Organization A would record revenue of $100 dollars in January on their income statement along with an accounts receivable on the balance sheet. When payment is received in February, Organization A will reduce the outstanding receivable by the amount of the cash collected.
The accrual method is more complicated but results in a more accurate representation of an organization’s earnings. It gives a better long-term picture of an organization’s ability to generate cash. Generally accepted accounting principles (GAAP) require the use of accrual accounting.
Cash Accounting (Cash Basis Accounting)
An accounting method in which revenue and expenses are recorded only once money is received or paid (see accrual accounting for the inverse). As the name implies, this method is focused on cash inflows and outflows.
For example: in January, Organization A provides a service and bills the customer $100, due in February. Under the cash accounting method, Organization A does not record the $100 as revenue until the payment is actually received. So, if their customer doesn’t send a check until February, then in this case, Organization A will not recognize revenue until the cash is received in February.
The cash accounting method is less complicated but may not give an accurate, long-term picture of an organization’s rights and obligations. Individuals and small businesses are more likely to use cash accounting.
The branch of accounting that tracks an organization’s monetary activities with the goal of providing an accurate picture of its finances. Its users are external stakeholders. The transactions are compiled into financial statements that are shared with outside groups such as investors, donors, creditors, and government agencies. Three important financial accounting terms are income statement, the balance sheet, and the statement of cash flows.
Financial accounting follows generally accepted accounting principles (GAAP). Its reporting needs to be objective, accurate, and verifiable.
Management accounting (managerial accounting)
A branch of accounting that collects and reports on an organization’s financial activities with the goal of guiding business decisions. Its users are internal stakeholders. Since each organization is different, the reports generated by managerial accounting are specific to each organization’s needs. These reports are used by finance departments, management teams, and other such owners and employees. Managerial accounting does not have to follow generally accepted accounting principles (GAAP).
The process of documenting and processing transactions over a period of time in order to create accurate financial statements. Traditionally, the cycle includes:
- Documentation: Transactions are collected and documented, usually in the form of source documents.
- Journal: Journal entries are created for each transaction.
- General ledger: The journal amounts are posted to the general ledger.
- Unadjusted trial balance: A listing is created of the ending balances of all general ledger accounts, which is checked to make sure all debits and credits are equal.
- Adjustments: The trial balance should reflect only what has happened in a particular accounting period, so the balance is adjusted by applying accruals, deferrals, prepaid expenses, and depreciation.
- Adjusted trial balance: After all the adjustments are made, a new trial balance is produced and, again, checked to make sure all debits and credits are equal.
- Financial statements: The income statement, balance sheet, and the statement of cash flows are prepared, along with any other specialized statements that an organization may need.
- Closing entries: All temporary accounts are zeroed out by transferring their balances to permanent accounts, which are balance sheet accounts that continue over multiple accounting periods. This is also called closing the books.
- Post-closing trial balance: After the whole accounting cycle takes place and the entries are closed, a summary is created that lists the final balance of all permanent, non-zero accounts. This is used to begin the next accounting cycle.
You may see this cycle broken down into anywhere from 6 to 10 steps, depending on the source, and many steps are now automated thanks to accounting software.
A record that groups together similar types of transactions, such as assets or liabilities. There are five basic types of financial accounts: assets, liabilities, equity, revenue, and expenses.
Chart of Accounts
A listing of all financial accounts where an organization might book activity. It functions as the table of contents to an organization’s financial profile. Balance sheet accounts appear first, followed by income statement accounts. A basic chart of accounts might list, in this order:
- Assets (starting with cash)
- Equity (owner’s or shareholder’s)
You can add more account types or subcategories, depending on the needs of your organization.
Current or future economic benefits controlled by an organization. This can be something tangible, like cash or equipment or land, or intangible, like copyrights or patents or brands.
Assets are generally categorized by how long they will benefit an organization and then arranged in order of liquidity.
|Examples of Assets||Tangible||Intangible|
|Monetary||Cash, other forms of currency||Bonds, interest|
|Non-Monetary||Land, equipment||Patents, copyrights|
Current Assets (Short-Term Assets)
Assets that will be turned into cash within one year or one business operating cycle, whichever is longer.
Example: cash and other currency, inventory, supplies, accounts receivable, prepaid expenses
Fixed Assets (Capital Assets or Property, Plant, and Equipment)
Equipment, property, and other tangible assets that are used in the production of goods or supply of services. Fixed assets do not include inventory. Unlike current assets, fixed assets are not expected to be used within one year or one business operating cycle. Once they reach the end of their usefulness to an organization, they are written off the balance sheet.
