Accounting TermsLearn Basic Accounting Terms

Accounting - process of identifying, measuring, and reporting financial information of an entity

Accounting Equation - assets = liabilities + equity

Accounts Payable - money owed to creditors, vendors, etc.

Accounts Receivable - money owed to a business, i.e.: credit sales

Accrual Accounting - a method in which income is recorded when it is earned and expenses are recorded when they are incurred

Asset - property with a cash value that is owned by a business or individual

Balance Sheet - summary of a company's financial status, including assets, liabilities, and equity

Bookkeeping - recording financial information

Cash-Basis Accounting - a method in which income and expenses are recorded when they are paid.

Chart of Accounts - a listing of a company's accounts and their corresponding numbers

Cost Accounting - a type of accounting that focuses on recording, defining, and reporting costs associated with specific operating functions

Credit - an account entry with a negative value for assets, and positive value for liabilities and equity.

Debit - an account entry with a positive value for assets, and negative value for liabilities and equity.

Depreciation - recognizing the decrease in the value of an asset due to age and use

Double-Entry Bookkeeping - system of accounting in which every transaction has a corresponding positive and negative entry (debits and credits)

Equity - money owed to the owner or owners of a company, also known as "owner's equity"

Financial Accounting - accounting focused on reporting an entity's activities to an external party; ie: shareholders

Financial Statement - a record containing the balance sheet and the income statement

Fixed Asset - long-term tangible property; building, land, computers, etc.

General Ledger - a record of all financial transactions within an entity

Income Statement - a summary of income and expenses

Job Costing - system of tracking costs associated with a job or project (labor, equipment, etc) and comparing with forecasted costs

Journal - a record where transactions are recorded, also known as an "account"

Liability - money owed to creditors, vendors, etc

Liquid Asset - cash or other property that can be easily converted to cash

Loan - money borrowed from a lender and usually repaid with interest

Net Income - money remaining after all expenses and taxes have been paid

Non-operating Income - income generated from non-recurring transactions; ie: sale of an old building

Note - a written agreement to repay borrowed money; sometimes used in place of "loan"

Operating Income - income generated from regular business operations

Payroll - a list of employees and their wages

Profit - see "net income"

Profit/Loss Statement - see "income statement"

Revenue - total income before expenses.

Single-Entry Bookkeeping - system of accounting in which transactions are entered into one account

Accounting, financial analysis and financial modeling are integrated disciplines which a good financial analyst should be familiar with. In particular, it is important that a sound knowledge of fundamental accounting principles and accounting terms is had to ensure a common basis and language for understanding, intepretating and analyzing financial statements and financial model results.

We provide here a long list of the most common accounting terms that a financial analyst may come across:

Absorption: the sharing out of the costs of a cost center amongst the products which use the cost center.

Account: a record in a double entry system that is kept for each (or each class) of asset, liability, revenue and expense.

Accounting equation: an expression of the equivalence, in total, of assets = liabilities + equity.

Accounting period: that time period, typically one year, to which financial statements are related.

Accounting policies: the specific accounting bases selected and followed by a business enterprise (e.g. straight line or reducing balance depreciation).

Accounting rate of return: a ratio sometimes used in investment appraisal but based on profits not cash flows.

Accounting standards: Prescribed methods of accounting by the accounting standards or financial reporting standards regulation body in your jurisdiction.

Accruals: (that which has accrued, accumulated, grown) expenses which have been consumed or enjoyed but which have not been paid for at the accounting date.

Accruals convention: the convention that revenues and costs are matched with one the other and dealt with in the Profit and Loss (P&L) Account of the period to which they relate irrespective of the period of receipt or payment.

Accumulated depreciation: that part of the original cost of a fixed asset which has been regarded as a depreciation expense in successive Profit and Loss (P&L) Accounts: cost less accumulated depreciation = net book value.

Acid test: The ratio of current assets (excluding stock) to current liabilities.

Acquisitions: operations of a reporting entity that are acquired in a period. Separate disclosure of turnover, profits, etc must be made.

Activity based costing: cost attribution to cost units on the basis of benefit received Irons indirect activities. The idea is that overhead costs are driven by activities (e.g. setting up a machine) not products.

Allocation: the charging of discrete, identifiable costs to cost centers or cost units. A cost is allocated when it is unique to a particular cost center.

Amortization: another word for depreciation: commonly used for depreciation of the capital cost of acquiring leasehold property.

Apportionment: the division of costs among two or more cost centers in proportion to estimated benefit on some sensible basis. Apportionment is for shared costs.

Assets: resources of value owned by a business entity.

Assets utilization ratio: a ratio which purports to measure the intensity of use of business assets. Calculated as sales over net operating assets. Can be expressed as sales as a percentage of net operating assets.

Asset value: a term which expresses the money amount of assets less liabilities of a company attributable to one ordinary share.

Avoidable costs: the specific costs of an activity or sector of a business which would be avoided if that activity or sector did not exist.

Auditing: the independent examination of, and expression of an opinion on, the financial statements of an enterprise by an appointed auditor in pursuance of that appointment and in compliance with any relevant statutory obligation.

AVCO (average cost): a method of valuing fungible assets (notably stock) at average (simple or weighted) input prices.

Bad debts: debts known to be irrecoverable and therefore treated as losses by inclusion in the Profit and Loss (P&L) Account as an expense.

Balance Sheet: a financial statement showing the financial position of a business entity in terms of assets, liabilities and capital at a specified date.

Bankruptcy: a legal status imposed by a court. Usually a trustee is appointed to receive and realize the assets of the bankrupt and to distribute the proceeds to his creditors according to the law.

Benefits in kind: things or services supplied by a company to its directors and others in addition to cash remuneration. A good example is the provision of and free use of a motor car. The value of benefits in kind are taxable.

Bond: a formal written document that provides evidence of a loan. Bond has mainly American usage. Its UK equivalent is debenture.

Bonus issue: a free issue of new shares to existing shareholders. No payment is made for the shares. Its main effect is to divide the substance of the company (assets less liabilities) into a larger number of shares.

Book value: the amount at which an asset is carried on the accounting records and Balance Sheet. The usual book value for fixed assets is cost less accumulated depreciation. Alternative words include written down value, net book value and carrying value. Book value rarely if ever corresponds to saleable value.

Breakeven chart: a chart which illustrates costs, revenues, profit and loss at various levels of activity within a relevant range.

Breakeven point: the level of activity (e.g. level of sales) at which the business makes neither a profit nor a loss i.e. where total revenues exactly equal total costs.

Budget: a formal quantitative expression of management’s plans or expectations. Master budgets are the forecast or planned Profit and Loss Account and Balance Sheet. Subsidiary budgets include those for sales, output, purchases, labor, cash etc.

Capital: an imprecise term meaning the whole quantity of assets less liabilities owned by a person or a business.

Capital allowances: deductions from profit for fixed asset purchases. In effect capital allowances is a standard system of depreciation used instead of depreciation for tax purposes only.

Capital budgeting: the process of planning or appraising possible fixed asset acquisitions.

Capital employed: a term describing the total net assets employed in a business. Various definitions are used, so beware when talking at cross purposes.

Capital expenditure: expenditure on fixed assets.

Cash: strictly coins and notes but used also to mean all forms of ready money including bank balances.

Cash discount: a reduction in the amount payable by a debtor to induce prompt payment (equivalent to settlement discount).

Cash flow: a vague term (compare cash flow difficulties) used for the difference between total cash in and total cash out in a period.

Cash flow forecast: a document detailing expected or planned cash receipts and outgoings for a future period.

Cash flow statement: a formal financial statement showing a summary of cash inflows and outflows under certain required headings.

Committed costs: those fixed costs which cannot be eliminated or even cut back without having a major effect on the enterprise’s activities (e.g. rent).

Common stock: the U.S equivalent of ordinary shares.

Conservatism: (also known as prudence) the convention whereby revenue and profits are not anticipated, but provision is made for all known liabilities (expenses and losses) whether the amount of these is known with certainty or is a best estimate. Essentially – future profit, wait until it happens – future loss, count it

Consideration: the amount to be paid for anything sold including businesses. May be cash, shares or other securities.

Consistency: convention that there is consistency of accounting treatment of like items within each year and from year to year.

Consolidation: the aggregation of the financial statements of the separate companies of a group as if they were a single entity.

Contribution: a term used in marginal costing – the difference between sale price and associated variable costs.

Controllable costs (also known as managed costs): costs, chargeable to a budget or cost centre, which can be influenced by the actions of the persons in whom control is vested.

Conversion cost: the cost of bringing a product or service into its present location or condition. May include a share of production overheads.

Convertible loan stock: loans where, at the option of the lender, the loan can be converted into ordinary shares at specified times and specified rates of conversion.

Cost behavior: the change in a cost when the level of output changes.

Cost center: a location, function, or item of equipment in respect of which costs may be ascertained and related to cost units.

Cost convention: the accounting convention whereby Balance Sheet assets are mostly valued at input cost or by reference to input cost.

Cost-volume-profit (CVP) analysis: the study of the relationships between variable costs, total fixed costs, levels of output and price and mix of units sold and profit, often analyzed in a financial modeling exercise.

Credit: commonly used to refer to a benefit or gain also the practice of selling goods and expecting payment at a later date.

Credit control: those measures and procedures adopted by a firm to ensure that its credit customers pay their accounts.

Creditors: those persons, firms or organizations to whom the enterprise owes money.

Creditors payment or settlement period: a ratio (usually creditors/ inputs on credit in a year x 365) which measures how long it takes the firm to pay its creditors.

Cumulative preference shares: preference shares where the rights to dividends omitted in a given year accumulate. These dividends must be paid before a dividend can be paid on the ordinary shares.

Current assets: cash + those assets (stock, debtors, prepayments, bank accounts) which the management intend to convert into cash or consume in the normal course of business within one year or within the operating cycle.

Current cost accounting (CCA): a system of accounting which recognizes the fluctuating value of money by measuring current value by applying specific indices and other devices to historical costs. A valid method which is complex and difficult to understand intuitively.

Current liabilities: debts or obligations that will be paid within one year of the accounting date. Another term used to describe the same is Creditors: amount falling due within one year.

Current ratio: the ratio of current assets to current liabilities.

Cut-off: the difficulties encountered by accountants in ensuring all items of income and expense are correctly ascribed to the right annual profit statement.

Debenture: a document which creates or acknowledges a debt. Commonly used for the debt itself.

Debt: a sum due by a debtor to his creditor. Commonly used also as a generic term for borrowings.

Debtors: those who owe money.

Debtors payment (settlement) period: a calculation of the average time taken by credit customers to pay for their goods. Calculated by Debtors/credit sales in a year x 365.

Depletion method: a method of depreciation applicable to wasting assets such as mines and quarries. The amount of depreciation in a year is a function of the quantity extracted in the year compared to the total resource.

Depreciation: a measure of the wearing out, consumption or other loss of value whether arising from use, passage of time or obsolescence through technology and market changes. Depreciation should be allocated to accounting period so as charge a fair proportion to each accounting period during the expected useful life of the asset.

Direct costs: those costs comprising direct materials, direct labor and direct expenses which can be traced directly to specific jobs, products or services.

Discontinued operations: operations of the reporting entity that are sold or terminated in a period. Turnover and results must be separately disclosed.

Discount: a monetary deduction or reduction. Settlement discount (also known as cash discount) is given for early settlement of debts. Debentures can be redeemed at a

discount. Trade discount is a simple reduction in price given to favored customers for reasons such as status or bulk purchase.

Discounted cash flow: an evaluation of the future cash flows generated by a capital investment project, by discounting them to their present value.

Dividend: a distribution of earnings to its shareholders by a company.

Dividend cover: a measure of the extent to which the dividend paid by a company covered by its earnings (profits).

Dividend yield: a measure of the revenue earning capacity of an ordinary share to its holder. It is calculated by dividend per share as a percentage of the quoted share price.

Drawings: cash or goods withdrawn from the business by a proprietor for his private use.

Earnings: another word for profits, particularly for company profits.

Earnings per share: an investor ratio, calculated as after tax profits from ordinary activities / number of shares.

Economic Order Quantity (EOQ): that purchasing order size which takes into account the optimum combination of stockholding costs and ordering costs.

