Financial Accounting

Financial accounting has its own language of terms and phrases that have very particular meanings. Their definitions are often far from intuitive, and they can often seem confusing or intimidating.

This article helps you to navigate your way through the minefield of financial accounting "speak." It provides a quick-reference glossary of words and phrases commonly used in the accounting departments of businesses and organizations, and covers the following terms:

Balance Sheet Items

• Accounts Payable.
• Accounts Receivable.
• Amortization.
• Asset.
• Balance Sheet.
• Book Value.
• Creditor.
• Current Asset.
• Current Liability.
• Debtor.
• Depreciation.
• Equity.
• FIFO.
• Fixed Asset.
• Goodwill.
• Liabilities.
• LIFO.
• Liquid Assets.
• Reserves/Reserve Account.
• Retained Earnings.

Income Statement Items

• Accrual.
• Cost of Goods Sold.
• EBIT.
• EBITDA.
• Expense.
• Fixed Cost.
• Gross Profit.
• Income Statement.
• Net Income.
• Profit and Loss Account – see Income Statement.
• Revenue.
• Statement of Cash Flows.
• Variable Cost.

Terms are defined below:

Accounts Payable

This is a current liability that represents the cash you owe to your creditors. When you make a purchase and pay for it at a later time, you have an obligation to pay that is recorded as a liability on your balance sheet. The business you purchased the item from records an account receivable in their books.

Accounts Receivable

Money owed to an organization by its customers for goods or services that they have already received, or that they have agreed you can invoice. When you extend a customer credit, you no longer have the asset they purchased. If they don't pay you right away, then the amount due is an account receivable. Accounts receivable are current assets as they are expected to be converted to cash in the short term. The business that purchased the item from you records an account payable in their books.

Accrual

An expense which is accounted for in one accounting period, but which is not actually paid for until the next. Accruals allow a business to reflect on when its expenses are incurred. Typical accruals include utility bills, which only arrive at the end of a quarter but which are accounted for monthly. When the reverse happens, and suppliers charge for services upfront that are not used until a later accounting period, the cost is accounted for in the later period as a prepayment.

Amortization

The depreciation of an intangible asset.

Asset

Anything of value that the organization owns and which can be used to generate revenue in the future. Assets can be tangible, such as inventory or equipment (which is a fixed asset); or intangible, such as patents or trademarks. Another term for assets is "economic resource."

Balance Sheet

A financial report showing the things of value that the organization owns (assets) and what it owes (to creditors and investors) at any one point in time. The daily transactions of the organization cause the balances of these items to change. For example, when you sell an item, your cash on hand (or another asset) will increase and your inventory will decrease. This is why it is a "point in time" statement. It's also known as a Statement of Financial Position and Statement of Financial Condition.

Book Value

The depreciated value of an asset at any time between its purchase and the point where it is depreciated to zero. The book value does not necessarily reflect what you would get for the asset if you sold it at that time.

Cost of Goods Sold (COGS)

The costs directly associated with the production and selling of the merchandise sold. For example, materials or sales commission.

Creditor

A person or organization that has supplied you with goods or services for which you have not yet paid.

Current Asset

Assets that can be expected to convert into cash in one operating cycle, typically one year. Current assets typically include cash, cash equivalents, accounts receivable, and inventory.

Current Liability

An obligation to pay a creditor within one year, using an existing resource or by creating another current liability (for example, a short-term bank loan).

Debtor

A person or organization to whom you have supplied goods or services, but which has not yet paid you for these.

Depreciation

A method of spreading the initial purchase cost of a tangible asset over the period for which it remains useful. Tax authorities generally stipulate an acceptable depreciation period for certain items. When "straight line" depreciation is used, the purchase cost is spread equally over the depreciation period. Depreciation is recorded as a liability offsetting the original value of the asset on your balance sheet.

EBIT (Earnings Before Interest and Taxes)

A calculation that shows an organization's net income before applying tax and interest payments. It is useful for determining how profitable a company is because it matches revenue from operations with expenses from operations.

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)

A measure of an organization's ability to earn a profit from its operations and other incomes, without the effect of the non-cash expenses of depreciation and amortization (while an organization records depreciation as an expense, there is no cash paid out in the transaction).

