Glossary of Commonly Used Accounting Terms
Whether completing undergraduate work or preparing for the CPA exam, accounting students have told us that a glossary of terms is never far from their side. But a simple definition rarely seems to be enough for a real understanding of complex concepts and processes.
Here we provide a list of the most frequently searched accounting terms, along with the supporting examples and contextual definitions necessary to not only understand the concepts, but to apply the processes behind them.
- Accounting Concepts
- Accounting Cycle
- Accounting Ratios
- Accounting Records
- Accounting Technology
- Accounting Worksheet
- Double Entry Accounting
Financial accounting concepts are the basic principles used in the preparation of financial statements.
The concept of the accounting period is an important one for financial statements. An accounting period is the interval of time during which accounting activities are measured. Common accounting periods include monthly, quarterly, and annually.
The four most important financial statements in accounting are:
- Income statement: Summarizes financial results for an accounting period. Revenues – Expenses = Income.
- Balance sheet: Lists the assets and liabilities at the end of an accounting period. Assets = Liabilities + Equity.
- Cash flow statement: Shows the actual flow of cash into and out of an organization during the accounting period.
- Statement of retained earnings: Shows the dividends paid from earnings to shareholders and the earnings kept (retained) by the company.
Financial Accounting Concepts
Accounting concepts for preparing financial statements include:
- Conservatism (also called prudence): If a financial result can be reported in two ways, the least beneficial way is used.
- Consistency: An organization should use the same accounting method over time, and not change accounting methods between accounting periods.
- Cost principle: Accounts and financial statements show the actual cost of an asset, rather than the current value.
- Dual aspect: Every transaction involves at least two accounts.
- Going concern: The assumption is that an organization will continue into at least the near future.
- Matching: When a transaction affects both revenues and expenses, the effect on financial statements should occur in the same accounting period.
- Materiality: While an organization needs to disclose all relevant information on financial statements, insignificant events need not be disclosed.
- Money (or monetary) measurement: Only transactions that can be quantified in actual amounts of money are included on the financial statements.
- Realization: An organization recognizes revenue when shipping goods or rendering services, not when payment is received.
- Separate Entity: A clearly defined business unit is used for financial reporting purposes.
Other important concepts concerning accounting information include the need for the information to be understandable, timely, relevant, reliable, and complete so as to serve as an objective representation of an organization’s financial status.
Sometimes, these concepts may come into conflict; in which case, it’s the accountant’s job to decide which concept to follow, based on the needs of the users of the financial information, whether this be financial regulators or internal managers.
As of November 2012, the Financial Standards Accounting Board (FASB) publishes five Concepts Statements that set objectives, qualitative characteristics, and other concepts accountants can use as a guide when preparing financial statements.
During each accounting period, businesses must perform a number of steps to account for business activities. These steps are called the accounting cycle. Although different sources identify the steps in the cycle slightly differently, the following ten-step accounting cycle covers the entire process comprehensively.
The first three steps take place throughout the accounting period, while the last seven steps happen only at the end of each accounting period.
Step One: Identify and Analyze Transactions
Identifying and analyzing transactions involves looking at the source documents, such as bank statements, checks, and purchase orders, that describe the transactions and their purpose, including the transaction amount. It is then decided which accounts are affected by the transaction, and how exactly those accounts were affected.
Step Two: Journalize
Journalizing refers to using double-entry accounting to record the appropriate debits and credits for a transaction into a journal.
Step Three: Post
Posting is the transfer of the debits and credits from the journal to the ledger. While a journal is simply a list of transactions, a ledger is a collection of all of the company’s accounts (Cash, Accounts Receivable, Accumulated Depreciation, Accounts Payable, etc.).
Step Four: Make an Unadjusted Trial Balance
A list of all accounts and their balances at a point in time is called a trial balance. The purpose of a trial balance is to make sure that the debits equal the credits.
Step Five: Make Adjusting Entries
Accrued and deferred items require the use of adjusting entries, which assign income and expenses to a different accounting period. Adjusting entries are recorded in the general journal and then posted to the ledger.