Example: equipment, buildings, hardware and software
Assets that can be converted into cash in a short amount of time without losing much, if any, of its market value.
Example: cash and cash equivalents, stocks, bonds, money markets
Physical assets of value to an organization.
Example: cash, equipment, land
Nonphysical assets of value to an organization.
Example: Copyright, patents, goodwill
Natural resources that can be used up over the course of an organization’s business activities.
Example: water, oil, crops
Money or other financial obligations that an organization owes to someone else; what you owe. This includes cash owed or services due. Accounts that end in “payable” are usually liability accounts.
Obligations that will be paid within one year.
Example: accounts payable, taxes, short-term loans
Long-term Liabilities (Non-current Liabilities)
Obligations that will not be paid within a year.
Examples: bonds payable, accounts payable, long-term loans
Economic benefits earned through business activities, such as selling goods or providing a service.
While some people use the terms revenue and income interchangeably, they do have different meanings in accounting. Revenue refers just to the money that comes from the sale of goods and services. Income is an organization’s total revenue minus expenses. When looking at a financial statement, revenue appears at the top and income at the bottom.
A reduction in the value of an asset as that asset is used to generate revenue. Expenses appear on the income statement.
Normal expenditures associated with an organization’s regular business activities that are not directly involved in making a product or providing a service (see cost of goods sold for expenses that are directly involved). These appear on the income statement.
Example: office supplies, equipment maintenance, marketing, wages for employees not involved in production or customer service
Expenditures that fall outside normal, day-to-day business operations. These appear on the income statement.
Example: interest on a loan, moving expenses, payment to temporary workers
Cost of Goods Sold (Cost of Sales)
The direct production costs involved in making a product or service that is intended for purchase. Materials and labor are always part of this calculation, as well as allocated overhead. Despite this having “cost” in its name, this is an expense and it appears on the income statement.
Example: A bakery would include flour and a baker’s wages into the cost of goods sold calculation for their cookies, and they may also include a portion of the monthly electric bill to cover the electricity used by the mixers and ovens. But the calculation would not include stocking napkins for customers, the rent on the bake shop, or the wages of the person working the front register.
The expenses involved in running an organization. These expenditures apply to the organization as a whole, are generally static, and are incurred even if the organization does not operate for some period of time.
Example: rent, utilities, insurance, benefits, salaries
An expense that stays the same, no matter how business activity changes. These expenses do not change much, if at all, from month to month.
Example: rent, utilities, insurance fees
An expense that changes with business activity, such as production levels or number of products sold.
Example: ingredients, packaging, shipping charges
An expense that changes with business activity, such as production levels or number of products sold.
Example: ingredients, packaging, shipping charges
Expense versus Cost
An expense is a type of cost, but the two are not exactly the same. A cost is a one-time amount that is spent to acquire an asset. Think of the phrase, “How much does it cost?” Cost appears on the balance sheet.
An expense is a regular amount that accounts for using an asset over time. This could include rent on a building, depreciation of a company vehicle, or an annual salary of an employee. It appears on the income statement. Paying $2,000 for new uniforms for your sales reps would be a cost. Paying out a monthly commission to your sales reps would be an expense.
Equity is the value of a business that belongs to an owner (if a business is a sole proprietorship) or to shareholders (if a business is a corporation). For individuals, equity is how much value someone has in a personal asset.
Notice that the equity equation is a rearranging of the basic accounting equation (assets = liabilities + equity).
Money an organization owes. This account is often used when an organization makes a purchase but does not pay cash right away.
Money owed to an organization. The product has been received or the service rendered, but payment will come later.
A planned-for reduction in the value of an intangible asset over its useful or legal life. Intangible assets are items such as patents or copyrights. A percentage of an intangible asset’s total cost is applied as a monthly expense. This allows an organization to spread out the cost over time, reflecting the fact that an asset usually brings value over many months or years, instead of just at the moment that the cost occurs. Other similar calculations are depreciation, which applies to tangible assets, and depletion, which applies to mineral assets.
Balance Sheet (Statement of Financial Position)
A record of all of an organization’s assets, liabilities, and equity. A balance sheet is a snapshot of one financial point in time (as opposed to an income statement, which shows a longer interval of financial activity, like a month, quarter, or year).
A balance sheet is built on the basic accounting equation—assets = liabilities + equity—and the sections of the sheet are listed in that order. The sheet’s goal is to balance the sums of debits with the sum of all credits. It forms a trio of important financial documents along with the income statement and the statement of cash flows.
Basic Accounting Equation (Fundamental Accounting Equation)
Assets = liabilities + equity
This formula is the foundation of double-entry bookkeeping and of accounting itself. A fundamental goal of financial recordkeeping is to make sure this equation is balanced. A balance sheet is a visual representation of this equation.
