For many small business owners, accounting terminology can be challenging. The concepts make sense but the phrases don’t. Most owners started a business out of a passion for a product or service, and not necessarily because they love administrative tasks. That said, you’ll need reliable accounting books frequently.
If you haven’t brushed up on your accounting terminology lately, here are some concepts you will want to review:
Accounts – This term can mean what you are probably accustomed to: bank accounts, credit card accounts, etc, where you have a number issued by your financial institution. However, ‘Accounts’ also refer to the various categories that are part of your Chart of Accounts.
Chart of Accounts – Your chart of accounts is a series of ‘categories’ that various transactions can be applied to. Your chart of accounts is specific to your business and is often set up when you adopt accounting software for the first time. Each Account in your Chart of Accounts typically has a numerical code that can vary in terms of the number of digits.
Cash Basis – Your business’s ‘Basis’ is like a setting for your books. When set to ‘Cash,’ everything revolves around when money moves. You recognize income when you receive money versus get a deal signed. You recognize an expense when you pay it, not when you get billed.
Accrual Basis – When you are using ‘Accrual’ as your basis, you will recognize income as soon as you earn it in a category/account called ‘Accounts Receivable.’ You’ll recognize expenses as soon as you get billed in a category/account called ‘Accounts Payable.’ See below for more on these two general ledger accounts.
Assets – A section of your Balance Sheet, ‘Assets’ represent stores of value for your company. Cash, real estate and equipment are assets but so are rights to value in the future. Your accounts receivable (money owed to you by clients) is an asset. If your company has made loans to others, that loan or note receivable is an asset as well.
Liabilities – Another section of your Balance Sheet, liabilities are what your company owes. Bills are represented by ‘Accounts Payable’ while money owed over time or multiple installments would fall into a ‘note payable.’
Equity – Equity is the value of shares held by owners. It can be thought of as what would be left over if all Assets were sold and then all liabilities were paid off.
The Accounting Equation – The interaction of the three Balance Sheet sections is often referred to as ‘The Accounting Equation’: Assets=Liabilities + Owner’s Equity.
Revenue – Also defined as Income, revenue is the money that your company receives selling goods or services.
Expenses – Also known costs, your company has to pay all kinds of expenses to stay in business.
Profit – When you have more revenue than expenses, your company is running at a profit or sometimes what is referred to as ‘in the black.’ If you have more expenses than revenue, you are running the company at a loss, which is also referred to as ‘in the red.’
Retained Earnings – When a business runs a profit, cash accumulates within the business. Owners may decide to pay dividends (which reduce retained earnings), or they may keep the money on hand for reinvestment in the company.
Accounts Receivable (A/R) – If you are using the accrual basis of accounting, you’ll show an account/category called ‘Accounts Receivable’ which represents all of the money that is owed from sales such as invoices you have sent to clients but that have not been paid yet. When the client pays you, your ‘A/R’ total goes down and your cash goes up.
Accounts Payable (A/P) – Also an account/category if you are using the accrual basis, ‘Accounts Payable’ in the money you owe vendors who have already billed you but you have not paid yet. When you pay a bill, your ‘A/P’ goes down and your cash goes down.
Learn these concepts, and you will be in good shape to have an informed conversation with your accountant or banker if you’re seeking financing.