Step Six: Make an Adjusted Trial Balance
Another trial balance is prepared to verify that debits still equal credits. This information is also used to prepare the financial statements.
Step Seven: Prepare Financial Statements
The financial statements must be prepared in a specific order:
- Income statement
- Retained earnings statement
- Balance sheet
- Cash flow statement
This order must be followed simply because the retained earnings statement uses information from the income statement and the balance sheet uses information from the retained earnings statement.
Step Eight: Close
Closing entries move the balances of temporary accounts to owner’s equity and get the accounts ready for recording transactions in the next period.
Step Nine: Make a Post-Closing Trial Balance
A post-closing trial balance contains only the balance of debits and credits for permanent accounts. Again, the purpose is to make sure that debits equal credits and that all temporary accounts have a zero balance.
Step Ten: Make Reversing Entries
This step is optional. A reversing entry reverses previous adjusting entries. Companies may use reversing entries to make it easier to record later transactions by getting rid of the need for compound entries.
Accounting ratios, also called financial ratios, are used in analyzing financial statements. A ratio shows the relationship between two amounts. However, a ratio by itself may have no meaning until it is compared to ratios from previous years (called time series analysis) or ratios of other firms in the same industry (called cross-sectional analysis).
Advantages and Limitations of Using Accounting Ratios
The use of accounting ratios is useful because it provides a quick summary of financial statements. This helps with trend analysis of a company, and also provides a way to compare companies of different sizes.
The limitations of ratio analysis include the inability for comparisons to be made across industries due to the fact that acceptable ratios vary by industry. Even within an industry, comparisons may not be accurate because different companies may make different assumptions in preparing financial statements. Plus, ratio analysis focuses on the past, rather than the present or future.
Types of Accounting Ratios
A number of possible ratios can be used to analyze financial statements, including the following most commonly used accounting ratios:
Liquidity ratios show how liquid the organization is. An organization is liquid if it can pay its bills on time. Four liquidity ratios are:
- Current Ratio is one of the most commonly used ratios. It is equal to Current Assets divided by Current Liabilities.
- Quick Ratio = Quick Assets / Current Liabilities
- Quick Assets = Cash + Short Term Securities + Accounts Receivable
- Net Working Capital Ratio = (Current Assets – Current Liabilities) / Total Assets
Profitability ratios show an organization’s returns on investments. Profitability ratios include:
- Profit Margin = Net Income / Revenue
- Return on Assets = Net Income / Average Total Assets
- Average Total Assets equals ending plus beginning Total Assets divided by two
- Return on Equity = Net Income / Average Stockholders’ Equity
- Average Stockholders’ Equity equals beginning plus ending stockholders’ equity divided by two. Return on Common Equity is a similar ratio but uses average common stockholders’ equity.
Capital structure ratios show how an organization has financed the purchase of assets and include:
- Debt to Equity Ratio = Total Liabilities / Total Stockholders’ Equity
- Interest Coverage Ratio = Income Before Income Taxes and Interest Expense)
- Debt to Asset Ratio = Total Liabilities / Total Assets
Market value ratios show the value created for shareholders and include:
- Price Earnings (P/E) ratio = Price per share of common stock / Earnings per share
- Dividend yield = Per share dividend / Per share price
- Dividend payout ratio = Common Stock Cash Dividends / Net Income
- Market to Book Ratio = Common share market value / Common share book value
Activity analysis ratios show how efficient the organization has been in using its assets to generate sales and include:
- Inventory Turnover Ratio = Cost of Goods Sold / Average Inventories
- Accounts Receivable Turnover Ratio = Sales / Average Accounts Receivable
- Assets Turnover Ratio = Sales / Average Total Assets
Accounting records are all of the documentation concerning the financial life of a business or individual. Records include the accounting system used to record and track financial transactions, prepared financial statements, and supporting documents, such as checks and invoices.