Equity convention: the convention that a business can be viewed as a unit that is a separate entity and apart from its owners and from other firms.

Equity: the ordinary shares or risk capital of an enterprise.

Exceptional items: material items which derive from events or transactions that fall within the ordinary activities of the reporting entity and which need to be disclosed by virtue of their size or incidence if the financial statements are to give a true and fair view. Examples are profits or losses on termination of an operation, costs of a fundamental reorganization and profits and losses on disposal of fixed assets.

Expense: a cost which will be in the Profit and Loss (P&L) Account of a year.

Exposure draft: a document issue on a specific accounting topic for discussion.

Extraordinary items: material items possessing a high degree of abnormality which arise from events or transactions that fall outside the ordinary activities of the reporting entity and which are not expected to recur. They should be disclosed but are very rare indeed.

Factoring: the sale of debtors to a factoring company to improve cash flow. Factoring is a method of obtaining finance tailored to the amount of business done but factoring companies also offer services such as credit worthiness checks, sales and debtor recording, and debt collection.

FIFO: first in first out – a method of recording and valuation of fungible assets, especially stocks, which values items on the assumption that the oldest stock is used first. FIFO stocks are valued at most recent input prices.

Finance lease: a leasing contract which transfers substantially all the risks and rewards of ownership of an asset to the lessee. In effect the lessee is really buying the assets with the aid of a loan and the lease installments are really payments of interest and repayments of capital. They are accounted for as such in accordance with the accounting convention of substance over form.

Financial statements: Balance Sheets, Profit and Loss Account, Income and Expenditure Accounts, Cash Flow Statements and other documents which formally convey information of a financial nature to interested parties concerning an enterprise. In companies, the financial statements are subject to audit opinion.

Fixed assets: business assets which have a useful life extending over more than one year. Examples are land and buildings, plant and machinery, vehicles.

Fixed cost: a cost which in the short term, remains the same at different levels of activity. An example is rent.

Flexible budget: a budget which is flexed to recognize the difference in behavior of fixed and variable costs in relation to levels of output. Total budgeted costs changed to accord with changed levels of activity.

Floating charge: an arrangement whereby a lender to a company has a floating charge over the assets generally of the company gives the lender priority of repayment from the proceeds of sale of the assets in the event of insolvency. Banks frequently take a floating charge when lending.

Format: a specific layout for a financial statement. Several alternatives are often prescribed by the prevailing governing authority or law of the country in which the enterprise operates or reports its financial performance.

Funds flow statement: a financial statement which links Balance Sheets at the beginning and end of a period with the Profit and Loss (P&L) Account for that period. Now replaced by the cash flow statement.

Fungible assets: assets which are substantially indistinguishable from each other. Used for stocks which can then be valued on FIFO or AVCO principles. LIFO is also possible but often not usually for tax reasons.

Gearing: also known as leverage, the relationship between debt and equity in the financing structure of a company.

Gilt-edged securities: securities and investments which offer a negligible risk of default. Principally government securities.

Goal congruence: the situation in which each individual, in satisfying his or her own interests, is also making the best possible contribution to the objectives of the enterprise.

Going concern: the accounting convention which assumes that the enterprise will continue in operational existence for the foreseeable future. This means in particular that the Profit and Loss (P&L) Account and Balance Sheet (BS) assume no intention or necessity to liquidate or curtail significantly the scale of operation.

Goodwill: an intangible asset which appears on the Balance Sheet of some businesses. It is valued at (or below) the difference between the price paid for a whole business and the fair value of the net assets acquired.

Gross: usually means before or without deductions. For example Gross Salary or Gross Profit.

Gross profit: sales revenue less cost of sales but before deduction of overhead expenses. In a manufacturing company it is sales revenue less cost of sales but before deduction of non-manufacturing overheads.

Gross margin: (or gross profit ratio), gross profit expressed as a percentage of sales.

Group: a set of interrelated companies usually consisting of a holding company and its subsidiary and sub-subsidiary companies.

Group accounts: the financial statements of a group wherein the separate financial statements of the member companies of a group are combined into consolidated financial statements.

HIFO: highest in highest out, a pricing policy where costs are collected for a job on the basis that the cost of materials and components is the highest recent input price.

Historical cost: the accounting convention whereby goods, resources and services are recorded at cost. Cost is defined as the exchange or transaction price. Under this Convention, realizable values are generally ignored. Inflation is also ignored. The almost universal adoption of this convention makes accounting harder to understand and lessens the credibility of financial statements.

Hurdle: a criteria that a proposed capital investment must pass before it is accepted. It may be a certain interest rate, a positive NPV or a maximum payback period.

Income and expenditure account: the equivalent to Profit and Loss (P&L) Accounts in nonprofit organizations such as clubs, societies and charities.

Indirect costs: costs which cannot be traced to particular products. An example is rent or management salaries. They are usually shared by more than one product and are called overheads.

Insolvency: the state of being unable to pay debts as they fall due. Also used to describe the activities of practitioners in the fields of bankruptcy, receivership and liquidations.

Intangible assets: assets which have long term value but no physical identity. Examples are goodwill, patents, trade marks and brands.

Interim dividend: a dividend paid during a financial year, generally after the issue of un-audited profit figures half way through the year.

Internal rate of return: the rate of discount which will just discount the future cash flows of a proposed capital investment back to the initial outlay.

Inventory: a detailed list of things. Used by accountants as another word for stock.

Investment appraisal: the use of accounting and mathematical methods to determine the likely returns for a proposed investment or capital project.

Key factor: a factor of production which is in limited supply and therefore constrains production.

Glossary Of Accounting Terms

Accounting, financial analysis and financial modeling are integrated disciplines which a good financial analyst should be familiar with. In particular, it is important that a sound knowledge of fundamental accounting principles and accounting terms is had to ensure a common basis and language for understanding, intepretating and analyzing financial statements and financial model results.

We provide here a long list of the most common accounting terms that a financial analyst may come across:

Absorption: the sharing out of the costs of a cost center amongst the products which use the cost center.

Account: a record in a double entry system that is kept for each (or each class) of asset, liability, revenue and expense.

Accounting equation: an expression of the equivalence, in total, of assets = liabilities + equity.

Accounting period: that time period, typically one year, to which financial statements are related.

Accounting policies: the specific accounting bases selected and followed by a business enterprise (e.g. straight line or reducing balance depreciation).

Accounting rate of return: a ratio sometimes used in investment appraisal but based on profits not cash flows.

Accounting standards: Prescribed methods of accounting by the accounting standards or financial reporting standards regulation body in your jurisdiction.

Accruals: (that which has accrued, accumulated, grown) expenses which have been consumed or enjoyed but which have not been paid for at the accounting date.

Accruals convention: the convention that revenues and costs are matched with one the other and dealt with in the Profit and Loss (P&L) Account of the period to which they relate irrespective of the period of receipt or payment.

Accumulated depreciation: that part of the original cost of a fixed asset which has been regarded as a depreciation expense in successive Profit and Loss (P&L) Accounts: cost less accumulated depreciation = net book value.

Acid test: The ratio of current assets (excluding stock) to current liabilities.

Acquisitions: operations of a reporting entity that are acquired in a period. Separate disclosure of turnover, profits, etc must be made.

Activity based costing: cost attribution to cost units on the basis of benefit received Irons indirect activities. The idea is that overhead costs are driven by activities (e.g. setting up a machine) not products.

Allocation: the charging of discrete, identifiable costs to cost centers or cost units. A cost is allocated when it is unique to a particular cost center.

Amortization: another word for depreciation: commonly used for depreciation of the capital cost of acquiring leasehold property.

Apportionment: the division of costs among two or more cost centers in proportion to estimated benefit on some sensible basis. Apportionment is for shared costs.

Assets: resources of value owned by a business entity.

Assets utilization ratio: a ratio which purports to measure the intensity of use of business assets. Calculated as sales over net operating assets. Can be expressed as sales as a percentage of net operating assets.

Asset value: a term which expresses the money amount of assets less liabilities of a company attributable to one ordinary share.

Avoidable costs: the specific costs of an activity or sector of a business which would be avoided if that activity or sector did not exist.

Auditing: the independent examination of, and expression of an opinion on, the financial statements of an enterprise by an appointed auditor in pursuance of that appointment and in compliance with any relevant statutory obligation.

AVCO (average cost): a method of valuing fungible assets (notably stock) at average (simple or weighted) input prices.

Bad debts: debts known to be irrecoverable and therefore treated as losses by inclusion in the Profit and Loss (P&L) Account as an expense.

Balance Sheet: a financial statement showing the financial position of a business entity in terms of assets, liabilities and capital at a specified date.

Bankruptcy: a legal status imposed by a court. Usually a trustee is appointed to receive and realize the assets of the bankrupt and to distribute the proceeds to his creditors according to the law.

Benefits in kind: things or services supplied by a company to its directors and others in addition to cash remuneration. A good example is the provision of and free use of a motor car. The value of benefits in kind are taxable.

Bond: a formal written document that provides evidence of a loan. Bond has mainly American usage. Its UK equivalent is debenture.

Bonus issue: a free issue of new shares to existing shareholders. No payment is made for the shares. Its main effect is to divide the substance of the company (assets less liabilities) into a larger number of shares.

Book value: the amount at which an asset is carried on the accounting records and Balance Sheet. The usual book value for fixed assets is cost less accumulated depreciation. Alternative words include written down value, net book value and carrying value. Book value rarely if ever corresponds to saleable value.

Breakeven chart: a chart which illustrates costs, revenues, profit and loss at various levels of activity within a relevant range.

Breakeven point: the level of activity (e.g. level of sales) at which the business makes neither a profit nor a loss i.e. where total revenues exactly equal total costs.

Budget: a formal quantitative expression of management’s plans or expectations. Master budgets are the forecast or planned Profit and Loss Account and Balance Sheet. Subsidiary budgets include those for sales, output, purchases, labor, cash etc.

Capital: an imprecise term meaning the whole quantity of assets less liabilities owned by a person or a business.

Capital allowances: deductions from profit for fixed asset purchases. In effect capital allowances is a standard system of depreciation used instead of depreciation for tax purposes only.

Capital budgeting: the process of planning or appraising possible fixed asset acquisitions.

Capital employed: a term describing the total net assets employed in a business. Various definitions are used, so beware when talking at cross purposes.

Capital expenditure: expenditure on fixed assets.

Cash: strictly coins and notes but used also to mean all forms of ready money including bank balances.

Cash discount: a reduction in the amount payable by a debtor to induce prompt payment (equivalent to settlement discount).

Cash flow: a vague term (compare cash flow difficulties) used for the difference between total cash in and total cash out in a period.

Cash flow forecast: a document detailing expected or planned cash receipts and outgoings for a future period.

Cash flow statement: a formal financial statement showing a summary of cash inflows and outflows under certain required headings.

Committed costs: those fixed costs which cannot be eliminated or even cut back without having a major effect on the enterprise’s activities (e.g. rent).

Common stock: the U.S equivalent of ordinary shares.

Conservatism: (also known as prudence) the convention whereby revenue and profits are not anticipated, but provision is made for all known liabilities (expenses and losses) whether the amount of these is known with certainty or is a best estimate. Essentially – future profit, wait until it happens – future loss, count it

Consideration: the amount to be paid for anything sold including businesses. May be cash, shares or other securities.

Consistency: convention that there is consistency of accounting treatment of like items within each year and from year to year.

Consolidation: the aggregation of the financial statements of the separate companies of a group as if they were a single entity.

Contribution: a term used in marginal costing – the difference between sale price and associated variable costs.

Controllable costs (also known as managed costs): costs, chargeable to a budget or cost centre, which can be influenced by the actions of the persons in whom control is vested.

Conversion cost: the cost of bringing a product or service into its present location or condition. May include a share of production overheads.

Convertible loan stock: loans where, at the option of the lender, the loan can be converted into ordinary shares at specified times and specified rates of conversion.

Cost behavior: the change in a cost when the level of output changes.

Cost center: a location, function, or item of equipment in respect of which costs may be ascertained and related to cost units.

Cost convention: the accounting convention whereby Balance Sheet assets are mostly valued at input cost or by reference to input cost.

Cost-volume-profit (CVP) analysis: the study of the relationships between variable costs, total fixed costs, levels of output and price and mix of units sold and profit, often analyzed in a financial modeling exercise.

