10 Key Accounting Terms
Knowing the correct accounting terms and what they mean can make a world of difference when you’re deciphering financial statements and reports and determining profits and losses. It’s easy to get debits and credits confused, and it’s a must to know which documents make up a complete financial report. A ton of cash could depend on your understanding of the following basic accounting terms:
- Accounting: The methods and procedures for identifying, analyzing, recording, accumulating, and storing information and data about the activities of an entity that has financial results and for preparing summary reports of these activities internally for managers and externally for those entitled to receive financial reports about the entity. A business’s managers, investors, and lenders depend on accounting reports called financial statements to make informed decisions. Accounting also encompasses preparing tax returns that the entity must file with government tax authorities and facilitating day-to-day operating functions.
- Balance sheet: This financial statement summarizes the assets, liabilities, and owners’ equity of a business at a moment in time. It’s prepared at the end of every profit period (and whenever else it’s needed). The main elements of a balance sheet are called accounts — such as cash, inventory, notes payable, and capital stock. Each account has a dollar amount, which is called its balance. But be careful: The fact that the accounts have balances is not the reason this financial statement is called a balance sheet; rather, the name refers to the equality (or balance) of assets with the total of liabilities and owners’ equity. This financial statement is also called the statement of financial condition and the statement of financial position.
- Cash flow: An ambiguous term that can refer to several different sources of or uses of cash. This term is often shorthand for cash flow from earning profit or from operating activities. Some friendly advice: When using this term, always make clear the particular source or use of cash you have in mind!
- Debits and credits: Accounting jargon for decreases and increases recorded in accounts according to the centuries-old scheme based on the accounting equation (Assets = Liabilities + Owners’ equity, or Assets = Sources of assets). An increase in an asset is a debit, and the ingenious twist of the scheme is that a decrease in a liability or an owners’ equity is also a debit. Conversely, a decrease in an asset is a credit, and an increase in a liability or an owners’ equity is a credit.
Revenue is recorded as a credit, and expenses are recorded as debits. In recording transactions, the debit or sum of debits must equal the credit or sum of credits. The phrase “the books are in balance” means that the total of accounts with debit balances equals the total of accounts with credit balances.
- Financial reports: The periodic financial communications from a business (and other types of organizations) to those entitled to know about the financial performance and position of the entity. Financial reports of businesses include three primary financial statements (the balance sheet, income statement, and statement of cash flows) as well as footnotes and other information relevant to the owners of the business. Public companies must file several types of financial reports and forms with the Securities and Exchange Commission (SEC), which are open to the public. The financial reports of a private business are generally sent only to its owners and lenders.
- Financial statement: Generally refers to one of the three primary accounting reports of a business: the balance sheet, statement of cash flows, and income statement. Sometimes financial statements are simply called financials. Internal financial statements and other accounting reports to managers contain considerably more detail, which is needed for decision-making and control.
- Fixed assets: The shorthand term for the variety of long-life physical resources used by a business in conducting its operations, which include land, buildings, machinery, equipment, furnishings, tools, and vehicles. These resources are held for use, not for sale. Please note that fixed assets is an informal term; the more formal term used in a balance sheet is property, plant, and equipment.
- Generally accepted accounting principles (GAAP): The authoritative standards and approved accounting methods that should be used by profit-motivated businesses and private not-for-profit organizations domiciled in the United States to measure and report their revenue and expenses; to present their assets, liabilities, and owners’ equity; and to report their cash flows in their financial statements. GAAP are not a straitjacket; these official standards are loose enough to permit alternative interpretations.
- Income statement: This financial statement summarizes sales revenue (and other income) and expenses (and losses) for a period and reports one or more different profit lines. Also, any unusual gains and losses are reported separately in this financial statement. The income statement is one of the three primary financial statements of a business included in its financial report and is also called the earnings statement, operating statement, or similar titles.
- Profit: A very general term that is used with different meanings. It may mean gains minus losses or other kinds of increases minus decreases. In business, the term means sales revenue (and other sources of income) minus expenses (and losses) for a period of time, such as one year. In an income statement, the preferred term for final or bottom-line profit is net income. For public companies, net income is put on a per-share basis, called earnings per share.