Glossary of Important
Financial Accounting Terms
The biggest problem most people have with an unfamiliar area is the jargon. Professionals overwhelm the amateurs with confusing words and phrases. The following pages will give you practical definitions of over 100 important terms used in financial accounting. If you have some grasp of these words and phrases you will be able to deal more effectively with financial people and their reports.
Use this glossary when you need to interpret memos, bulletins, reports, articles, and presentations by accountants, financial analysts, bankers, and so on. If you have a good grasp of the jargon you will be amazed at how well you can hold your own in discussions. Knowing the accounting vocabulary is an important factor in management success.
Glossary
Account --
a record of financial transactions; usually refers to a specific category or type, such as travel expense account or purchase account.
Accountant --
a person who trained to prepare and maintain financial records.
Accounting --
a system for keeping score in business, using dollars.
Accounting period
--the period of time over which profits are calculated. Normal accounting periods are months, quarters, and years (fiscal or calendar).
Accounts payable --
amounts owed by the company for the goods or services it has purchased from outside suppliers.
Accounts receivable --
amounts owed to the company by its customers.
Accrual basis, system, or method --
an accounting system that records revenues and expenses at the time the transaction occurs, not at the time cash changes hands. If you buy a coat and charge it, the store records or accrues the sale when you walk out with the coat, not when you pay your bill. Cash basis accounting is used by individuals. Accrual basis accounting is used by most businesses.
Accrued expenses, accruals --
an expense which has been incurred but not yet paid for. Salaries are a good example. Employees earn or accrue salaries each hour they work. The salaries continue to accrue until payday when the accrued expense of the salaries is eliminated.
Aging --
a process where accounts receivable are sorted out by age (typically current, 30 to 60 days old, 60 to 120 days old, and so on.) Aging permits collection efforts to focus on accounts that are long overdue.
Amortize --
to charge a regular portion of an expenditure over a fixed period of time. For example if something cost $100 and is to be amortized over ten years, the financial reports will show an expense of $10 per year for ten years. If the cost were not amortized, the entire $100 would show up on the financial report as an expense in the year the expenditure was made. (See entries on Expenditure and Expense.)
Appreciation --
an increase in value. If a machine cost $1,000 last year and is now worth $1,200, it has appreciated in value by $200. (The opposite of depreciation.)
Assets --
things of value owned by a business. An asset may be a physical property such as a building, or an object such as a stock certificate, or it may be a right, such as the right to use a patented process.
Current Assets are those assets that can be expected to turn into cash within a year or less. Current assets include cash, marketable securities, accounts receivable, and inventory.
Fixed Assets cannot be quickly turned into cash without interfering with business operations. Fixed assets include land, buildings, machinery, equipment, furniture, and long-term investments.
Intangible Assets are items such as patents, copyrights, trademarks, licenses, franchises, and other kinds of rights or things of value to a company, which are not physical objects. These assets may be the most important ones a company owns. Often they do not appear on financial reports.
Audit --
a careful review of financial records to verify their accuracy.
Bad debts --
amounts owed to a company that are not going to be paid. An account receivable becomes a bad debt when it is recognized that it won't be paid. Sometimes, bad debts are written off when recognized. This is an expense. Sometimes, a reserve is set up to provide for possible bad debts. Creating or adding to a reserve is also an expense.
Balance sheet --
a statement of the financial position of a company at a single specific time (often at the close of business on the last day of the month, quarter, or year.) The balance sheet normally lists all assets on the left side or top while liabilities and capital are listed on the right side or bottom. The total of all numbers on the left side or top must equal or balance the total of all numbers on the right side or bottom. A balance sheet balances according to this equation: Assets = Liabilities + Capital.
Bond --
a written record of a debt payable more than a year in the future. The bond shows amount of the debt, due date, and interest rate.
Book value --
total assets minus total liabilities. (See also net worth.) Book value also means the value of an asset as recorded on the company's books or financial reports. Book value is often different than true value. It may be more or less.
Breakeven point --
the amount of revenue from sales which exactly equals the amount of expense. Breakeven point is often expressed as the number of units that must be sold to produce revenues exactly equal to expenses. Sales above the breakeven point produce a profit; below produces a loss.
Capital --
money invested in a business by its owners. (See equity.) On the bottom or right side of a balance sheet. Capital also refers to buildings, machinery, and other fixed assets in a business. A capital investment is an investment in a fixed asset with a long-term use.
Capitalize --
to capitalize means to record an expenditure on the balance sheet as an asset, to be amortized over the future. The opposite is to expense. For example, research expenditures can be capitalized or expensed. If expensed, they are charged against income when the expenditure occurs. If capitalized, the expenditure is charged against income over a period of time usually related to the life of the products or services created by the research.
Cash --
money available to spend now. Usually in a checking account.
Cash flow --
the amount of actual cash generated by business operations, which usually differs from profits shown.
Chart of accounts --
a listing of all the accounts or categories into which business transactions will be classified and recorded. Each account usually has a number. Transactions are coded by this number for manipulation on computers.