A type of asset that includes currency as well as money in digital form, such as the sum in bank accounts. It is the most liquid asset.
Certified Public Accountant (CPA)
A professional title held by people who have passed the Uniform CPA Examination from the American Institute of Certified Public Accountants and who have met the licensing requirements of their state. CPAs advise and serve the public, as opposed to working for a private company.
At its most basic, the right column of a T account. When recording a transaction on the credit side using the basic accounting equation:
Assets and Expenses decrease
Liabilities, Revenue and Equity increase
At its most basic, the left column of a T account. When recording a transaction on the debit side using the basic accounting equation:
Assets and Expenses increase
Liabilities, Revenue and Equity decrease
Like liabilities, debt is money or other financial obligations that an organization owes. Debts almost always refer to financial obligations due to a bank or other lender. Debts carry a contractual obligation and can have legal consequences if not paid.
A planned-for reduction in the value of a tangible fixed asset over its useful life. Fixed assets are tangible items like buildings and equipment, and those wear out over time. Depreciation takes this into account by assigning part of an asset’s cost from the balance sheet to the income statement each year.
Applying depreciation also allows an organization to match the cost of an asset to the revenues it helps bring in, fulfilling the matching principle.
Common depreciation methods fall into two categories:
- Straight-line Method. The cost of the asset is simply divided by the number of years of its expected lifespan. The resulting quotient is applied each year.
- Accelerated Methods. The cost of an asset is divided unevenly, with higher depreciation costs applied to the early years of an asset’s lifespan. These methods assume an asset is more useful in the early part of its lifespan, and that an asset may incur more maintenance/repair costs later in its lifespan. Accelerated methods include declining balance methods and sum-of-the-years’-digits methods.
Other similar calculations are amortization, which applies to intangible assets, and depletion, which applies to mineral assets.
A reduction in the amount of a natural asset over time. Natural assets are geological items such as water or oil. These assets get used up and so depletion allows an organization to account for this. A percentage of an intangible asset’s total cost–usually the resources spent on extraction–is applied as a monthly expense. This allows an organization to spread out the cost over time, reflecting the fact that an asset usually brings value over many months or years, instead of just at the moment that the cost occurs.
Other similar calculations are depreciation, which applies to tangible assets, and amortization, which applies to intangible assets.
Spreading investments among a variety of assets in order to potentially maximize a return and to minimize risk. If one of those investments goes bad, it will have less of an effect on the overall finances of an organization.
Payments a corporation makes from its profits to its shareholders. These are usually paid as cash, but can sometimes take the form of stock.
A foundational method of accounting that requires every transaction to be recorded in two different accounts. For every increase, there is a decrease; for every debit, there is a credit. This “double-check” helps to expose errors and keep the basic accounting equation in balance. Double-entry bookkeeping is also the second of the three generally accepted accounting principles.
A professional title for experts who thoroughly know the US tax code and are licensed to represent taxpayers to the IRS. Enrolled agents are regulated by the Department of the Treasury and must either (a) pass the Special Enrollment Exam or (b) have at least five years experience with the IRS.
Equity (Net Assets)
Money that belongs to the owner (if the business is privately owned) or shareholders (if the business is a corporation) once all liabilities are paid.
Records that portray an organization’s financial situation. The three main financial statements are the balance sheet, income statement, and the statement of cash flows.
Fiscal Year (Budget Year)
A twelve-month period that doesn’t start on January 1 and end on December 31 (known as a calendar year). A fiscal year is a way to divide an organization’s financial history.
The start and end dates of a fiscal year are up to the reporting organization. For example, the US government’s fiscal year begins on October 1 and ends on September 30. A university’s fiscal year might begin on July 1 and end on June 30. A retailer may begin their fiscal year on February 1 and end on January 30, after the holiday shopping season is over.
Fiscal years are referenced by the year they start, so an organization reporting from 10/1/21 through 9/30/22 would refer to that period as FY2021 or FY21. This is usually further broken into quarters, which are often referenced as Q1, Q2, and so on.
The estimated worth of an asset or investment at a specific point in the future, using an assumed rate of return.
Generally Accepted Accounting Principles (GAAP)
A set of fundamental, generally agreed-upon rules that govern standard accounting. These are set by the Financial Accounting Standards Board. These principles create uniform standards for how financial statements should be prepared. They encourage sound, accurate reporting that is useful to outside parties. According to the Financial Accounting Foundation, all financial reports should be
- Relevant: the information is up-to-date and can be used to make business and financial decisions
- Comparable: a person examining the financial reports of multiple companies can clearly see how they measure up to each other
- Verifiable: an outside auditor could confirm that the financial information is correct
- Understandable: reports should be clearly presented in a standard format so that anyone with a basic financial background can review and comprehend them
These principles are often abbreviated as GAAP, which is pronounced gap.