Records can be kept on paper, using a spreadsheet program, or using specialized accounting software. Record keeping for an individual or small-to-medium sized business may be relatively simple and straightforward, while a large corporation, as would be expected, has complex and involved records.
Basic Record Keeping in Accounting
A basic record keeping system for a business generally consists of:
- A basic journal for recording transactions, such as revenues and expenses
- Accounts receivable and accounts payable records
- Inventory records
- Payroll records
- Petty cash records
- Records also include tracking of assets and liabilities.
Records and the Accounting Process
Although an individual or small-to-medium sized business might operate on a cash basis, simply recording cash transactions, most businesses use double entry accounting. Transactions are first recorded in a general journal by date of transaction. Every transaction affects at least two accounts, one with a credit and the other with a debit.
Debits and credits to each account in the general journal are then posted (transferred) to the chart of accounts in the general ledger. A general journal is just a list of transactions by date, while the general ledger is a collection of all of the company’s accounts.
Journalizing and posting are done throughout the accounting period. At the end of the accounting period, these records are then used to prepare financial reports and statements.
The Importance of Good Accounting Records
Well-organized and thorough records provide quick and easy access to important information, such as cash flow, expenses, money owed, accounts receivable, inventory turnover, and profit.
The survival of a business can depend on accurate and timely accounting records. For a publicly traded company, good records are needed to produce the financial statements required by law. For every business, good records provide essential information needed by management or owners to increase profits and grow the business.
Then there are taxes; lack of good tax records can bring down the wrath of the Internal Revenue Service. This is the prime reason most individuals and small organizations make every effort to maintain sound accounting records.
Accounting has evolved from a pencil and paper ledger profession to one that uses the full extent of computer technology. In fact, there are in excess of 3,300 accounting software options available.
Most of these fall within the following general classification types:
- Work Order Management
- Warehouse Management
- Time and Billing
- Tax Preparation
- Purchase Order
- Project Management
- Point Of Sale
- Order Entry
- Material Resource Planning
- Job Cost
- Inventory Control
- General Ledger
- Fund Accounting
- Foreign Currency Conversion
- Fixed Asset Management
- Customer Relationship Management
- Cash Management
- Budgeting, Planning & Forecasting
- Bill of Materials
- Accounts Receivable
- Accounts Payable
Accounting in the Cloud
While traditional accounting software is computer based, cloud accounting operates exclusively within the cloud.
Two benefits of using cloud-based accounting applications:
- Multiple people can access and work with the information at any given time
- Data is safe from onsite physical hazards such as fire or computer theft
Business Management Systems
A business management system, or enterprise resource planning (ERP) system, is a collection of high-level tools that companies use for planning and implementing business decisions. Accounting software and tools are typically an important part of a business management system.
Client portals are secure, password-protected online storage areas that let accountants and their clients exchange files and information. A portal provides a way to securely exchange confidential information that shouldn’t be sent through non-secure e-mail, while also allowing both accountants and clients real-time access.
A number of companies offer client portal websites used by accountants, while larger accounting firms have client portals built into their own websites.
Some portals are simple, basically just allowing for the exchange of files, such as completed tax returns or accounting software files. Other portals have more functionality, such as invoicing capabilities, tax organizing, and payroll organizing.
Emerging Trends in Accounting Technology
According to an October 18, 2012, article in Accounting Today, retail tax businesses need to consider developing mobile components for their client portals, as a study by OnDevice Research showed that Americans spend more time on mobile devices than on any other platform. The article also noted that the South African Revenue Service has pioneered the use of mobile portals and now has a mobile site and application for e-filing individual income tax returns from smartphones and tablets. It is expected that in just a few years the Internal Revenue offices of many more industrialized countries will offer the same services.
More information on emerging accounting technology can be found in the Journal of Emerging Technologies in Accounting (JETA) from the American Accounting Association.