Contingent liabilities --
liabilities not recorded on a company's financial reports, but which might become due. If a company is being sued, it has a contingent liability that will become a real liability if the company loses the suit.
Cost of sales, cost of goods sold --
the expense or cost of all items sold during an accounting period. Each unit sold has a cost of sales or cost of the goods sold. In businesses with a great many items flowing through, the cost of sales or cost of goods sold is often computed by this formula: Cost of Sales = Beginning Inventory + Purchases During the Period - Ending Inventory.
Credit --
an accounting entry on the right or bottom of a balance sheet. Usually an increase in liabilities or capital, or a reduction in assets. The opposite of credit is debit. Each credit in a balance sheet has a balancing debit. Credit has other usages, as in "You have to pay cash, your credit is no good." Or "we will credit your account with the refund."
Debit --
an accounting entry on the left or top of a balance sheet. Usually an increase in assets or a reduction in liabilities. Every debit has a balancing credit.
Deferred charges --
see prepaid expenses.
Deferred income --
a liability that arises when a company is paid in advance for goods or services that will be provided later. For example, when a magazine subscription is paid in advance, the magazine publisher is liable to provide magazines for the life of the subscription. The amount in deferred income is reduced as the magazines are delivered.
Depreciation --
an expense that is supposed to reflect the loss in value of a fixed asset. For example, if a machine will completely wear out after ten year's use, the cost of the machine is charged as an expense over the ten-year life rather than all at once, when the machine is purchased. Straight line depreciation charges the same amount to expense each year. Accelerated depreciation charges more to expense in early years, less in later years. Depreciation is an accounting expense. In real life, the fixed asset may grow in value or it may become worthless long before the depreciation period ends.
Discounted cash flow --
a system for evaluating investment opportunities that discounts or reduces the value of future cash flow. (See present value.)
Dividend --
a portion of the after-tax profits paid out to the owners of a business as a return on their investment.
Double entry --
a system of accounting in which every transaction is recorded twice -- as a debit and as a credit.
Earnings per share --
a company's net profit after taxes for an accounting period, divided by the average number of shares of stock outstanding during the period.
80 - 20 rule --
a general rule of thumb in business that says that 20% of the items produce 80% of the action -- 20% of the product line produces 80% of the sales, 20 percent of the customers generate 80% of the complaints, and so on. In evaluating any business situation, look for the small group which produces the major portion of the transactions you are concerned with. This rule is not exactly accurate, but it reflects a general truth, nothing is evenly distributed.
Equity --
the owners' share of a business.
Expenditure --
an expenditure occurs when something is acquired for a business -- an asset is purchased, salaries are paid, and so on. An expenditure affects the balance sheet when it occurs. However, an expenditure will not necessarily show up on the income statement or affect profits at the time the expenditure is made. All expenditures eventually show up as expenses, which do affect the income statement and profits. While most expenditures involve the exchange of cash for something, expenses need not involve cash. (See expense below.)
Expense --
an expenditure which is chargeable against revenue during an accounting period. An expense results in the reduction of an asset. All expenditures are not expenses. For example, a company buys a truck. It trades one asset - cash - to acquire another asset. An expenditure has occurred but no expense is recorded. Only as the truck is depreciated will an expense be recorded. The concept of expense as different from an expenditure is one reason financial reports do not show numbers that represent spendable cash. The distinction between an expenditure and an expense is important in understanding how accounting works and what financial reports mean. (To expense is a verb. It means to charge an expenditure against income when the expenditure occurs. The opposite is to capitalize.)
Fiscal year --
an accounting year than begins on a date other than January 1.
Fixed asset --
see asset.
Fixed cost --
a cost that does not change as sales volume changes (in the short run.) Fixed costs normally include such items as rent, depreciation, interest, and any salaries unaffected by ups and downs in sales.
Goodwill --
in accounting, the difference between what a company pays when it buys the assets of another company and the book value of those assets. Sometimes, real goodwill is involved - a company's good reputation, the loyalty of its customers, and so on. Sometimes, goodwill is an overpayment.
Income --
see profit.
Interest --
a charge made for the use of money.
Inventory --
the supply or stock of goods and products that a company has for sale. A manufacturer may have three kinds of inventory: raw materials waiting to be converted into goods, work in process, and finished goods ready for sale.
Inventory obsolescence --
inventory no longer salable. Perhaps there is too much on hand, perhaps it is out of fashion. The true value of the inventory is seldom exactly what is shown on the balance sheet. Often, there is unrecognized obsolescence.
Inventory shrinkage --
a reduction in the amount of inventory that is not easily explainable. The most common cause of shrinkage is probably theft.
Inventory turnover --
a ratio that indicates the amount of inventory a company uses to support a given level of sales. The formula is: Inventory Turnover = Cost of Sales ¸ Average Inventory. Different businesses have different general turnover levels. The ratio is significant in comparison with the ratio for previous periods or the ratio for similar businesses.
Invested capital --
the total of a company's long-term debt and equity.
Journal --
a chronological record of business transactions.
Ledger --
a record of business transactions kept by type or account. Journal entries are usually transferred to ledgers.