Credit: commonly used to refer to a benefit or gain also the practice of selling goods and expecting payment at a later date.

Credit control: those measures and procedures adopted by a firm to ensure that its credit customers pay their accounts.

Creditors: those persons, firms or organizations to whom the enterprise owes money.

Creditors payment or settlement period: a ratio (usually creditors/ inputs on credit in a year x 365) which measures how long it takes the firm to pay its creditors.

Cumulative preference shares: preference shares where the rights to dividends omitted in a given year accumulate. These dividends must be paid before a dividend can be paid on the ordinary shares.

Current assets: cash + those assets (stock, debtors, prepayments, bank accounts) which the management intend to convert into cash or consume in the normal course of business within one year or within the operating cycle.

Current cost accounting (CCA): a system of accounting which recognizes the fluctuating value of money by measuring current value by applying specific indices and other devices to historical costs. A valid method which is complex and difficult to understand intuitively.

Current liabilities: debts or obligations that will be paid within one year of the accounting date. Another term used to describe the same is Creditors: amount falling due within one year.

Current ratio: the ratio of current assets to current liabilities.

Cut-off: the difficulties encountered by accountants in ensuring all items of income and expense are correctly ascribed to the right annual profit statement.

Debenture: a document which creates or acknowledges a debt. Commonly used for the debt itself.

Debt: a sum due by a debtor to his creditor. Commonly used also as a generic term for borrowings.

Debtors: those who owe money.

Debtors payment (settlement) period: a calculation of the average time taken by credit customers to pay for their goods. Calculated by Debtors/credit sales in a year x 365.

Depletion method: a method of depreciation applicable to wasting assets such as mines and quarries. The amount of depreciation in a year is a function of the quantity extracted in the year compared to the total resource.

Depreciation: a measure of the wearing out, consumption or other loss of value whether arising from use, passage of time or obsolescence through technology and market changes. Depreciation should be allocated to accounting period so as charge a fair proportion to each accounting period during the expected useful life of the asset.

Direct costs: those costs comprising direct materials, direct labor and direct expenses which can be traced directly to specific jobs, products or services.

Discontinued operations: operations of the reporting entity that are sold or terminated in a period. Turnover and results must be separately disclosed.

Discount: a monetary deduction or reduction. Settlement discount (also known as cash discount) is given for early settlement of debts. Debentures can be redeemed at a discount. Trade discount is a simple reduction in price given to favored customers for reasons such as status or bulk purchase.

Discounted cash flow: an evaluation of the future cash flows generated by a capital investment project, by discounting them to their present value.

Dividend: a distribution of earnings to its shareholders by a company.

Dividend cover: a measure of the extent to which the dividend paid by a company covered by its earnings (profits).

Dividend yield: a measure of the revenue earning capacity of an ordinary share to its holder. It is calculated by dividend per share as a percentage of the quoted share price.

Drawings: cash or goods withdrawn from the business by a proprietor for his private use.

Earnings: another word for profits, particularly for company profits.

Earnings per share: an investor ratio, calculated as after tax profits from ordinary activities / number of shares.

Economic Order Quantity (EOQ): that purchasing order size which takes into account the optimum combination of stockholding costs and ordering costs.

Equity convention: the convention that a business can be viewed as a unit that is a separate entity and apart from its owners and from other firms.

Equity: the ordinary shares or risk capital of an enterprise.

Exceptional items: material items which derive from events or transactions that fall within the ordinary activities of the reporting entity and which need to be disclosed by virtue of their size or incidence if the financial statements are to give a true and fair view. Examples are profits or losses on termination of an operation, costs of a fundamental reorganization and profits and losses on disposal of fixed assets.

Expense: a cost which will be in the Profit and Loss (P&L) Account of a year.

Exposure draft: a document issue on a specific accounting topic for discussion.

Extraordinary items: material items possessing a high degree of abnormality which arise from events or transactions that fall outside the ordinary activities of the reporting entity and which are not expected to recur. They should be disclosed but are very rare indeed.

Factoring: the sale of debtors to a factoring company to improve cash flow. Factoring is a method of obtaining finance tailored to the amount of business done but factoring companies also offer services such as credit worthiness checks, sales and debtor recording, and debt collection.

FIFO: first in first out – a method of recording and valuation of fungible assets, especially stocks, which values items on the assumption that the oldest stock is used first. FIFO stocks are valued at most recent input prices.

Finance lease: a leasing contract which transfers substantially all the risks and rewards of ownership of an asset to the lessee. In effect the lessee is really buying the assets with the aid of a loan and the lease installments are really payments of interest and repayments of capital. They are accounted for as such in accordance with the accounting convention of substance over form.

Financial statements: Balance Sheets, Profit and Loss Account, Income and Expenditure Accounts, Cash Flow Statements and other documents which formally convey information of a financial nature to interested parties concerning an enterprise. In companies, the financial statements are subject to audit opinion.

Fixed assets: business assets which have a useful life extending over more than one year. Examples are land and buildings, plant and machinery, vehicles.

Fixed cost: a cost which in the short term, remains the same at different levels of activity. An example is rent.

Flexible budget: a budget which is flexed to recognize the difference in behavior of fixed and variable costs in relation to levels of output. Total budgeted costs changed to accord with changed levels of activity.

Floating charge: an arrangement whereby a lender to a company has a floating charge over the assets generally of the company gives the lender priority of repayment from the proceeds of sale of the assets in the event of insolvency. Banks frequently take a floating charge when lending.

Format: a specific layout for a financial statement. Several alternatives are often prescribed by the prevailing governing authority or law of the country in which the enterprise operates or reports its financial performance.

Funds flow statement: a financial statement which links Balance Sheets at the beginning and end of a period with the Profit and Loss (P&L) Account for that period. Now replaced by the cash flow statement.

Fungible assets: assets which are substantially indistinguishable from each other. Used for stocks which can then be valued on FIFO or AVCO principles. LIFO is also possible but often not usually for tax reasons.

Gearing: also known as leverage, the relationship between debt and equity in the financing structure of a company.

Gilt-edged securities: securities and investments which offer a negligible risk of default. Principally government securities.

Goal congruence: the situation in which each individual, in satisfying his or her own interests, is also making the best possible contribution to the objectives of the enterprise.

Going concern: the accounting convention which assumes that the enterprise will continue in operational existence for the foreseeable future. This means in particular that the Profit and Loss (P&L) Account and Balance Sheet (BS) assume no intention or necessity to liquidate or curtail significantly the scale of operation.

Goodwill: an intangible asset which appears on the Balance Sheet of some businesses. It is valued at (or below) the difference between the price paid for a whole business and the fair value of the net assets acquired.

Gross: usually means before or without deductions. For example Gross Salary or Gross Profit.

Gross profit: sales revenue less cost of sales but before deduction of overhead expenses. In a manufacturing company it is sales revenue less cost of sales but before deduction of non-manufacturing overheads.

Gross margin: (or gross profit ratio), gross profit expressed as a percentage of sales.

Group: a set of interrelated companies usually consisting of a holding company and its subsidiary and sub-subsidiary companies.

Group accounts: the financial statements of a group wherein the separate financial statements of the member companies of a group are combined into consolidated financial statements.

HIFO: highest in highest out, a pricing policy where costs are collected for a job on the basis that the cost of materials and components is the highest recent input price.

Historical cost: the accounting convention whereby goods, resources and services are recorded at cost. Cost is defined as the exchange or transaction price. Under this Convention, realizable values are generally ignored. Inflation is also ignored. The almost universal adoption of this convention makes accounting harder to understand and lessens the credibility of financial statements.

Hurdle: a criteria that a proposed capital investment must pass before it is accepted. It may be a certain interest rate, a positive NPV or a maximum payback period.

Income and expenditure account: the equivalent to Profit and Loss (P&L) Accounts in nonprofit organizations such as clubs, societies and charities.

Indirect costs: costs which cannot be traced to particular products. An example is rent or management salaries. They are usually shared by more than one product and are called overheads.

Insolvency: the state of being unable to pay debts as they fall due. Also used to describe the activities of practitioners in the fields of bankruptcy, receivership and liquidations.

Intangible assets: assets which have long term value but no physical identity. Examples are goodwill, patents, trade marks and brands.

Interim dividend: a dividend paid during a financial year, generally after the issue of un-audited profit figures half way through the year.

Internal rate of return: the rate of discount which will just discount the future cash flows of a proposed capital investment back to the initial outlay.

Inventory: a detailed list of things. Used by accountants as another word for stock.

Investment appraisal: the use of accounting and mathematical methods to determine the likely returns for a proposed investment or capital project.

Key factor: a factor of production which is in limited supply and therefore constrains production.

Labor hour rate: a method of absorption where the costs of a cost centre are shared out amongst products on the basis of the number of hours of direct labor used on each product.

Leverage: another word for gearing.

LIFO: Last in first out – a valuation method for fungible items where the newest items are assumed to be used first. Means stocks will be valued at old prices. Not used in certain jurisdictions such as the U.K for tax reasons.

Limiting or key factor: a factor of production which is in limited supply and therefore constrains output.

Liquidation: the procedure whereby a company is wound up, its assets realized and the proceeds divided up amongst the creditors and shareholders.

Liquidity: the ease with which funds can be raised by the sale of assets.

Liquidity ratios: ratios which purport to indicate the liquidity of a business. They include the current ratio and the acid test ratio.

Listed companies: companies whose shares are traded on the stock exchange.

Machine hour rate: a method of absorption of the costs of a cost center where the costs are shared out among the products which use the centre in proportion to the use of machine hours by the relevant products.

Management accounting: the provision and interpretation of information which assists management in planning, controlling, decision making, and appraising performance.

Management by exception: control and management of costs and revenues by concentrating on those instances where significant variances by actual from budgets have occurred.

Manufacturing accounts: financial statements which measure and demonstrate the total costs of manufacturing in a period. They are followed by Trading and Profit and Loss (P&L) Accounts.

Marginal costing: a system of cost analysis which distinguishes fixed costs from variable costs.

Marginal cost: the additional cost incurred by the production of one extra unit.

Margin of safety: the excess of budgeted activity over breakeven activity. Usually expressed as a percentage of budgeted activity.

Mark-up: gross profit expressed as a percentage of cost of goods sold.

Matching convention: the idea that revenues and costs are accrued, matched with one another as far as possible so far as their relationship can be established or justifiably assumed, and dealt with in the Profit and Loss (P&L) Account of the period in which they relate. An example is the matching of sales of a product with the development costs of that product. The appropriate periods would be when the sales occur.

Master budgets: the overall budgets of an enterprise comprising cash budget, forecast Profit and Loss (P&L) Account and forecast Balance Sheet (BS). They are made up from subsidiary budgets.

Materiality: the accounting convention that recognizes that accounting is a summarizing process. Some items and transactions are large (i.e. material) enough to merit separate disclosure rather than inclusion with others in a lump sum. Examples are an exceptionally large bad debt or an exceptionally large loss on sale of a fixed asset.

Minority interest: the interests in the assets of a Group relating to shares in group companies not held by the holding company or other members of the group.

Modified accounts: financial statements which are shortened versions of full accounts. Small and medium sized companies can file these with the Registrar of Companies instead of full accounts.

Money measurement: the convention that requires that all assets, liabilities, revenues and expenses shall be expressed in money terms.

Net: usually means after deductions. For example net current assets current assets less current liabilities and net cash flow means cash inflows less cash outflows. Contrast gross.

Net book value: the valuation on the Balance Sheet of an asset. Also known as the carrying value or written down value.

Net present value: the value obtained by discounting all cash inflows and outflows attributable to a proposed capital investment project by a selected discount rate.

Net realizable value: the actual or estimated selling price of an asset less all further costs to completion (e.g. Cost of a repair if it needs to be repaired before sale) and all costs to be incurred before and on sale (e.g. commission).

NIFO: Next in first out – a pricing policy where costs are collected on the basis that the cost of materials and components is the next input price.

Nominal value: the face value of a share or debenture as stated in the official documents. Will not usually be the same as the issue price which may be at a premium and which will almost never correspond to actual value.

Objectivity: the convention of using reliable and verifiable facts (e.g. the input cost of an asset) rather than estimates of ‘value’ even if the latter is more realistic.

