30 Common Accounting Terminology Explained
Every industry has its own special language. A language that is made up of unique phrases, vocabulary, and acronyms. Most people know one industry-specific language because its the area they work in every day. However, it is crucial for business owners and individuals alike, to have at least some basic understanding of common accounting terminology.
Accounting terminology is complicated. It’s because of all of the rules, laws, and topics surrounding it. It’s nearly impossible for those of us who work in this industry to master everything, let alone people who don’t!
However, having a clear understanding of commonly used accounting terminology and phrases is important to truly understanding your financial situation. Whether you are an entrepreneur or not, you should be able to understand what your accountant is telling you.
Common Accounting Terminology to Know
Here are 30 common accounting terminology explained using real-world definitions to help you better understand what your accountant is talking about.
A 401(k) plan is a type of retirement account funded by a taxpayer’s pre-tax contributions. This has favorable tax benefits for the taxpayer. Because the contributions are made before taxes, taxable income is reduced and hence fewer taxes are paid on that income. Later, when distributions are made from the 401k plan, that income is taxed, but generally at a lower rate since most people are in a lower tax bracket at retirement.
Accounts payable or AP is a current liability which represents money owed by a business to a vendor after the vendor provided a service or product. Sometimes vendors extend credit to its customers. If your vendor allows you to pay later for a good or service, the cost should be classified as accounts payable until it is paid.
Accounts receivable or AR is a current asset which represents money owed to a business by its customers after the business rendered a service or product. For example, let’s say you provide computer products to a customer for $500. The payment arrangement is for them to pay you in full in 30 days. During those 30 days, you will have $500 in accounts receivable until it is paid. Accounts receivable represents an obligation of the customer.
Accrual Basis of Accounting
Accrual basis of accounting is a method of accounting for a business’ revenues and expenses. Revenues are recorded when earned and expenses are recorded when incurred. Earned means when a business actually delivers the product or service. Incurred means when a business used a particular expense. Accounts receivable and accounts payable are used frequently with the accrual basis of accounting because you can earn revenue without receiving cash and can incur an expense without payment.
An asset is a resource that you own that will provide an economic benefit later on. For example, if you own a car, that is considered an asset because it will provide you the benefit of transportation.
Assets can be classified as short term or long term. Short-term assets have a useful life of 12 months or less. Long-term assets have a useful life of more than 12 months. Long terms assets, like a car, are depreciated over its useful life. Depreciation is discussed below.
Certain businesses have to report the assets it owns on its tax return. Generally, businesses who make over $250,000 in revenue and/or have over $1,000,000 in assets, have to report their assets on a balance sheet with their tax return.
Speaking of the balance sheet- it is a financial statement that lists out a company’s assets, liabilities, and equity at a specified point in time. The balance sheet gets its name from the fact that it balances. Assets equal liabilities plus equity.
The balance sheet is also referred to as the statement of financial position. Business owners use this statement to evaluate their company’s debt or ability to take on more debt. It is also used to value a company which is helpful if the owners wish to sell. The value lies in the equity section or by taking total assets minus total liabilities.
Bankrupt is a way to legally declare an individual’s or company’s inability to pay its outstanding debt. There are many different ways to declare bankruptcy. The 3 most common are Chapter 7, Chapter 11 and Chapter 13. Chapter 7 involves the liquidation of assets to pay off debt. Chapter 11 is for businesses who wish to stay in business and a reorganization plan is implemented to pay off its debt. Chapter 13 involves the repayment of all or some of the outstanding debt.
An accounting terminology list would not be complete without bookkeeping. Bookkeeping is the routine, systematic method of retrieving financial information, categorizing that information, inputting it into an accounting system, and generating reports based on that information which can be used by decision-makers. Check our blog post on What Is Bookkeeping for more details.
Bottom line refers to the net income or loss of a company. It could also refer to the taxes owed or tax refund on a tax return.
Carryover refers to losses that were occurred in a prior year but are applied in the current year.
Cash Basis of Accounting
Cash basis of accounting is a method of accounting for a business’ revenues and expenses. Revenues are recorded when cash is received and expenses are recorded when cash is paid. The cash basis of accounting is determined by the movement of cash, whether in or out. For companies that use this method, they don’t have accounts receivable or accounts payable on their books because they don’t recognize the corresponding revenue or expense until cash is involved.
Certified Public Accountant (CPA)
A Certified Public Accountant (CPA) is an accountant who has satisfied educational, experience and exam requirements to practice as a public accountant. Every state has its own specific licensing requirements, however, the CPA exam is considered “uniform” and is the same across all 50 states. CPAs also have to complete ongoing continuing education to stay up to date on what’s going on in the industry.
CPAs are considered more qualified than regular accountants because of all of the strict requirements that must be met for licensure. Some of the duties you can entrust a CPA with include tax planning, business consulting, audits, forensic accounting and more.
Depreciation is the amount a long-term asset has decreased in value. For example, a car is not expected to last forever. It has an expected useful life. Every year, the car is closer to the end of its useful life and thus decreases in value. The value the car decreases by is depreciation.
Depreciation is considered an expense for book and tax purposes but it calculated differently under both methods. From a book perspective, an asset might be depreciated over a 5-year useful life whereas from a tax perspective, may have a 7-year useful life. This is why it’s important to keep up with both methods on the financial statements and on the tax returns.