The Issue of Security and Integration in the use of Accounting Technology
The foremost issue concerning the use of accounting technology is, of course, security, according to a 2012 survey by the American Institute of Certified Public Accountants (AICPA). Security concerns include:
- Securing the IT environment
- Managing risk
- Ensuring privacy
- Preventing fraud
The survey also revealed that AICPA members found the following issues related to the use of accounting technology to be the highest priority:
- Leveraging emerging technologies
- Managing implementation of systems
- Setting up decision support and managing performance
- Managing vendors and service providers
Accountants use an accounting worksheet to compile, organize, and structure data from the ledger accounts onto one page. In the past, worksheets were constructed on basic ruled paper, but today worksheets are prepared mostly using spreadsheet software.
Worksheets aren’t formal documents and are an optional intermediary step for preparing financial statements. Accountants generally prepare worksheets at the end of an accounting period to make sure the books are balanced and to pull together information for the financial statements.
Structure of an Accounting Worksheet
Although the structure of a worksheet can vary, depending on the purpose for which the accountant is preparing the sheet, the traditional accounting worksheet usually has a far left column that contains a list of all the open accounts, plus five pairs of debit and credit columns. One pair at a time would be completed, from left to right.
- The first pair of columns contains the debit or credit balance for the accounts listed in the far left column. This pair of columns is the unadjusted trial balance
- The second pair of columns contains adjusting entries for the accounts
- The third pair of columns is for the adjusted trial balance (Some worksheets skip using these columns)
- The fourth pair of columns is for income statement data (revenue and expense account balances)
- The fifth pair of columns is for balance sheet data (assets, liabilities, owner’s capital, and owner’s draw)
If the worksheet contains the third, adjusted trial balance column, the accountant can take the numbers from that third column and enter them in the appropriate place in either the fourth or fifth column.
Determining Net Income or Loss
After completing the fourth and fifth columns, the accountant finds the sum totals of the columns. In the income statement columns, if total credits are more than total debits, there’s net income. The accountant then adds the net income number to the debit column for the income statement and to the credit column (representing an increase in owner’s equity) for the balance sheet.
If the income statement column shows total debits more than total credits, there’s a net loss. The accountant then adds the net loss number to the income statement’s credit column and to the balance sheet’s debit column.
The worksheet is now complete and can be used to prepare financial statements.
Double Entry Accounting
The simplest type of accounting system involves simply making a list of income and expenses recorded when a cash transaction occurs–that’s called single entry (or cash) accounting.
In contrast, a double entry accounting system consists of a chart of accounts where every financial transaction is recorded into at least two of the accounts, once as a debit and once as a credit. This is done to add an additional layer of verification to further ensure the accuracy of the accounting.
Single vs. Double Entry Accounting
The advantages of single entry (cash) accounting is that it’s simple and provides information needed for income tax purposes. However, single entry accounting offers a limited ability to track financial performance and do financial analysis.
Although double entry accounting is more complex, it also has a number of advantages, including an automatic way to catch arithmetic mistakes. Also, accrual adjustments are automatic, whereas in single entry accounting, they have to be made manually. Double entry accounting provides detailed financial information for tracking financial performance and producing the income statement and net worth statement.
Chart of Accounts
Setting up a double entry accounting system consists of setting up a chart of accounts in a general ledger. There are five basic types of accounts made up of three balance sheet accounts (assets, liabilities, and equities) and two income statement accounts (revenue and expenses).
- Examples of asset accounts: Cash and Accounts Receivable.
- Examples of liability accounts: Accounts Payable and Wages Payable.
- Examples of equity accounts: Retained Earnings and Common Stock.
- Examples of revenue accounts: Merchandise Sold and Service Revenues.
- Examples of expense accounts: Wages Paid, Rent, and Office Supplies.
When a financial transaction occurs, entries are made in at least two of the accounts on the chart of accounts. In a general ledger chart of accounts, debits are recorded on the left side and credits are recorded on the right side.
The left side must always equal the right side.
The Basic Accounting Equation and Examples of Double Entry Accounting
The basis of double entry accounting is the equation:
Assets + Expenses = Liabilities + Equities + Revenues.