Operating cycle: the period of time it takes a firm to buy inputs, make or market a product and sell to and collect the cash from a customer.

Opportunity cost: the value of a benefit sacrificed in favor of an alternative course of action.

Ordinary shares: the equity capital of a company.

Outsourcing: the use of services (such as administration or computing) from separate outside firms instead of using the enterprise’s own employees.

Overheads: Indirect cost.

Overtrading: a paradoxical situation when a company does so much business that stocks and debtors rise leading to working capital and liquidity difficulties.

Par value: the nominal sum imprinted on a share certificate and which spears on the Balance Sheet (BS) of a company as share capital. It has no significance as a value.

Payback: the number of years which will elapse before the total incoming cash receipts of a proposed project are forecast to exceed the initial outlays.

Periodicity: the convention that financial statements are produced at regular intervals usually at least annually.

Preference shares: shares in which holders are entitled to a fixed rate of dividend (if one is declared) in priority to the ordinary shareholders in a winding up situation.

Planning variance: a variance arising because the budgeted cost is now seen as out of date. Examples are wage or price rises.

Prepayments: expenditure already made on goods or services but where the benefit will be felt after the Balance Sheet (BS) date. Examples are rent or rates or insurances paid in advance.

Price earnings ratio: an investor ratio calculated as – share / earnings per share.

Prime cost: the direct costs of production.

Private company: any company that is not a public company.

Profitability index: in investment appraisal, the net present value of cash inflows / the initial out lays.

Profit and Loss (P&L) Account: a financial statement which measures and reports the profit earned over a period of time.

Pro Rata: in proportion to.

Prospectus: an official document being in advertisement offering shares for sale to the public.

Provision: a charge in the Profit and Loss (P&L) Account of a business for an expense which arose in the past but which will only give rise to a payment in the future. To be a provision the amount payable must be uncertain as to amount or as to payability or both. An example is possible damages awardable by a court in a future action over a past incident (e.g. a libel).

Prudence (or conservatism): the convention whereby revenue and profits are not anticipated, but provision is made for all known liabilities (expenses and losses) whether the amount of these is known with certainty or is a best estimate. Essentially future profit, wait until it happens – future loss, count it now.

Quick ratio: also known as acid test ratio, current assets (except stock) / current liabilities.

Quoted company: also known as a listed company, a company whose shares are traded on the stock exchange.

Realizable value: the amount that an asset can be sold for.

Realization: to sell an asset and hence turn it into cash.

Realization convention: the concept that a profit is accounted (or when a good is sold and not when the cash is received.

Receiver: an insolvency practitioner who is appointed by a debenture holder with a fixed or floating charge when a company defaults.

Redemption: repayment of shares, debentures or loans.

Redemption yield: the yield given by an investment expressed as a percentage and taking into account both income and capital gain or loss.

Reducing balance: a method of depreciation whereby the asset is expensed to the Profit and Loss (P&L) Account over its useful life by applying a fixed percentage to the written down value.

Relevant costs: costs that will only be incurred if a proposed course of action is actually taken. The only ones relevant to an actual decision.

Relevant range: the range of activity which is likely. Within it variable costs are expected to be linearly variable with output and fixed costs are expected to be unchanged.

Reporting: the process whereby a company or other institution seeks to inform shareholders and other interested parties of the results and position of the entity by means of financial statements.

Reserves: a technical term indicating that a company has total assets which exceed in amount the sum of liabilities and share capital. This excess arises from retained profits or from revaluations of assets.

Resource accounting and budgeting: the use of normal accruals accounting and Balance Sheets in federal / government departments and agencies.

Retained profits: also known as retentions, the excess of profits over dividends.

Return on capital employed: a profitability ratio being income expressed as a percentage of the capital which produced the income.

Return on sales: the ratio of profit to sales expressed as a percentage.

Returns: the income flowing from the ownership of assets. May include capital gains.

Revenue: amounts charged to customers for goods or services rendered.

Revenue expenditure: expenditure that benefits only the current period and which will therefore be charged in the Profit and Loss (P&L) Account.

Rights issue: an invitation to existing shareholders to subscribe cash for new shares in the company in proportion to their holdings.

Salvage value: also known as residual value, the amount estimated to be recoverable from the sale of a fixed asset at the end of its useful life.

Secured liabilities: liabilities secured by a fixed or floating charge or by other operation of law such as hire purchase commitments.

Securities: financial assets such as shares, debentures and loan stocks.

Segmental reporting: the practice of breaking down turnover, profits and capital employed into sections to show the separate contributions of each to the overall picture. Segments can be distinct products, geographical areas, or classes of customers, etc.

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Accounting - Basic AccountingBasic Terms and Concepts

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Accounting

Basic Terms and Concepts

There are a few (and only a few) things you need to understand in order to make setting up your accounting system easier. They're basic (trust me), and they will probably clear up any confusion you may have had in the past when talking with your CPA or other technical accounting types.

Debits and CreditsThese are the backbone of any accounting system. Understand how debits and credits work and you'll understand the whole system. Every accounting entry in the general ledger contains both a debit and a credit. Further, all debits must equal all credits. If they don't, the entry is out of balance. That's not good. Out-of-balance entries throw your balance sheet out of balance.

Therefore, the accounting system must have a mechanism to ensure that all entries balance. Indeed, most automated accounting systems won't let you enter an out-of-balance entry-they'll just beep at you until you fix your error.

Depending on what type of account you are dealing with, a debit or credit will either increase or decrease the account balance. (Here comes the hardest part of accounting for most beginners, so pay attention.) Figure 1 illustrates the entries that increase or decrease each type of account.

Figure 1Debits and Credits vs. Account Types

Account         Type Debit          CreditAssets             Increases          DecreasesLiabilities         Decreases          IncreasesIncome            Decreases          IncreasesExpenses         Increases          Decreases

Notice that for every increase in one account, there is an opposite (and equal) decrease in another. That's what keeps the entry in balance. Also notice that debits always go on the left and credits on the right.

Let's take a look at two sample entries and try out these debits and credits:

In the first stage of the example we'll record a credit sale:

Accounts Receivable          $1,000 Sales Income                     $1,000

If you looked at the general ledger right now, you would see that receivables had a balance of $1,000 and income also had a balance of $1,000.

Now we'll record the collection of the receivable:

Cash                                 $1,000 Accounts Receivable          $1,000

Notice how both parts of each entry balance? See how in the end, the receivables balance is back to zero? That's as it should be once the balance is paid. The net result is the same as if we conducted the

whole transaction in cash:

Cash                     $1,000 Sales Income         $1,000

Of course, there would probably be a period of time between the recording of the receivable and its collection.

That's it. Accounting doesn't really get much harder. Everything else is just a variation on the same theme. Make sure you understand debits and credits and how they increase and decrease each type of account.

Assets and LiabilitiesBalance sheet accounts are the assets and liabilities. When we set up your chart of accounts, there will be separate sections and numbering schemes for the assets and liabilities that make up the balance sheet.

A quick reminder: Increase assets with a debit and decrease them with a credit. Increase liabilities with a credit and decrease them with a debit.

Identifying assetsSimply stated, assets are those things of value that your company owns. The cash in your bank account is an asset. So is the company car you drive. Assets are the objects, rights and claims owned by and having value for the firm.

Since your company has a right to the future collection of money, accounts receivable are an asset-probably a major asset, at that. The machinery on your production floor is also an asset. If your firm owns real estate or other tangible property, those are considered assets as well. If you were a bank, the loans you make would be considered assets since they represent a right of future collection.

There may also be intangible assets owned by your company. Patents, the exclusive right to use a trademark, and goodwill from the acquisition of another company are such intangible assets. Their value can be somewhat hazy.

Generally, the value of intangible assets is whatever both parties agree to when the assets are created. In the case of a patent, the value is often linked to its development costs. Goodwill is often the difference between the purchase price of a company and the value of the assets acquired (net of accumulated depreciation).

Identifying liabilitiesThink of liabilities as the opposite of assets. These are the obligations of one company to another. Accounts payable are liabilities, since they represent your company's future duty to pay a vendor. So is the loan you took from your bank. If you were a bank, your customer's deposits would be a liability, since they represent future claims against the bank.

We segregate liabilities into short-term and long-term categories on the balance sheet. This division is nothing more than separating those liabilities scheduled for payment within the next accounting period (usually the next twelve months) from those not to be paid until later. We often separate debt like this. It gives readers a clearer picture of how much the company owes and when.

Owners' equity

After the liability section in both the chart of accounts and the balance sheet comes owners' equity. This is the difference between assets and liabilities. Hopefully, it's positive-assets exceed liabilities and we have a positive owners' equity. In this section we'll put in things like

Partners' capital accounts

Stock

Retained earnings

Another quick reminder: Owners' equity is increased and decreased just like a liability:

Debits decrease

Credits increase

Most automated accounting systems require identification of the retained earnings account. Many of them will beep at you if you don't do so.

By the way, retained earnings are the accumulated profits from prior years. At the end of one accounting year, all the income and expense accounts are netted against one another, and a single number (profit or loss for the year) is moved into the retained earnings account. This is what belongs to the company's owners-that's why it's in the owners' equity section. The income and expense accounts go to zero. That's how we're able to begin the new year with a clean slate against which to track income and expense.

The balance sheet, on the other hand, does not get zeroed out at year-end. The balance in each asset, liability, and owners' equity account rolls into the next year. So the ending balance of one year becomes the beginning balance of the next.

Think of the balance sheet as today's snapshot of the assets and liabilities the company has acquired since the first day of business. The income statement, in contrast, is a summation of the income and expenses from the first day of this accounting period (probably from the beginning of this fiscal year).

Income and ExpensesFurther down in the chart of accounts (usually after the owners' equity section) come the income and expense accounts. Most companies want to keep track of just where they get income and where it goes, and these accounts tell you.

A final reminder: For income accounts, use credits to increase them and debits to decrease them. For expense accounts, use debits to increase them and credits to decrease them.

Income accountsIf you have several lines of business, you'll probably want to establish an income account for each. In that way, you can identify exactly where your income is coming from. Adding them together yields total revenue.

Typical income accounts would be

Sales revenue from product A

Sales revenue from product B (and so on for each product you want to track)

Interest income

Income from sale of assets

Consulting income

Most companies have only a few income accounts. That's really the way you want it. Too many accounts are a burden for the accounting department and probably don't tell management what it wants to know. Nevertheless, if there's a source of income you want to track, create an account for it in the chart of accounts and use it.

Expense accountsMost companies have a separate account for each type of expense they incur. Your company probably incurs pretty much the same expenses month after month, so once they are established, the expense accounts won't vary much from month to month. Typical expense accounts include

Salaries and wages

Telephone

Electric utilities

Repairs

Maintenance

Depreciation

Amortization

Interest

Rent

General Ledger

The general ledger is the core of your company’s financial records. These constitute the central “books” of your system, and every transaction flows through the general ledger. These records remain as a permanent track of the history of all financial transactions since day one of the life of your company.

Subledgers and the General LedgerYour accounting system will have a number of subsidiary ledgers (called subledgers) for items such as cash, accounts receivable, and accounts payable. All the entries that are entered (called posted) to these subledgers will transact through the general ledger account. For example, when a credit sale posted in the account receivable subledger turns into cash due to a payment, the transaction will be posted to the general ledger and the two (cash and accounts receivable) subledgers as well.

There are times when items will go directly to the general ledger without any subledger posting. These are primarily capital financial transactions that have no operational subledgers. These may include items such as capital contributions, loan proceeds, loan repayments (principal), and proceeds from sale of assets. These items will be linked to your balance sheet but not to your profit and loss statement.

Setting up the General LedgerThere are two main issues to understand when setting up the general ledger. One is their linkage to your financial reports, and the other is the establishment of opening balances.

The two primary financial documents of any company are their balance sheet and the profit and loss statement, and both of these are drawn directly from the company’s general ledger. The order of how the numerical balances appear is determined by the chart of accounts , but all entries that are entered will appear. The general ledger accrues the balances that make up the line items on these reports, and the changes are reflected in the profit and loss statement as well.