A collection of all accounts and activities. This is used to create financial statements.
Money received for goods sold, services provided, or capital invested.
Net income (Accounting Income, Net Profit)
The amount of revenue left after paying all expenses. This appears at the bottom of the income statement.
Operating income (Earnings Before Interest & Taxes)
The amount of revenue left after subtracting operating expenses and cost of goods sold. This shows the true amount of profit coming from an organization’s core business activities.
Revenue that comes from outside an organization’s core business activities.
Income Statement (Profit and Loss Statement)
A report of an organization’s revenues, expenses, gains, and losses over a specified time period. This can be a week, a quarter, a fiscal year, etc. The end of the statement includes an organization’s net income or losses.
It forms a trio of important financial documents along with the balance sheet and the statement of cash flows. An income statement gives a picture of an organization’s financial activities over time, instead of at one moment as a balance sheet does.
Additional money paid to a creditor in return for a loan, based on a set percentage of the principal (the original amount of money borrowed). This is the cost of borrowing money.
Current assets that are to be sold. These include:
- Finished goods–goods ready to be sold to customers
- Work in progress–goods in the midst of being produced
- Raw materials–goods used in the process of production
A document that records the details of a transaction between a seller and a buyer. This is usually issued with a request for payment by a designated future date.
A chronological listing of an organization’s financial transactions. Each transaction is entered on a separate line. A journal entry should include:
- A unique identifying number
- The date of the transaction
- The amount involved
- The account number affected
- A debit and a credit
All journal entries must be transferred to the general ledger eventually. While journal entries should be created as soon as a transaction occurs, those entries can be transferred to the general ledger in batches.
An organization’s primary journal is called the general journal or book of original entry. Some organizations may use additional journals, called special journals.
How fast an asset can be turned into cash.
Revenues and expenses that are related to each other should be recorded on the income statement at the same time. This is a fundamental part of accrual accounting.
The time it takes for a business to turn their inventory into cash. A basic cycle would move through the following steps:
The wages, salaries, and other compensation owed to an organization’s employees. This also includes payroll taxes and other tax withholding.
An estimation of how much a future sum of money would be worth right now. Or, what current sum is needed to equal a target amount in the future, using an estimated rate of return.
This is based on the time value of money: money received in the future is less valuable, because it is not being invested and earning interest.
The profit that is left after paying out dividends to stockholders. These appear on the balance sheet.
A physical or digital record of a business transaction. These provide proof that the transaction occurred and should include, at the very least, a unique identifier, date, and amount.
Statement of Account
A listing of all transactions between a business and a customer, or between two businesses, over a period of time.
Statement of Cash Flows (Cash Flow Statement)
A record of the cash and cash equivalents moving through an organization as the organization conducts business. It is an indicator of how an organization uses money and whether it can fulfill its obligations to shareholders and debtors.
The statement of cash flows forms a trio of important financial documents along with the balance sheet and the income statement. Cash received is debited; cash paid is credited. The statement of cash flows covers the following activities:
- Operating activities—the flow of revenues received and expenses paid
- Investing activities—gains or losses on the sale of investments and fixed assets
- Financing activities—cashflows related to debt and equity financing such as bond issues, interest on loans and stock dividends paid by the organization
A basic, visual representation of general ledger accounts. The T in the name refers to the shape of the account. The account name appears at the top of the chart, and then debits are listed in the left column while credits are listed on the right. Account balances appear at the end.
|Electric bill, paid in March $200|
Time Value of Money
Money received in the future is less valuable than money received today. This is because money received in the future has missed out on earning interest.
For example, if an organization received a $10,000 payment today, that organization could reinvest that money and end the year with $10,000 + interest. They could also reinvest that money in the organization itself, hiring staff or purchasing more inventory. If an organization received the payment at the end of the year, they would just have the $10,000.
A report that lists the credit and debit balances of all general ledger accounts. This is an internal document that is usually generated at the end of an accounting period in order to make sure all credits and debits are in balance.
An unadjusted trial balance is a report generated before adjusting entries are applied. There are journal entries that ensure that the income statement and balance sheet reflect only the revenues and expenses that occurred during the accounting period, as required by accrual accounting. These entries include:
- Prepaid expenses
- Unearned revenues
- Accrued expenses
- Accrued revenues
- Non-cash expenses
An adjusted trial balance is a report generated after these adjusting entries are applied.
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