Dividends are a company’s distributions of earnings to its investors. Dividends are declared by a company’s board of directors and may be in the form of cash, stock or other property.
If you or your company are invested in a business that pays dividends, this is considered income to you. For tax purposes, you must report all dividend income received for the year on your tax return. Qualified dividend income is taxed at your long-term capital gains rate which is typically lower than your ordinary rate.
Equity represents the ownership or amount of money invested in a company. Equity can also be derived by taking assets minus liabilities. Hence, equity can be found on a company’s balance sheet.
Other terms used to describe equity are owner’s equity or stockholders equity.
An error is considered an unintentional misstatement relating to an entity’s financials. When errors are detected, they should be corrected immediately. If an error is detected on an already filed tax return, an amended return should be filed. If an error is detected in your financial statements, it should be corrected accordingly and updated financial statements should be issued.
Fiscal Year (FY)
A fiscal year is a period of 12 consecutive months chosen by a company to be its accounting period. Usually, a fiscal year is anything but a calendar year (ie January 1 – December 31). The IRS default system is based on the calendar year taxpayers. However, deadlines are adjusted for fiscal year taxpayers. For example, most individuals’ filing deadline is April 15th. However, the IRS rule is that taxpayers must file by the 15th day of the 4th month after their fiscal year, which for most people is April 15th.
A general ledger is a complete recording of all of a company’s transactions and accounts. The general ledger shows all of the assets, liabilities, equity, revenues, and expenses over the lifetime of a company. It can be used to prepare the other financial statements like the balance sheet or income statement.
Head of Household
Head of household is a tax classification for an unmarried individual with a qualifying child or dependent. Certain requirements as to the dependent and cost of living must be met. Head of household status comes with tax advantages that would otherwise be unavailable for an individual filing as single.
Interest is the cost of borrowing money. The cost is depicted as a rate based on the amount borrowed. The amount of interest paid depends on the type of loan taken, repayment period, credit score, down payment, etc. A portion of your payment goes towards interest and the other portion goes towards paying down your principal.
Interest is recorded as an expense in your books and is 100% deductible for tax purposes. However, because interest is a cost, it should be minimized as much as possible. The lower the interest rate, the better.
If you are a creditor to a business, you are paid “interest income” and must report the income on your tax return.
Journal Entry (JE)
A journal entry (JE) is the recording of a transaction in the accounting records. A JE consist of debits and credits that must equal each other. It’s possible and frequent for a journal entry to have multiple debits and multiple credits. The only stipulation is the journal entry must balance.
In bookkeeping, sometimes journal entries are made to correct errors. Towards the end of an accounting period, adjusting journal entries are made to more accurately present certain transactions, such as those relating to accounts receivable or accounts payable.
Key Performance Indicator (KPI)
An important accounting terminology phrase for a business owner is a key performance indicator. A key performance indicator (KPI) is a quantifiable measure to evaluate the success of a company. KPIs are measured against a predetermined goal or objective. Examples of key performance indicators are profit, cost, and turnover. KPIs are specific to your business and industry. Business owners should use KPIs to make strategic business decisions.
Limited liability is where one’s personal liability is limited to their investment in a company. If, for example, someone sues a limited liability company, the petitioner(s) may only sue for the assets of the company and not for the owners or investors personal assets. Different types of limited liability businesses exist such as limited liability companies (LLC), limited partnerships (LP), and C corporations.
Margin is the difference between the selling price of a product or service and the cost of acquiring that product or service. Sometimes called, the profit margin is a common key performance indicator used by business owners and managers to assess whether or not a company has met a specific benchmark. Margin can be expressed as a percentage or as an amount.
Material is used to describe the impact or influence a financial statement component could have in investment decisions. If the impact of a financial statement item is small, then it is considered immaterial.
To determine if something is material requires professional judgment. Materiality is subjective to the particular business. What is material for one, may not be material to another.
Ordinary income is income other than long-term capital gains. Ordinary income is taxed at a higher rate than long-term capital gains or qualified dividends. Examples of ordinary income are salaries, wages, bonuses, and interest.
Passive income is income from dividends, interest, rent, royalties, trusts or estates or any other source where an entity is not actively involved. Passive income is considered taxable but is taxed differently compared to ordinary or active income. Depending on the type passive determines the rules and how it is taxed.
Retained Earnings (RE)
Retained earnings (RE) is the number of earnings a company does not pay in dividends or distributions. Retained earnings or sometimes called accumulated earnings is considered a reinvestment back into the company. RE is found under the equity section of the balance sheet.
A variable expense is dependent on the usage of resources which can vary from period to period. This differs from fixed expenses since their amounts are the same throughout. A variable expense is things like your groceries since the amount you spend depends on how much food you buy, whereas your mortgage is fixed and does not change depending on your usage.
Write off has 2 meanings. (1) Cancellation of debt. It is an expense account specifically for debts that will not be paid. For example, if you have a customer that does not pay an outstanding invoice, you would write off the amount of the invoice as uncollectible. (2) For tax purposes, a write off is any expense that is deductible on your tax return. Examples are depreciation, office supplies or office rent.
There is a lot more accounting terminology than spans beyond this list. However, you now know the most common accounting terminology which will equip you to have a more in-depth conversation with your accountant or CPA.
Once you understand accounting terminology, you will have a better idea of your financial situation and possible solutions to your problems.