Liabilities --
amounts owed by a company to others. Current liabilities are those amounts due within one year or less and usually include accounts payable, accruals, loans due to be paid within a year, taxes due within a year, and so on. Long-term liabilities normally include the amounts of mortgages, bonds, and long-term loans that are due more than a year in the future.
Liquid --
having lots of cash or assets easily converted to cash.
Marginal cost, marginal revenue --
marginal cost is the additional cost incurred by adding one more item. Marginal revenue is the revenue from selling one more item. Economic theory says that maximum profit comes at a point where marginal revenue exactly equals marginal cost.
Net worth --
total assets minus total liabilities. Net worth is seldom the true value of a company.
Opportunity cost --
a useful concept in evaluating alternate opportunities. If you choose alternative A, you cannot choose B, C, or D. What is the cost or loss of profit of not choosing B, C, or D? This cost or loss of profit is the opportunity cost of alternative A. In personal life you may buy a car instead of taking a European vacation. The opportunity cost of buying the car is the loss of the enjoyment of the vacation.
Overhead --
a cost that does not vary with the level of production or sales, and usually a cost not directly involved with production or sales. The chief executive's salary and rent are typically overhead.
Post --
to enter a business transaction into a journal or ledger or other financial record.
Prepaid expenses, deferred charges --
assets already paid for, that are being used up or will expire. Insurance paid for in advance is a common example. The insurance protection is an asset. It is paid for in advance, it lasts for a period of time, and expires on a fixed date.
Present value --
a concept that compares the value of money available in the future with the value of money in hand today. For example, $78.35 invested today in a 5% savings account will grow to $100 in five years. Thus the present value of $100 received in five years is $78.35. The concept of present value is used to analyze investment opportunities that have a future payoff.
Price-earnings (p/e) ratio --
the market price of a share of stock divided by the earnings (profit) per share. P/e ratios can vary from sky high to dismally low, but often do not reflect the true value of a company.
Profit --
the amount left over when expenses are subtracted revenues. Gross profit is the profit left when cost of sales is subtracted from sales, before any operating expenses are subtracted. Operating profit is the profit from the primary operations of a business and is sales minus cost of sales minus operating expenses. Net profit before taxes is operating profit minus non-operating expenses and plus non-operating income. Net profit after taxes is the bottom line, after everything has been subtracted. Also called income, net income, earnings. Not the same as cash flow and does not represent spendable dollars.
Retained earnings --
profits not distributed to shareholders as dividends, the accumulation of a company's profits less any dividends paid out. Retained earnings are not spendable cash.
Return on investment (ROI) --
a measure of the effectiveness and efficiency with which managers use the resources available to them, expressed as a percentage. Return on equity is usually net profit after taxes divided by the shareholders' equity. Return on invested capital is usually net profit after taxes plus interest paid on long-term debt divided by the equity plus the long-term debt. Return on assets used is usually the operating profit divided by the assets used to produce the profit. Typically used to evaluate divisions or subsidiaries. ROI is very useful but can only be used to compare consistent entities -- similar companies in the same industry or the same company over a period of time. Different companies and different industries have different ROIs.
Revenue --
the amounts received by or due a company for goods or services it provides to customers. Receipts are cash revenues. Revenues can also be represented by accounts receivable.
Risk --
the possibility of loss; inherent in all business activities. High risk requires high return. All business decisions must consider the amount of risk involved.
Sales --
amounts received or due for goods or services sold to customers. Gross sales are total sales before any returns or adjustments. Net sales are after accounting for returns and adjustments.
Stock --
a certificate (or electronic or other record) that indicates ownership of a portion of a corporation; a share of stock. Preferred stock promises its owner a dividend that is usually fixed in amount or percent. Preferred shareholders get paid first out of any profits. They have preference. Common stock has no preference and no fixed rate of return. Treasury stock was originally issued to shareholders but has been subsequently acquired by the corporation . Authorized by unissued stock is stock which official corporate action has authorized but has not sold or issued. (Stock also means the stock of goods, the stock on hand, the inventory of a company.)
Sunk costs --
money already spent and gone, which will not be recovered no matter what course of action is taken. Bad decisions are made when managers attempt to recoup sunk costs.
Trial balance --
at the close of an accounting period, the transactions posted in the ledger are added up. A test or trial balance sheet is prepared with assets on one side and liabilities and capital on the other. The two sides should balance. If they don't, the accountants must search through the transactions to find out why. They keep making trial balances until the balance sheet balances.
Variable cost --
a cost that changes as sales or production change. If a business is producing nothing and selling nothing, the variable cost should be zero. However, there will probably be fixed costs.
Working capital --
current assets minus current liabilities. In most businesses the major components of working capital are cash, accounts receivable, and inventory minus accounts payable. As a business grows it will have larger accounts receivable and more inventory. Thus the need for working capital will increase.
Write-down --
the partial reduction in the value of an asset, recognizing obsolescence or other losses in value.
Write-off --
the total reduction in the value of an asset, recognizing that it no longer has any value. Write-downs and write-offs are non-cash expenses that affect profits.
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