The opening balances that are established on your general ledgers may not always be zero as you might assume. On the asset side, you will have all tangible assets (the value of all machinery, equipment, and inventory) that is available as well as any cash that has been invested as working capital. On the liability side, you will have any bank (or stockholder) loans that were used, as well as trade credit or lease payments that you may have secured in order to start the company. You will also increase your stockholder equity in the amount you have invested, but not loaned to, the business.

The General Ledger Creates an Audit TrailDon’t let the word audit strike fear in your heart; I am not talking about a tax audit. Although, if you are called to respond to an outside audit for any reason, a well-maintained general ledger is essential.

But you will also want an internal trail of transaction so that you can trace any discrepancy (such as double billing or an unrecorded payment) through your own system. You must be able to find the origin of any transaction in order to verify its accuracy, and the general ledger is where you will do this.

The Language of Accounting

ACCOUNTING: A NECESSARY EVIL?Many of the small-business managers I know view accounting this way. It's overhead and really doesn't contribute to the bottom line. Or does it? The people who run the accounting system speak in an unintelligible blur of debits and credits. They have little grasp of the operation that generates the money to pay their salaries.

Sound familiar? Maybe you're one of the entrepreneurs who share these thoughts. Welcome. I'm not out to convert you to the good of accounting. However, my guess is that once you see how to set up an efficient accounting system for your small business-one that really does contribute to overall profitability-you'll convert yourself.

Information Means ProfitsThe purpose of the accounting system is to communicate. It produces useful information (not raw data) that tells specific things about the company. To those who understand what this intricate system is saying (and you'll be one of them by the end of this book), it's like money in the bank.

Suddenly, information that you need to run the company is at your fingertips. Of course, this information is couched in financial terms. That's the language your accounting system uses. But it's not complicated and-with help from this book-it's not foreign.

Here are two examples that prove this.

Overdrawing TDO's bank accountTDO Enterprises fabricates the chassis boxes for computers. It always seemed that there wasn't enough money in the bank to pay the bills. A quick look at the aging of accounts receivable revealed that customers paid on average two weeks after the time stated in the terms of sale.

Rather than dip into its line of credit again, TDO's solution was to mount an aggressive collection campaign. The company used its accounts receivable system to monitor progress toward getting and keeping customers current.

Within the space of two months, TDO's bank account balance had risen to a point where it could pay its bills regularly without having to draw on its credit line.

MAG's eroding profit marginsMAG Partners, Ltd. sells grass seed on a wholesale basis. Profits recently turned down for no apparent reason. However, the partners were savvy enough to investigate the sales department's ability to pass on recent price increases to customers.

Comparison of the sales prices for MAG's grass seed with what MAG had to pay for it showed a 20 percent decline in gross profit margin (sales - cost of goods sold = gross margin). The solution was to dock sales commissions for the amount under the company's list price. Profits miraculously rebounded.

Knowing What to Look ForWas the language the accounting system used to describe these two problems foreign? No. Was the solution a great mystery? Again, no. For TDO, the answer was simply to collect receivables faster. The accounting system identified the delinquent customers. For MAG, the answer was to raise prices. Once again, the accounting system showed which products and salespeople weren't following company policy.

All management needed was an understanding of the information available in the accounting system to help run the company. That's how we'll use your accounting system.

WHAT YOU WANT FROM YOUR ACCOUNTING SYSTEMThe kind of information we found in the prior examples is what you want from your accounting system. This feedback must

Be accurate

Fulfill management's requirements

Be easy to use

We can employ information like this in solving problems and running the business. As well as having the attributes of accuracy, relevancy, and simplicity, our accounting system ought to be set up in such a way that it does not require an inordinate amount of time to maintain. Remember, you aren't an accountant, and we don't want you to spend your time trying to do accounting.

Further, your accounting system should not require a CPA to operate it or to interpret the output. Some of the popular automated accounting systems require specific knowledge not only about computers but about the field of accounting as well. Make sure that those running the system have the background needed to install and operate it. If they don't, get a package that is more in tune with your firm's capabilities.

Further, if you are using an automated accounting package, it must run on the computer equipment that is either currently in place or to be acquired in the near future.

If you choose to use an automated accounting system, this book will be of immense help in teaching you the basics of how it works. Whether manual or automated, all accounting systems use debits, credits, a general ledger, and subledgers. All entries are posted the same way. The only difference is which buttons to push. The last chapter demonstrates methods of selecting the proper automated accounting system for your company.

ACCOUNTING FOR THE BUSINESS CYCLEThe business cycle is nothing more than the flow of transactions needed in your business to complete a sale and collect the proceeds. It's important to setting up your accounting system. We want to know what types of transactions are involved and the accounting entries to make along the way. Most companies business cycles progress something like this:

1.Purchase raw materials. 2.Enter goods into raw materials inventory. 3.Begin the manufacturing or assembly process. 4.Enter goods into work in process inventory. 5.Pay suppliers or pay employees (at service companies). 6.Complete the manufacturing or assembly process. 7.Enter goods into finished goods inventory. 8.Sell the inventory. 9.Collect payment for credit sales.

Briefly, here is the way your accounting system interacts at each stage of the business cycle.

Purchase Raw MaterialsWhat happens when you buy the raw materials used to create your company's product? You receive the goods, and you either pay cash for the goods or obligate the company for future payment. Both transactions require these accounting entries:

Increase raw materials inventory

Decrease cash (if you paid on the spot)

Increase accounts payable (if you didn't)

At this point, we've covered the first two steps of the business cycle listed above.

Begin the Manufacturing ProcessWhen we use raw materials to make our product, the accounting system transfers the inventory from raw materials to an intermediate stage called work in process (WIP for short). This transaction explains the third and fourth steps of the business cycle.

Pay SuppliersSometime during the production process we must pay our suppliers if we bought the raw materials on credit. The accounting entry for this transaction does two things:

Reduces accounts payable

Reduces cash

Complete the Manufacturing ProcessAt last, we have completed our manufacturing process. Now we can move the product from the work in

process inventory to the finished goods inventory. This transaction particularly interests the sales staff, since it means that the product is now available for sale, and that's what generates their commissions. The entries into the accounting system that record this event go like this:

Reduce work in process inventory

Increase finished goods inventory

We've now completed the sixth and seventh steps of the business cycle.

Sell the ProductAt last we're ready to make a sale. If it's a credit sale, our accounting system must record these transactions:

Reduction in finished goods inventory

Increase in accounts receivable

Increase in sales revenue

If this was a cash sale, replace the increase in receivables with an increase in cash. We just finished the eighth step of the business cycle.

Collect the ReceivableThe final stage of the business cycle is conversion of the receivable (which is an asset) into spendable cash. When the customer pays, the accounting system records a decrease in receivables and an increase in cash.

This ends the business cycle and the various accounting transactions involved. The accounting system we're setting up will cover every one of these transactions.

Components of the Accounting System

Think of the accounting system as a wheel whose hub is the general ledger (G/L). Feeding the hub information are the spokes of the wheel. These include

Accounts receivable

Accounts payable

Order entry

Inventory control

Cost accounting

Payroll

Fixed assets accounting

These modules are ledgers themselves. We call them subledgers. Each contains the detailed entries of its specific field, such as accounts receivable. The subledgers summarize the entries, then send the summary up to the general ledger. For example, each day the receivables subledger records all credit

sales and payments received. The transactions net together then go up to the G/L to increase or decrease A/R, increase cash and decrease inventory.

We'll always check to be sure that the balance of the subledger exactly equals the account balance for that subledger account in the G/L. If it doesn't, then there's a problem.

Differences between Manual and Automated LedgersThink of the G/L as a sheet of paper on which transactions from all four categories of accounts-assets, liabilities, income, and expenses-are recorded. Some of them flow up from various subledgers, and some are entered directly into the G/L through a general journal entry. An example of such a direct entry would be the payment on a loan.

The same concept of a sheet of paper holds for each subledger that feeds the general ledger. A computerized accounting system works the same way, except that the general ledger and subledgers are computer files instead of sheets of paper. Entries are posted to each and summarized, then the summary is sent up to the G/L for posting.

ORGANIZATION OF THE ACCOUNTING DEPARTMENTOrganize your small-business accounting system by function. Often there's just one person there to do all the transaction entries. From an internal control standpoint, this isn't desirable. Having too few people doing all the accounting opens the door for fraud and embezzlement. Companies with more people assign functions in such a way that those done by the same person don't pose a control threat.

Having the same person draft the checks and reconcile the checking account is a good example of how not to assign accounting duties. We'll talk extensively about internal control later. However, for now, small businesses often can't afford the number of people needed for an adequate separation of duties. The internal control structure that we'll install in your new accounting system helps mitigate that risk through mechanics and procedures rather than expensive people.

Assignment of DutiesHere's your first assignment: Figure out who is going to do what in your new accounting system. The duties and areas of responsibility we need to assign include

Overall responsibility for the accounting system

Management of the computer system (if you're using one)

Accounts receivable

Accounts payable

Order entry

Cost accounting

Monthly reporting

Inventory control

Payroll (even if you use an outside payroll service, someone must be in control and responsible)

Internal accounting control

Fixed assets

In many cases the same person will do many of these things. However, these are the areas we'll be dealing with in setting up the accounting system. The person you assign to be in overall charge of the system should be the one who is most familiar with accounting. If you are just starting your company, you might want to think about the background of some of your new employees. At least one should have the capacity to run the accounting system.

If you find it difficult to determine someone's expertise in a field with which you are unfamiliar, here are some solutions:

1. Have them interviewed by an expert. Your own CPA will probably be glad to interview a few for you.

2. Carefully check references from past jobs. Ask detailed questions on exactly what they did in the accounting function. Compare the answers with what they say they did.

3. Ask them some accounting questions. It may sound odd that you (of all people) should be asking such questions. However, even if you can't judge the technical merit of the answers, you can get a feel for how comfortable they are with the subject and the authority with which they answer.

Basic Terms and Concepts

There are a few (and only a few) things you need to understand in order to make setting up your accounting system easier. They're basic (trust me), and they will probably clear up any confusion you may have had in the past when talking with your CPA or other technical accounting types.

Debits and CreditsThese are the backbone of any accounting system. Understand how debits and credits work and you'll understand the whole system. Every accounting entry in the general ledger contains both a debit and a credit. Further, all debits must equal all credits. If they don't, the entry is out of balance. That's not good. Out-of-balance entries throw your balance sheet out of balance.

Therefore, the accounting system must have a mechanism to ensure that all entries balance. Indeed, most automated accounting systems won't let you enter an out-of-balance entry-they'll just beep at you until you fix your error.

Depending on what type of account you are dealing with, a debit or credit will either increase or decrease the account balance. (Here comes the hardest part of accounting for most beginners, so pay attention.) Figure 1 illustrates the entries that increase or decrease each type of account.

Figure 1Debits and Credits vs. Account Types

Account         Type Debit          CreditAssets             Increases          DecreasesLiabilities         Decreases          IncreasesIncome            Decreases          IncreasesExpenses         Increases          Decreases

Notice that for every increase in one account, there is an opposite (and equal) decrease in another. That's what keeps the entry in balance. Also notice that debits always go on the left and credits on the right.

Let's take a look at two sample entries and try out these debits and credits:

In the first stage of the example we'll record a credit sale:

Accounts Receivable          $1,000 Sales Income                     $1,000

If you looked at the general ledger right now, you would see that receivables had a balance of $1,000 and income also had a balance of $1,000.

Now we'll record the collection of the receivable:

Cash                                 $1,000 Accounts Receivable          $1,000

Notice how both parts of each entry balance? See how in the end, the receivables balance is back to zero? That's as it should be once the balance is paid. The net result is the same as if we conducted the whole transaction in cash:

Cash                     $1,000 Sales Income         $1,000

Of course, there would probably be a period of time between the recording of the receivable and its collection.

That's it. Accounting doesn't really get much harder. Everything else is just a variation on the same theme. Make sure you understand debits and credits and how they increase and decrease each type of account.

Assets and LiabilitiesBalance sheet accounts are the assets and liabilities. When we set up your chart of accounts, there will be separate sections and numbering schemes for the assets and liabilities that make up the balance sheet.

A quick reminder: Increase assets with a debit and decrease them with a credit. Increase liabilities with a credit and decrease them with a debit.