Increases in assets and expenses are left side entries (debits) in the chart of accounts, and increases in liabilities, equities, and revenues are right side entries (credits). Here are three example entries:
(This entry represents an increase in assets (cash) and an increase in owner’s equity.
(This entry represents an increase in assets (merchandise) and an increase in liabilities (accounts payable)).
(This entry represents an increase in expenses (office supplies) and a decrease in assets (cash)).
Here’s a slightly more complex example: A business sells $5,000 in merchandise (that cost the company $2,500), and the customer pays $3,000 at the time of the sale.
Cost of Merchandise Sold
GAAP (Generally Accepted Accounting Principals)
Generally accepted accounting principles (GAAP) are the guidelines and standards used in financial accounting and reporting all non-government organizations. They are the universal standard by which all financial accounting and reporting must conform. Having a single accounting standard that all companies are required to adhere to – regardless of industry, ownership structure or the regulatory body they are beholden to – is the very thing that allows the performance and value of one company, including all assets and holdings, to be compared accurately to the value of another company.
Financial accounting and reporting refers to tracking financial information and preparing financial statements that a company presents to the public. In using the generally accepted accounting principles as the common platform for assessment and reporting of value and performance, the investing public is assured of like to like comparisons between companies so as to be protected against inconsistencies that would arise from multiple valuation and reporting systems.
The Financial Accounting Standards Board (FASB) originally established GAAP and continues to oversee the amendments that need to be made from time to time. In The Wall Street MBA, author Reuben Advani compares the FASB to the Supreme Court; just as the Supreme Court is the final decider of legal questions, the FASB is the final decider of generally accepted accounting principles for the private sector. However, the FASB must still follow any legal requirements the Securities and Exchange Commission hands down.
The body that set the accounting standards used by state and local government is the Governmental Accounting Standards Board (GASB), while the Federal Accounting Standards Advisory Board (FASAB) sets standards for federal entities.
The generally accepted accounting principals are based on the basic tenets of accounting:
- Four basic assumptions
- Four principles
- Four constraints
The Four Basic Assumptions of Accounting
- Economic or Separate Entity: The company is treated as a separate economic entity for accounting purposes, even if it isn’t a separate legal entity.
- Monetary Unit: The only business transactions recorded are those in financial terms (dollars and cents in the U.S.).
- Time Period: Financial reports cover a specific period of time.
- Going concern: Financial reporting assumes, unless otherwise known, that the business will continue operating indefinitely.
The Four Principles of Accounting
- Historical Cost: Initial recording of financial transactions must be at their original cash equivalent cost.
- Full Disclosure: Financial statements contain enough information that they are not misleading.
- Revenue Recognition: A company records revenue in the accounting period when services are completed or goods are delivered to the customer, not when the customer makes payment.
- Matching: A company records expenses in the accounting period in which it helped create revenue, not when payment was made for the expenses.
The Four Constraints of Accounting
- Materiality: Should purchases of assets be expensed or depreciated? Theoretically, an asset expected to last four years would be depreciated over four years. However, if the asset cost is immaterial, for example $30, expensing the $30 may be acceptable.
- Conservatism: If a company could equally use more than one accounting method, the company should use the one that affects the financial statements in the least favorable immediate way.
- Cost-Benefit: Cost-benefit analysis compares the outflows of resources needed to create additional inflows of resources. The benefits should outweigh the costs.
- Industry Practice: Some industries have unique requirements, and companies in those industries can follow standard industry practices.
GAAP and International Accounting Standards
GAAP are U.S.-based accounting standards. Each country has its own accounting standards, creating challenges for companies that do business across borders. These differences affect everything from how depreciation and amortization are treated to how financial statements are structured.
Although the differences between GAAP and the standards used in some countries, such as the UK, are minor, significant differences exist with the standards used by many other countries, in particular Asian countries that are among the top U.S. trade partners.
The International Accounting Standards Board (IASB) works to develop internationally accepted financial reporting standards. A movement is underway to align the standards of the FASB and IASB to make accounting across borders consistent.