I think it’s important for all small business owners to know something about accounting so that they can better understand the financial, or money, side of their business; especially if you’re going to undertake your company’s bookkeeping work yourself. Just like every other industry, accounting has its own important terms. Becoming familiar with these terms will help you to better understand basic financial reports and to communicate more effectively with other financial people such as bankers and accountants.
This post explains twelve common accounting terms. My next post will explain terms related to financial reporting.
Accounts payable – is the money that you owe to your suppliers and/or vendors. It can include vendors such as utility companies, your landlord, the insurance company, and the credit card company; pretty much anyone who sends you a bill. The account balance appears on your balance sheet and is increased when you enter a bill and reduced when you record payment of the bill. Accounts payable is a liability in your chart of accounts.
Accounts receivable – is the money that is owed to you by your customers. It represents the income (or revenue) that you have earned (billed for) but not received yet. The account balance appears on your balance sheet and is increased when you generate an invoice and decreased when you record payment of the invoice. Accounts receivable is an asset in your chart of accounts.
Accrual method – is a method of keeping track of your business’ financial activities. The accrual method tracks income and expenses in the period in which they occur even though cash may not have come into or left your checking account. For example, if you sold someone your product in April but they didn’t pay you until May, you would record the income for that sale in April not May.
Cash Method – this is another method of keeping track of your business’ financial activities. The cash method tracks income and expenses in the period in which cash actually came into or left the business regardless of when the underlying transaction took place. For example, if you painted someone’s house in June but they didn’t pay you until July, you would record the income from the job in July not June. The cash method of accounting is simpler to use than the accrual method and is appropriate for smaller businesses that receive payment for their product or services at the time the transaction takes place.
Budget – is an itemized summary of all of the income and expenses that your business estimates will be realized during a given period of time. Budgets are usually created to cover the business’ normal business cycle, such as a year, but also can be done for longer or shorter periods (such as a budget for a specific project). It is used as a guide throughout the specified period to gauge operating performance and to alert the business owner of potential cash flow problems.
Capital contribution – is the money that an owner (in the case of a sole proprietor or corporation) or a member (in the case of a partnership or an LLC) contributes for the start-up of a business. It is not a loan to the business and typically is not paid back until and unless the business ends or the owner or member withdraws. Capital contributions can also be made during the life of the business if cash is needed for continuing operations and can’t be borrowed. The account balance appears on your balance sheet and is an equity account in your chart of accounts.
Chart of accounts – is a list of all of the accounts that you will use to categorize the money that comes into and goes out of your business. The main categories of accounts are income, expenses, assets, liabilities and equity. You are free to name your accounts in any way that makes the most sense to you and your business. There are basic accounts such as rent, utilities, advertising and notes payable. But in a specialized industry you may use whatever term best describes what the cash flow is for.
Deduction – this is actually a tax term not an accounting term but I find that many untrained business people use it when talking about their business finances. A deduction is something that you can subtract from income to arrive at taxable income on your tax return. Generally, business expenses become deductions on your return but not always. Some expenses are either not deductible or only partially deductible.
Depreciation – is a method of expensing the cost of large-dollar items that generally have a useful life of longer than 12 months or take longer than 12 months to use up. These types of items need to be listed in your chart of accounts as fixed assets. This is known as capitalizing or capitalization. Depreciation expense, however, is an account that appears on your profit and loss statement (P&L).
Income – also called revenue or operating income, is the money that you earn selling your product or services. Income is NOT refunds or reimbursements or money you receive from miscellaneous sources like bank interest or insurance refunds; those are classified as “other income.” Income accounts appear on your profit and loss statement. A business may have as many income accounts as they need in order to provide the level of detail that provides the most meaningful reporting.
Expense – expenses are the money that you pay out for everyday purchases and bills. Expense accounts appear on your profit and loss statement. Payments on loans and credit cards are NOT expenses; those are liabilities. It is the items that you purchase with a credit card or loan that are expenses. A business may have as many expense accounts as they need in order to provide the level of detail that provides the most meaningful reporting.
Fiscal Year – the period of time (generally 12 months) over which you measure your business’ financial performance. Your company’s fiscal year can be the calendar year (January thru December) or it can be any other period of time that best captures a full business cycle (i.e. July thru June). Your fiscal year is established at the time you start your business and does not change; unless there are extraordinary circumstances that warrant it.
I hope you find these explanations helpful. Please feel free to post a comment or question if you need additional input or if you have a term not shown above that you would like to know about.