Identifying assetsSimply stated, assets are those things of value that your company owns. The cash in your bank account is an asset. So is the company car you drive. Assets are the objects, rights and claims owned by and having value for the firm.

Since your company has a right to the future collection of money, accounts receivable are an asset-probably a major asset, at that. The machinery on your production floor is also an asset. If your firm owns real estate or other tangible property, those are considered assets as well. If you were a bank, the loans you make would be considered assets since they represent a right of future collection.

There may also be intangible assets owned by your company. Patents, the exclusive right to use a trademark, and goodwill from the acquisition of another company are such intangible assets. Their value can be somewhat hazy.

Generally, the value of intangible assets is whatever both parties agree to when the assets are created. In the case of a patent, the value is often linked to its development costs. Goodwill is often the difference

between the purchase price of a company and the value of the assets acquired (net of accumulated depreciation).

Identifying liabilitiesThink of liabilities as the opposite of assets. These are the obligations of one company to another. Accounts payable are liabilities, since they represent your company's future duty to pay a vendor. So is the loan you took from your bank. If you were a bank, your customer's deposits would be a liability, since they represent future claims against the bank.

We segregate liabilities into short-term and long-term categories on the balance sheet. This division is nothing more than separating those liabilities scheduled for payment within the next accounting period (usually the next twelve months) from those not to be paid until later. We often separate debt like this. It gives readers a clearer picture of how much the company owes and when.

Owners' equityAfter the liability section in both the chart of accounts and the balance sheet comes owners' equity. This is the difference between assets and liabilities. Hopefully, it's positive-assets exceed liabilities and we have a positive owners' equity. In this section we'll put in things like

Partners' capital accounts

Stock

Retained earnings

Another quick reminder: Owners' equity is increased and decreased just like a liability:

Debits decrease

Credits increase

Most automated accounting systems require identification of the retained earnings account. Many of them will beep at you if you don't do so.

By the way, retained earnings are the accumulated profits from prior years. At the end of one accounting year, all the income and expense accounts are netted against one another, and a single number (profit or loss for the year) is moved into the retained earnings account. This is what belongs to the company's owners-that's why it's in the owners' equity section. The income and expense accounts go to zero. That's how we're able to begin the new year with a clean slate against which to track income and expense.

The balance sheet, on the other hand, does not get zeroed out at year-end. The balance in each asset, liability, and owners' equity account rolls into the next year. So the ending balance of one year becomes the beginning balance of the next.

Think of the balance sheet as today's snapshot of the assets and liabilities the company has acquired since the first day of business. The income statement, in contrast, is a summation of the income and expenses from the first day of this accounting period (probably from the beginning of this fiscal year).

Income and ExpensesFurther down in the chart of accounts (usually after the owners' equity section) come the income and expense accounts. Most companies want to keep track of just where they get income and where it goes, and these accounts tell you.

A final reminder: For income accounts, use credits to increase them and debits to decrease them. For expense accounts, use debits to increase them and credits to decrease them.

Income accountsIf you have several lines of business, you'll probably want to establish an income account for each. In that way, you can identify exactly where your income is coming from. Adding them together yields total revenue.

Typical income accounts would be

Sales revenue from product A

Sales revenue from product B (and so on for each product you want to track)

Interest income

Income from sale of assets

Consulting income

Most companies have only a few income accounts. That's really the way you want it. Too many accounts are a burden for the accounting department and probably don't tell management what it wants to know. Nevertheless, if there's a source of income you want to track, create an account for it in the chart of accounts and use it.

Expense accountsMost companies have a separate account for each type of expense they incur. Your company probably incurs pretty much the same expenses month after month, so once they are established, the expense accounts won't vary much from month to month. Typical expense accounts include

Salaries and wages

Telephone

Electric utilities

Repairs

Maintenance

Depreciation

Amortization

Interest

Rent

Income Statements

An income statement, otherwise known as a profit and loss statement, is a summary of a company’s profit or loss during any one given period of time, such as a month, three months, or one year. The income statement records all revenues for a business during this given period, as well as the operating expenses for the business.

What are income statements used for? You use an income statement to track revenues and expenses so that you can determine the operating performance of your business over a period of time. Small business owners use these statements to find out what areas of their business are over budget or under budget. Specific items that are causing unexpected expenditures can be pinpointed, such as phone, fax, mail, or supply expenses. Income statements can also track dramatic increases in product returns or cost of goods sold as a percentage of sales. They also can be used to determine income tax liability.

It is very important to format an income statement so that it is appropriate to the business being conducted.

Income statements, along with balance sheets, are the most basic elements required by potential lenders, such as banks, investors, and vendors. They will use the financial reporting contained therein to determine credit limits.

1. Sales The sales figure represents the amount of revenue generated by the business. The amount recorded here is the total sales, less any product returns or sales discounts.

2. Cost of goods sold This number represents the costs directly associated with making or acquiring your products. Costs include materials purchased from outside suppliers used in the manufacture of your product, as well as any internal expenses directly expended in the manufacturing process.

• Gross profit Gross profit is derived by subtracting the cost of goods sold from net sales. It does not include any operating expenses or income taxes.

3. Operating expenses These are the daily expenses incurred in the operation of your business. In this sample, they are divided into two categories: selling, and general and administrative expenses.

• Sales salaries These are the salaries plus bonuses and commissions paid to your sales staff.

• Collateral and promotions Collateral fees are expenses incurred in the creation or purchase of printed sales materials used by your sales staff in marketing and selling your product. Promotion fees include any product samples and giveaways used to promote or sell your product.

• Advertising These represent all costs involved in creating and placing print or multi-media advertising.

• Other sales costs These include any other costs associated with selling your product. They may include travel, client meals, sales meetings, equipment rental for presentations, copying, or miscellaneous printing costs.

• Office salaries These are the salaries of full- and part-time office personnel.

• Rent These are the fees incurred to rent or lease office or industrial space.

• Utilities These include costs for heating, air conditioning, electricity, phone equipment rental, and phone usage used in connection with your business.

• Depreciation Depreciation is an annual expense that takes into account the loss in value of equipment used in your business. Examples of equipment that may be subject to depreciation includes copiers, computers, printers, and fax machines.

• Other overhead costs Expense items that do not fall into other categories or cannot be clearly associated with a particular product or function are considered to be other overhead costs. These types of expenses may include insurance, office supplies, or cleaning services.

4. Total expenses This is a tabulation of all expenses incurred in running your business, exclusive of taxes or interest expense on interest income, if any.

5. Net income before taxes This number represents the amount of income earned by a business prior to paying income taxes. This figure is arrived at by subtracting total operating expenses from gross profit.

6. Taxes This is the amount of income taxes you owe to the federal government and, if applicable, state and local government taxes.

7. Net income This is the amount of money the business has earned after paying income taxes.

Balance Sheets

A balance sheet is a snapshot of a business’ financial condition at a specific moment in time, usually at the close of an accounting period. A balance sheet comprises assets, liabilities, and owners’ or stockholders’ equity. Assets and liabilities are divided into short- and long-term obligations including cash accounts such as checking, money market, or government securities. At any given time, assets must equal liabilities plus owners’ equity. An asset is anything the business owns that has monetary value. Liabilities are the claims of creditors against the assets of the business.

What is a balance sheet used for? A balance sheet helps a small business owner quickly get a handle on the financial strength and capabilities of the business. Is the business in a position to expand? Can the business easily handle the normal financial ebbs and flows of revenues and expenses? Or should the business take immediate steps to bolster cash reserves?

Balance sheets can identify and analyze trends, particularly in the area of receivables and payables. Is the receivables cycle lengthening? Can receivables be collected more aggressively? Is some debt uncollectable? Has the business been slowing down payables to forestall an inevitable cash shortage?

Balance sheets, along with income statements, are the most basic elements in providing financial reporting to potential lenders such as banks, investors, and vendors who are considering how much credit to grant the firm.

1. Assets Assets are subdivided into current and long-term assets to reflect the ease of liquidating each asset. Cash, for obvious reasons, is considered the most liquid of all assets. Long-term assets, such as real estate or machinery, are less likely to sell overnight or have the capability of being quickly converted into a current asset such as cash.

2. Current assets Current assets are any assets that can be easily converted into cash within one calendar year. Examples of current assets would be checking or money market accounts, accounts receivable, and notes receivable that are due within one year’s time.

• Cash Money available immediately, such as in checking accounts, is the most liquid of all short-term assets.

• Accounts receivables This is money owed to the business for purchases made by customers, suppliers, and other vendors.

• Notes receivables Notes receivables that are due within one year are current assets. Notes that cannot be collected on within one year should be considered long-term assets.

3. Fixed assets Fixed assets include land, buildings, machinery, and vehicles that are used in connection with the business.

• Land Land is considered a fixed asset but, unlike other fixed assets, is not depreciated, because land is considered an asset that never wears out.

• Buildings Buildings are categorized as fixed assets and are depreciated over time.

• Office equipment This includes office equipment such as copiers, fax machines, printers, and computers used in your business.

• Machinery This figure represents machines and equipment used in your plant to produce your product. Examples of machinery might include lathes, conveyor belts, or a printing press.

• Vehicles This would include any vehicles used in your business.

• Total fixed assets This is the total dollar value of all fixed assets in your business, less any accumulated depreciation.

4. Total assets This figure represents the total dollar value of both the short-term and long-term assets of your business.

5. Liabilities and owners’ equity This includes all debts and obligations owed by the business to outside creditors, vendors, or banks that are payable within one year, plus the owners’ equity. Often, this side of the balance sheet is simply referred to as “Liabilities.”

• Accounts payable This is comprised of all short-term obligations owed by your business to creditors, suppliers, and other vendors. Accounts payable can include supplies and materials acquired on credit.

• Notes payable This represents money owed on a short-term collection cycle of one year or less. It may include bank notes, mortgage obligations, or vehicle payments.

• Accrued payroll and withholding This includes any earned wages or withholdings that are owed to or for employees but have not yet been paid.

• Total current liabilities This is the sum total of all current liabilities owed to creditors that must be paid within a one-year time frame.

• Long-term liabilities These are any debts or obligations owed by the business that are due more than one year out from the current date.

• Mortgage note payable This is the balance of a mortgage that extends out beyond the current year. For example, you may have paid off three years of a fifteen-year mortgage note, of which the remaining eleven years, not counting the current year, are considered long-term.

• Owners’ equity Sometimes this is referred to as stockholders’ equity. Owners’ equity is made up of the initial investment in the business as well as any retained earnings that are reinvested in the business.

• Common stock This is stock issued as part of the initial or later-stage investment in the business.

• Retained earnings These are earnings reinvested in the business after the deduction of any distributions to shareholders, such as dividend payments.

6. Total liabilities and owners’ equity This comprises all debts and monies that are owed to outside creditors, vendors, or banks and the remaining monies that are owed to shareholders, including retained earnings reinvested in the business.

Depreciation

The concept of depreciation is really pretty simple. For example, let’s say you purchase a truck for your business. The truck loses value the minute you drive it out of the dealership. The truck is considered an operational asset in running your business. Each year that you own the truck, it loses some value, until the truck finally stops running and has no value to the business. Measuring the loss in value of an asset is known as depreciation.

Depreciation is considered an expense and is listed in an income statement under expenses. In addition to vehicles that may be used in your business, you can depreciate office furniture, office equipment, any buildings you own, and machinery you use to manufacture products.

Land is not considered an expense, nor can it be depreciated. Land does not wear out like vehicles or equipment.

To find the annual depreciation cost for your assets, you need to know the initial cost of the assets. You also need to determine how many years you think the assets will retain some value for your business. In the case of the truck, it may only have a useful life of ten years before it wears out and loses all value.

Straight-line depreciation Straight-line depreciation is considered to be the most common method of depreciating assets. To compute the amount of annual depreciation expense using the straight-line method requires two numbers: the initial cost of the asset and its estimated useful life. For example, you purchase a truck for $20,000 and expect it to have use in your business for ten years. Using the straight-line method for determining depreciation, you would divide the initial cost of the truck by its useful life.

The $20,000 becomes a depreciation expense that is reported on your income statement under operation expenses at the end of each year.

For tax purposes, some accountants prefer to use other methods of accelerating depreciation in order to record larger amounts of depreciation in the early years of the asset to reduce tax bills as soon as possible.