Equity

The value of net assets owing to the owner of the organization. If a company were to dissolve (in a controlled way), creditors have the first claim against the assets. Once all the liabilities are paid, the balance that remains is the owner's share. This is the equity that the owners are owed by the organization.

Expense

Assets or obligations incurred in the process of generating revenue. Buying inventory, paying rent and paying salaries are examples of common expenses incurred in the course of doing business.

FIFO (First in, first out)

This is an inventory valuation method where the first item brought into inventory is the first one taken out of inventory. The assumption is that the first items purchased are the first ones sold. For example, you purchase 100 dresses for resale at a cost of $50 each, and then purchase another batch for $60 each. For the first 100 dresses you sell, you remove $50 from your inventory account. For the 101st dress you sell, you take $60 out of inventory. FIFO approximates replacement cost of inventory items and is a more accurate depiction of the actual flow of goods in and out of an organization. Many jurisdictions require FIFO inventory valuation for income tax purposes.

Fixed Asset

An asset that is used over more than one accounting period (usually for longer than a year), such as computers and other office equipment, production machinery, and trucks. These are also known as Capital Assets.

Fixed Cost

Expenses that are incurred regardless of sales. Items like salaries and insurance can remain the same whether you sell 100 units or 10,000 units.

Goodwill

The value attached to an organization's ability to produce superior earnings compared to its competitors. Branding results in goodwill, as does earning a great reputation for customer service. Goodwill is an intangible asset that typically only appears on the balance sheet if the organization is purchased. It often represents the premium a purchaser pays for the company after the difference between tangible assets and liabilities is accounted for.

Gross Profit

The difference between revenue and the cost of goods sold during an accounting period. This represents the amount of revenue an organization has left to cover the expenses of operating the business. Gross profit is often expressed as a percentage of sales, so that comparisons can be made from one period to another to monitor costs.

Income Statement

A financial report summarizing the organization's progress during a specified period of time. It summarizes revenue earned and expenses incurred, and the difference is recorded at net income for the period. It is used as a guide to how profitably the organization conducts its activities. It's also known as a Profit and Loss Sheet (P&L) or Account.

Liabilities

An obligation to pay for an asset or provide a good or service in the future to a creditor. Until the organization fulfills its obligation, the creditor has a claim against the assets of the business. Common liabilities include bank loans and accounts payable.

LIFO (Last in, first out)

This is an inventory valuation method where the last item brought into inventory is the first one taken out of inventory. The assumption is that the last items purchased are the first ones sold. For example, you purchase 100 dresses for resale at a cost of $50 each and then purchase another batch of 100 for $60 each. For the first 100 dresses you sell, you remove $60 from your inventory account. For the 101st dress, you take $50 out of inventory (assuming no other dresses have been purchased in the interim). In a period of rising prices, LIFO would produce a higher inventory cost and thus lower income. This would result in lower income taxes paid so many jurisdictions do not allow LIFO valuation for income tax purposes.

Liquid Assets

Assets that can be sold quickly for cash without any significant loss in value. Cash in the bank, as well as marketable securities (stocks and bonds) are highly liquid.

Net Income

The excess of revenues over expenses for an accounting period. If the figure is negative, it is referred to as a Net Loss. It's important to recognize that net income does not equal cash or the amount of money brought in. This is also called Net Profit or "the bottom line."

Reserves/ Reserve Account

A portion of equity that is not available for regular business use. It is often allowed to accumulate to cover future liabilities or other major expenditure planned.

Retained Earnings

The accumulated earnings of the company that are not distributed to owners. These funds are retained for the organization's future use or for distribution to the owners in the future.

Revenue

The inflow of assets (cash and accounts receivable) to the organization in exchange for goods and services. Revenue is sometimes called Sales or Turnover.

Statement of Cash Flows

A financial statement that shows the cash flows in and out of a business for an accounting period. It identifies the sources and uses of the cash, and categorizes these as cash from operations, financing, and investing. The main purpose of the statement is to determine whether the organization has enough cash to cover its short-term obligations. It is also referred to as the Statement of Changes in Financial Position.

Variable Cost

Expenses that vary with sales of the organization. As you sell more, your material costs increase, as do things like transportation, wages and utilities. Some of these may be strictly variable and others have a fixed portion as well. For instance, you incur a minimum wage cost regardless of production.

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