You need, additionally, to check the regulations published by the federal Internal Revenue Service and various state revenue authorities for any specific rules regarding depreciation and methods of calculating depreciation for various types of assets.

Amortization

In the course of doing business, you will likely acquire what are known as intangible assets. These assets can contribute to the revenue growth of your business and, as such, they can be expensed against these future revenues. An example of an intangible asset is when you buy a patent for an invention.

Calculating amortization The formula for calculating the amortization on an intangible asset is similar to the one used for calculating straight-line depreciation. You divide the initial cost of the intangible asset by the estimated useful life of the intangible asset. For example, if it costs $10,000 to acquire a patent and it has an estimated useful life of ten years, the amortized amount per year equals $1,000. The amount of amortization accumulated since the asset was acquired appears on the balance sheet as a deduction under the amortized asset.

Formula

Initial Cost / Useful Life = Amortization per Year

$10,000 / 10 = $1,000 per Year

Inventory Accounting

Inventory accounting may sound like a huge undertaking but in reality, it is quite straightforward and easy to understand. You start with the inventory you have on hand. No matter when you sell product, the value of your inventory will remain constant based on accepted and rational methods of inventory accounting. Those methods include weighted average, first in/first out, and last in/first out.

Weighted average Weighted average measures the total cost of items in inventory that are available for sale divided by the total number of units available for sale. Typically this average is computed at the end of an accounting period.

Suppose you purchase five widgets at $10 apiece and five widgets at $20 apiece. You sell five units of product. The weighted average method is calculated as follows:

Total Cost of Goods for Sale at Cost (divided)Total Number of Units Available for Sale =

Weighted Average Cost per Widget-

Five widgets at $10 each = $50Five widgets at $20 each = $100

Total number of widgets = 10Weighted Average = $150 / 10 = $15

$15 is the average cost of the 10 widgets

First in/first out First in, first out means exactly what it says. The first widgets you bring into inventory will be the first ones sold as product. First in, first out, or FIFO as it is commonly referred to, is based on the principle that most businesses tend to sell the first goods that come into inventory.

Suppose you buy five widgets at $10 apiece on January 3 and purchase another five widgets at $20 apiece on January 7. You then sell five widgets on January 30. Using first in, first out, the five widgets you purchased at $10 would be sold first. This would leave you with the five widgets that you purchased at $20, which would leave the value of your inventory at $100.

Last in/first out This method, commonly referred to as LIFO, is based on the assumption that the most recent units purchased will be the first units sold. A “widget” is an imaginary item that could be just about any product. The advantage of last in, first out accounting, or LIFO, is that typically the last widgets purchased were purchased at the highest price and that by considering the highest priced items to be sold first, a business is able to reduce its short-term profit, and hence, taxes.

Suppose you purchase five widgets at $10 apiece on January 4 and five more widgets at $20 apiece on February 2. You then sell five widgets on February 20. The value of your inventory, using LIFO, would be $50, since the most recent widgets purchased, at a total value of $100 on February 2, were sold. You were left with the five widgets valued at $10 each.

Basic Accounting Terminology 101

Prior to actually beginning work as an accountant, there is generally exposure to accounting terminology and concepts; whether in the form of classroom instruction or as an intern with on-the-job training.  However, rather than risk the possibility of an individual beginning work as a bookkeeper, or an accounting intern, without the necessary understanding of basic terms and concepts, we will provide a brief overview.

When you get past the automatic block that many individuals put up upon hearing the word “accounting”, the basic concepts and terms are quite easily grasped.  (I personally believe the terms used in learning to calculate baseball statistics is more complicated than accounting terminology).

Debits and CreditsEvery single transaction recorded in the accounting process falls into one of two categories: it is either a debit or a credit.   We could use the official definitions here, but I prefer to keep absorption levels (and interest) high, so we are going to use very simple definitions and examples.  A debit is a transaction of value “added” to an account.  A credit is a transaction of value “removed” from an account.  Debit, value is added.  Credit, value is removed.  For example, in your checking account, a deposit is a debit, a check is a credit. This is as simple as the definition gets in practical application.  How you apply those transactions, depends upon the type of account you are working with.

AccountsOkay, now you will need to know what we mean by >account.  Accounts are simply established to provide a record of individual business transactions as they apply to a certain area or item.  Your personal checking account is established in order to provide a record of individual personal financial transactions you create when you write a check.

All of the accounts are listed in a general ledger.   Today, the actual ledger book has long since been replaced by accounting software that creates a general ledger on the computer.  The concept however has not been altered.  The general ledger is the central location for maintaining all your accounts. Journal entries refer to the posting or entering of the financial transactions to a particular account.

Assets, Liabilities, Equity, Revenue and ExpensesThese are all the different types of accounts the accounting system utilizes.  Assets are accounts that add value to your individual or business worth.  Liabilities are accounts that remove value from your individual or business worth.  Equity is used to identify the individual contribution of money, or other financial equivalent, invested in individual or business worth.  The revenue account is simply the account that tracks all income generated.  Expense accounts are the individual accounts setup to record the financial transactions that occur, as expenditure, in generating that income.

An example of an asset would be your car.  Your car has a dollar value attached to it.  It adds value to your individual worth.  An example of a liability would be your car loan.  The loan removes value from your individual worth.  The equity in your car would be any money you paid down toward the purchase.  If you use your car to operate a pizza delivery service, the income

generated from delivering pizzas would be known as revenue.  Any expense for gas or car repairs would be recorded in an expense account known as “automotive expense”.

Accounting SystemThe reason for establishing any accounting system is to track this information in order to provide for a unified method of “accounting” for all financial transactions as they occur.  Accounting practices give us a way to keep a record, or to give an accounting for your financial transactions.

An accounting system offers a method for checking, balancing, and reconciling all those transactions in order to produce accurate pictures of our financial health.  Profit and Loss Reports, Balance Sheets, and Cash Flow Statements are the end result of compiling all the transactions into meaningful, usable information for individuals and business owners alike.

NAME Introduction

Account

Account Groups

Assets

Balance

Books of Account

Consumption

Depreciation

Expenditure

Expenses

General Ledger

Income

Liabilities

Loss

Net Worth

Production

Profit

Revenue

Transaction

Author

NAME General Ledger - Some accounting terms relating to general ledgers

Introduction This article does no more than list a few accounting terms, with a simple explanation of each.

Account Each category of money is called an 'account'.

Account Groups There are 4 major 'account groups' in the ledger.

The 'account groups' are:

'Assets' 'Liabilities' 'Income' or 'Revenue' or 'Production' 'Expenditure' or 'Expenses' or 'Consumption'

Assets 'Assets' are what the enterprise owns.

Typical 'asset' 'accounts' are:

Cash account Equipment account Real estate account Debtors account

A business might usefully have 4 'asset' 'accounts', corresponding to these 4 'assets'.

Balance Businesses need to keep track of the 'balance' of each 'account'.

Books of Account These are the financial records of a business.

Consumption Whatever the enterprise consumes is recorded in a 'consumption' or 'expense' 'account'.

Typical 'consumptions' are:

Payments for wages Payments for tax Payments for electricity Payments for telephone Payments for postage Payments for raw materials

Depreciation This is allowing for wear and tear of 'assets'.

Expenditure

See 'Consumption'

Expenses See 'Consumption'

General Ledger The 'general ledger' is the mechanism for keeping these 'account' 'balances'.

Income See 'Production'.

Liabilities 'Liabilities' are what the enterprise owes.

Typical 'liability' 'accounts' are:

Mortgage account Credit card accounts Bills payable or Creditors account

'Liabilities' might be recorded in a mortgage 'account', a credit card 'account' and a bills payable or creditors 'account'.

Loss If the enterprise 'consumes' more than it 'produces', it makes a loss.

Net Worth The 'net worth' of a business at any point in time is the difference between its total 'assets' and total 'liabilities'.

Production Whatever the enterprise produces is recorded in a 'production' or 'income' 'account'.

Typical 'productions' are:

Sales of goods and services Interest on money in the bank Reimbursement of 'expenses' incurred on behalf of someone else

Profit If the enterprise 'produces' more than it 'consumes', it makes a profit.

Revenue See 'Production'.

Transaction Anything a business enterprise does relating to money must be recorded in the 'books of account'. The record of any particular event is called a 'transaction'.

Typical 'transactions' are:

Paying bills Sending invoices Purchasing goods by credit card Lending or borrowing money 'Depreciation'

Every 'transaction' refers to categories of money called 'accounts'.

Author

Ron Savage.

Home page: http://savage.net.au/index.html

Version: 1.01 01-Jun-2006

This version disguises my email address.

Version: 1.00 18-Feb-2002

Original version.

Licence

Australian Copyright © 2002 Ron Savage. All rights reserved.

All Programs of mine are 'OSI Certified Open Source Software';you can redistribute them and/or modify them under the terms ofThe Artistic License, a copy of which is available at:http://www.opensource.org/licenses/index.html

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Home Business & Finance Accounting

Accounting 101 – Basic Concepts and Terms

 

Introduction to Fundamental Financial Bookkeeping Theory

Nov 8, 2009 James Clausen

Accounting 101 – Basics, Concepts and Terms - ppdigital

Learn basic accounting terms like debits and credits, journals, general ledger, balance sheet and income statement. Discover accounting concepts and their relationship.

Debits and credits are two terms that are the backbone of understanding basic accounting concepts. After grasping the concept of these two terms, an individual can then move on to understanding basic accounting concepts. Learn the progression from posting business financial transactions, to reporting profits and owner’s equity.

Accounting 101 - Debits and Credits

Financial business transactions are posted with debits and credits. The total dollar amount of debits must be equal to the total dollar amount of credits. If they do not equal, the transaction will be out of balance. Debits and credit represent an increase or decrease, depending on the financial account category. Understanding debits and credits is essential to grasping the concepts of accounting.

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Asset – debit increase, credit decrease Liability – debit decrease, credit increase

Revenue – debit decrease, credit increase

Expense – debit increase, credit decrease

Equity – debit decrease, credit increase

Accounting 101 - Journals

The journals are like a log for business transactions. The logs, or journals are where the financial transactions are posted using debit and credits. Some of the typical accounting journals include:

Sales Journal – Is where the sales activities are posted, usually from a sales invoice. Typical transaction include debit and credit postings to sales, cash, account receivables, cost of goods sold and inventory.

Purchase Journal – is used when items are purchased on open account. This is the primary journal used to record accounts payable (liability) transactions. Purchases can include inventory and expense items, among other accounts.

Check Register – is used to simultaneously write checks and post the transactions that affect cash (asset). When a check is written, cash is posted with a credit (decrease) and the opposite account is usually posted with a debit. For example, making a payment on account would be a debit (decrease) to accounts payable.

General Journal – is used for making adjustment to accounts that aren’t covered by other journals. There can also be other types of journals that could be unique to a particular business or industry.

Accounting 101 – General Ledger Accounts

Each transaction that is recorded in a journal is then posted to a general ledger (GL) account. Usually at the end of each business day, the journals are totaled and posted to the respective general ledger. The general ledgers are generally separated into main categories of assets, liabilities, revenue, expense and equity. The actual GL accounts are the subcategories within the main categories. As an example, the GL accounts within the asset categories may include:

Read on  Accounting 101 – Inventory, Cost of Goods Sold Accounting 101 – Accounts Payable

Accounting 101 – Journal to General Ledger

Asset General Ledger Accounts

Cash Accounts Receivables

Inventory

Equipment

Building

Vehicles

Furniture

Accounting 101 – Financial Statements

Usually at end of each month the financial statements are created to show the financial strength of the company. The income statement and balance sheet are the two main financial statements. The general ledger account totals for the month ending are transferred to the appropriate financial statements. The income statement reports the net profit (or loss) of the company. The balance sheet reports owner’s equity or the company’s net worth.

In summary, journals are used to post the business financial transactions with debits and credits. The total dollar amount for a particular journal posting must balance. The individual journal account totals are then transferred to the general ledgers. The general ledgers are then transferred to the appropriate financial statements.

Read more at Suite101: Accounting 101 – Basic Concepts and Terms: Introduction to Fundamental Financial Bookkeeping Theory http://www.suite101.com/content/accounting-101-basics-concepts-and-terms-a167287#ixzz1I4AM6ENI

Accounting 101 – Inventory, Cost of Goods SoldSmall Business Bookkeeping Basic Account Entry Debits and Credits

Nov 4, 2009 James Clausen

Accounting 101 – Inventory and Cost of Goods Sold - alvimann

Understanding inventory and cost of goods sold is important to learning accounting basics. Learn the steps from journal to general ledger to financial statements.

Even though using bookkeeping software will help with the daily use of accounting functions for a small business, it’s still important to have an understanding of the basic functions of accounting. Before learning about inventory and cost of goods sold, it’s important to first have an understanding of debits and credits.

The Relationship of Inventory and Cost of Goods Sold

Inventory and cost of goods sold or cost of sale, are both general ledger (GL) accounts. The main difference between the two is that inventory is an asset and cost of goods sold is used to figure gross profit. Since inventory is an asset, it’s reported on the balance sheet. Since the cost of goods sold is a GL that’s used to figure gross profit, it’s reported on the income statement. As it increases, gross profit decreases.

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The Sales Invoice, Inventory and Cost of Goods Sold

When a sales invoice is written that affects the inventory account, the cost of sales GL account is generally used as a reciprocal account. A reciprocal account means that it acts like an opposite. If a sales invoice is written, and a credit is posted to reduce inventory, a debit is automatically posted for the same amount to increase the cost of sales.

To illustrate how a sales invoice would post to the sales journal, let’s assume that an item was sold for $100.00, with an inventory cost of $60.00. The customer paid cash and there’s a 6% sales tax. If accounting software is used to generate a sale invoice, the posting of all appropriate GL accounts is generally automatic.

Read on  Income Tax Liability and LIFO Inventory Valuation Method Accounting 101 – Inventory Valuation Methods

Accounting 101 – Journal to General Ledger

Cash $106.00 debit (increase)

Sale Tax $6.00 credit (liability increase)

Sales $100.00 credit (income increase)

Cost of Goods Sold $60.00 debit (increase)

Inventory $60.00 credit (asset decrease)

The Purchase Journal and Inventory

When inventory is purchased on open credit terms, it is posted to the purchase journal. Cost of sale is not affected because it only relates to income generated from a sale. If inventory is paid for when purchased, it is generally posted through the check register. To illustrate how inventory is posted using the purchase journal, we’ll assume that $1,000 worth of inventory is purchased and a 5% bulk discount was received on the purchase.

Inventory $1,000 debit (asset increase) Accounts Payable $950 credit (liability increase)

Discounts $50 credit (income increase)

In this illustration, the $50 discount would be reported on the income statement as straight gross profit.

At the end of each month, the general ledger totals are transferred to the financial statements. Cost of goods sold is deducted from sales and reported as gross profit. The inventory balance is reported as an asset on the balance sheet.

Read more at Suite101: Accounting 101 – Inventory, Cost of Goods Sold: Small Business Bookkeeping Basic Account Entry Debits and Credits http://www.suite101.com/content/accounting-101-inventory-cost-of-goods-sold-a166123#ixzz1I4ArPetm

Accounting 101 – Journal to General LedgerSmall Business Bookkeeping Basic Account Entries

Sep 27, 2009 James Clausen

Accounting 101 - Journals to General Ledgers - iphis

Understanding how journals relate to the general ledger is one of the first steps to learning accounting basics. Learn the steps from journal to general ledger.

Even though using bookkeeping software will help with the daily use of accounting functions for a small business, it’s still important to have an understanding of the basic functions of accounting. Before understanding the relationships between journals and general ledgers it’s important to understand the functions of debits and credits. Understanding how debits and credits work is the first step into grasping the fundamentals of bookkeeping.

Accounting 101 – What is a Journal?

The accounting journal is where all the monetary transactions of a small business are posted. Monetary values from documents used in the day-to-day operations of a small business are transferred to journals. The values are posted with debits and credits. One of the more common journals for a small business is the sales journal.

Using the sales journal as an example let’s see how a typical sales invoice will post. Product XYZ is sold for $100.00, the cost of XYZ is $50.00 and it is sold with open credit terms. There is sales tax of 5% and a $7.00 dollar freight charge.

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Sales Journal Example

Debits

Accounts Receivables $112.00 Cost of Sale $50.00

Credits

Read on  General Accounting 101 Basic Fundamentals Small Business Accounting Software

Accounting General Ledger Management

Sales $100.00

Freight Expense $7.00

Sales Tax $5.00

Inventory $50.00

From the Journal to the General Ledger Accounts

Once the journals are posted, the monetary amounts are then transferred to the general ledgers (GL), usually the following business day. All of the above examples (i.e. accounts receivables, cost of sales, sales, freight, tax and inventory) are separate GL accounts. If the business entrepreneur or manager wants to know how sales are for the month, all they have to do is look at the sales general ledger. If they want to know how the gross profit is doing, they can subtract the cost of sales from the sales GL total.

Accounting General Ledgers

GL accounts are usually numbered for ease of identification and transfers to the financial statements. Most businesses have hundreds of general ledgers in order to analyze financial data. For example, expenses are often broken up into several general ledgers in order to keep track of expenses. Below is an example of some of the GL expense accounts variations.

Freight Building Maintenance

Vehicle Maintenance

Equipment Maintenance

Payroll

Utilities

Rent

Insurance

Office Supplies

Inventory Control

Advertising

These are just some examples. Each business is unique and GL accounts will vary from one business to another. If looking for business accounting software, it’s important that the software have general ledger flexibility. Businesses that have several departments may also have separate general ledgers for each department.

When manual adjustments need to be made to a general ledger, a journal voucher (JV) is generally used. JV entries need to have good references and explanations as to why the entry is made for audit purposes. At end of each month, the JV entries are transferred to the appropriate general ledgers. GL totals are then transferred to the appropriate income statements.

Read more at Suite101: Accounting 101 – Journal to General Ledger: Small Business Bookkeeping Basic Account Entries http://www.suite101.com/content/accounting-101-journal-to-general-ledger-a153296#ixzz1I4B3qoww

General Accounting 101 Basic FundamentalsLearn Bookkeeping Basics From Journals to Financial Statements

Nov 11, 2009 James Clausen

General Accounting 101 Basic Fundamentals - iphis

Discover how the accounting process works from journal entries to the financial statements. Learn the steps to produce the balance sheet and income statement.

Even though using bookkeeping software will help with the daily use of accounting functions for a small business, it’s still important to have an understanding of the process to create the financial statements. Before understanding the relationships between journals and general ledgers it’s important to understand the functions of debits and credits. Understanding how debits and credits work is the first step into grasping the fundamentals of bookkeeping.

Function and Types of Accounting Journals

The accounting journals are used to post the financial transactions of the business. The journals are posted with debits and credits. The total dollar amount of debits must equal the total dollar amount of credits for each financial transaction. There are different journals that are used depending on the type of dollar transaction. The following are some typical journals and their functions.

Sales Journal – is used to record all the sales activities for the business. Normally the posting of the sales journal is taken from invoices written for customer sales.

Purchase Journal – is used for purchases made from vendors and suppliers on open credit terms. Normally the posting of the purchase journal is taken from vendors and suppliers invoices. Purchases are posted with a credit (increase) to accounts payable and a debit to an asset or expense.

Cash Receipts Journal – is used for all cash taken in. Cash is usually debited (increase) and other accounts like accounts receivable are usually credited.

Cash Disbursement Journal – or check register is used for various payments. Cash is credited (decrease) and other accounts like payables are debit, although there can be some exceptions to the rule.

General Journal – is used for miscellaneous transactions that are not covered by other journals. The general journal is more commonly used for month end adjustments.

Accounting General Ledger Chart of Accounts

The separate accounts that are posted in journals are known as the general ledger (GL) chart of accounts or just simply general ledgers. The journal totals are transferred to the individual GL accounts. The GL accounts usually have 5 main categories.

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Assets Liabilities

Equity

Income

Expense

Within each main category, there are sub accounts. As an example, the sub accounts for assets might consist of:

Cash Inventory

Equipment

Accounts Receivable

Furniture

Vehicles

From the General Ledger Accounts to the Financial Statements

The two main financial statementsa are the balance sheet and income statement. Usually at the end if each month, the general ledger accounts are transferred to the trial balance. The trial balance is used to make sure that the debits and credits balance. Once they are balanced, the general ledger accounts are then transferred to the balance sheet and income statement. The following main GL accounts are transferred to the appropriate financial statements.

Balance Sheet

Read on  Accounting 101 – Inventory, Cost of Goods Sold Accounting 101 Balance Sheet

Accounting 101 – Income Statement

Assets

Liabilities

Equity

Income Statement

Income Expenses

The main purpose for the balance sheet is to report owner’s equity. The equation for owner’s equity is assets minus liabilities. The income statement reports net profit (or loss). The equation for net profit is income minus expenses. The accounting process starts with journal entries. The journal transactions are then transferred to the general ledgers.The general ledgers are then listed on the two main financial statements.

Read more at Suite101: General Accounting 101 Basic Fundamentals: Learn Bookkeeping Basics From Journals to Financial Statements http://www.suite101.com/content/general-accounting-101-basic-fundamentals-a168743#ixzz1I4BUhwx5

Accounting 101 – Accounts ReceivableSmall Business Bookkeeping Basic Account Entry Lesson

Sep 28, 2009 James Clausen

Accounting 101- Accounts Receivable - jppi

Learn how to post accounts receivable with the sales journal and receipts journal. A basic understanding of the functions of accounts receivable.

Accounts receivable (AR) is an important part of almost every small business. Even cash retail businesses normally accept credit cards, which is considered a receivable. AR is any product or service sale on account where cash (checks are considered cash) is not immediately received, including debit and credit cards.

Even though using bookkeeping software will help with the daily use of accounting functions for a small business, it’s still important to have an understanding of the basic functions of accounting. Before learning how accounts receivable is posted to the journals, it’s important to understand the functions of debits and credits. Understanding how debits and credits work is the first step into grasping the fundamentals of accounting.

Posting Accounts Receivable to the Sales Journal

Since accounts receivable is an asset of the business, posting a debit is an increase and a credit is a decrease. Since a debit increases an asset, if a sale is made to a customer on open credit terms, the AR account is posted with a debit for the total amount that is owed on the invoice or sales receipt.

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Generally sales are posted to the sales journal, whether it’s on open account or a cash sale. Using the sales journal as an example, let’s see how a typical AR sale will post. Product XYZ is sold for $100.00, there is sales tax of 5% and a $7.00 dollar freight charge.

Sales Journal Example of Accounts Receivable

Debit

Accounts Receivables $112.00

Credit

Read on  Accounting Basics – General Ledger Accounts General Accounting 101 Basic Fundamentals

Accounting 101 Balance Sheet

Sales $100.00

Freight Expense $7.00

Sales Tax $5.00

Posting to Individual Customer Accounts Receivable

With most small business accounting software, sales on account are generally posted directly to individual customer accounts. With the traditional manual method of bookkeeping, separate ledgers are kept for each customer. The receivable amounts are transferred to the customer’s ledger from the sales journal. After the amount is transferred a simply check mark is made next to the transaction on the sales journal.

Posting Accounts Receivable – The Receipts Journal

When cash or checks are received for any business transaction they should be posted to the receipts journal. This includes incoming cash or checks for accounts receivable. Recording the transaction for payment against an account is fairly simple. Using the above example the payment against the account would be as follows:

Receipts Journal Example of Accounts Receivables

Debit

Cash $112.00

Credit

Accounts Receivable $112.00

Below is an example for the same sale that was made with a credit card. The amount the credit card company charges is 2%. .

Receipts Journal Credit Card Example of AR

Debit

Cash $109.76 Credit Card Expense $2.24

Credit

Accounts Receivable $112.00

Naturally when a payment is made against an account, the customer’s individual receivable ledger must be credited. At the end of the business day the AR journal totals are transferred to the accounts receivable general ledger. The AR general ledger always carries a debit balance and fluctuates daily as sales are made and receipts are posted.

Read more at Suite101: Accounting 101 – Accounts Receivable: Small Business Bookkeeping Basic Account Entry Lesson http://www.suite101.com/content/accounting-101-accounts-receivable-a153845#ixzz1I4CczT1q