10 Accounting Terms You Just Need to Know
“Speak English!” I’ve lost count on how many times I’ve been interrupted in the middle of a financial meeting with this exclamation; and hey, I get it, you didn’t cash in $50,000 of your precious savings when you opened your business to learn accounting, you wanted to open a boutique shop! Let’s face it though, accounting is the heartbeat of “business”, and the business world is protective of its own jargon and vocabulary. Here are ten accounting terms to master in order to sound like an expert in the business world:
#1. “ACCORDING TO GAAP”
Layman definition: GAAP is an acronym for Generally Accepted Accounting Procedures, which are a set of professional rules and guidelines on how to record and report business transactions. This means that although your accountant works on your behalf, you, the business owner, may not request any and every way you want your transactions recorded and reported. Your degreed and certified accountant must play by the rules. So when they say “According to GAAP” they mean, we understand what you’d like to see, however we must adhere to federal standards on what to do in this situation.
Why should you care about GAAP: The time will come when you’ll want to attract funding through financial lenders or investors. Before they wire you cash, they will want to review your company’s progress through financial reports, and they’ll expect these reports to be delivered in accordance with GAAP.
Special notes about GAAP:
- GAAP rules and guidelines change often enough that you want to ensure that your accountant is up-to-date on all revisions applicable to your business to ensure compliance. This is typically why CPAs (Certified Public Accountants) are the highest level of qualified accountants; part of their license requirements is consistent training on updated accounting subjects.
- GAAP is relevant only for countries that agree to utilize GAAP. Other countries, such as European countries, use other rules and guidelines such as IFRS (International Financial Reporting Standards). GAAP and IFRS are NOT the same. If your company is located in multiple countries, your location in New York will utilize GAAP while your location in London will utilize IFRS, or a conversion method must be strategically applied.
Layman definition: Everything your business owns.
Where to find your Assets: Open an updated version of your company’s Balance Sheet. Assets are listed first, typically in the order of ease to convert them into cash.
Why should you care about assets: The larger the balance of your Total Assets, the healthier your business. If you’re looking to lure investors or business funding, they want to know the shape of your assets, especially your cash! So many business owners are obsessed with sales—as they should be—but a savvy entrepreneur will scrutinize his/her assets just the same.
Special notes about assets:
- Your assets should be reconciled at least monthly by a qualified accountant. There are many accounting rules relating to prepaids, depreciation, and amortization that even an experienced business owner might not be aware of. Remember that in business you get what you pay for, and if you allocate cheaply towards your accounting, you might have cause to regret it down the road.
- Assets are normally positive figures. If a negative balance appears, something’s terribly wrong!
- Business credit and funding can rely on your assets. Many lenders will supply 3 times your average cash balance or a percentage of your accounts receivable.
Layman definition: Everything your business owe.
Where to find your Liabilities: On your Balance Sheet, liabilities are shown just below your Assets (or to the right of Assets), typically listed in the order that they’re due.
Why should you care about liabilities: Memorizing the balance of your Assets is one thing, and sure enough, if you have fat balances under your Assets, you’re doing great! Now take your Total Assets and subtract your Total Liabilities [$510,000 – ($70,000) = $440,000], then divide that difference into your Total Assets [$440,000 / $510,000 = 86%]. The larger this percentage (according to your industry), the faster banks and investors push your business to the top of their list to fund and invest in.
Special notes about liabilities:
- Liability balances tend to build faster than your Assets because you carry them longer. Be very careful on how new credit balances impact your Liabilities to Assets percentage.
- Liabilities are not “bad”, again, they represent what you owe. Accounts Payables means purchases or services you received with a promise to pay later. This late payment allowed you to reserve your cash, which is a good thing. A line of credit can take care of pricier investments that made better sense to pay off installments, like a $10,000 inventory Management Software. This is also good because you reserved your cash.
- Having a high liability total can negatively influence how much business credit you receive. No one wants to lend you debt to pay for someone else’s debt.
Layman definition: Represents the figures that influence your investment in your business.
Where to find your Equity: The final section of your company’s Balance Sheet, listed under the Liabilities, is Equity.
Why should you care about equity: The purpose of a “for-profit” business is to generate wealth for its owners and investors. The equity section of a Balance sheet explains if the business is indeed retaining profit from its operations, who is investing, and who is receiving dividends/distributions on their investments.
Special notes about equity:
- Assets – Liabilities = Equity. Assets – Liabilities does NOT = your company’s worth should you decide to sell your business. Please don’t make that mistake!
- Although your business is yours to do as you deem best, business owners should be strategic on how much and how often you distribute profits from your company.
Layman definition: This is an accounting term for Operational Sales within your business. Revenue is also substituted for “Income” and “Sales”.
Where to find your Revenue: The first section of your company’s Income Statement.
Why should you care about revenue: Your primary focus is interpreting your sale trends. Which seasons show an increase and decrease in income? Which of your services brings in the most and the least revenue?
Special notes about revenue:
- Discounts & Returns are included into your revenue term, because it is not an expense, but a reversal of a sale. It is very important to watch your returns as much as your sales.
- Other Income is a specific term to recognize income your business received that doesn’t relate to your operational sales. For example, recognized bank interest.
Layman definition: Costs incurred to operate your business.
Where to find your Expenses: The second section of your company’s Income Statement.
Why should you care about expenses: Expenses can be segregated into three primary categories. The first being your Operation Expenses, meaning these expenses impact your Revenue directly. For example, Tiny Tots Boutique delivers all of its retail items to its customers for free. This is a direct cost of selling an item. Selling, General, and Administrative Expenses are typically segregated as marketing, advertising, and commission expenses, which normally rise and fall with Revenue. You want to compare your Selling trends with your Revenue to see if they are working. Finally Overhead Expenses are those general costs of business you owe regardless if your Revenue is high or low. For example, rent and utilities, corporate salaries and benefits, and office supplies. This is an important category, because you want to ensure that your fixed costs aren’t sucking the cash from your business, especially during periods when you anticipate low sales.
Special notes about expenses:
- There is a difference between the importance of expenses to a Financial Accountant and a Tax Accountant. Your Financial Accountant ensures that they are recording your expenses according to GAAP. They are not concerned with the IRS code. Your Tax Accountant is monitoring your expenses closely to ensure that your business tax return appropriately itemize these expenses so you pay the least amount of taxes possible. Tax Accountants are not concerned with GAAP and monitor the IRS code thoroughly. You need both types of accountants to look out for your financial reporting interest as well as your tax interests.
- While it is very important to monitor your expenses, sometimes business owners become obsessive, thinking they can receive the highest net income by slashing costs all the time. While ensuring you remain on budget and do not incur costs unnecessarily, business owners should focus the majority of their efforts on increasing their revenue; expenses can only be decreased so much.
#7. “MONTH-END CLOSE”
Layman definition: At the end of each month accountants follow business-standard, industry-standard, and accounting-standard procedures to finalize the transactions performed that month. It’s called “closing the books” or “month-end close”.
Why should you care about Month-End Close: Most companies report the business’s performance on a monthly occurrence. To do this, a trained accountant generates all necessary reports for stakeholders to review. If these procedures are delayed, management cannot determine how to make appropriate decisions for their department.
Special notes about Month-End Close:
- The complexity of the month-end close period will determine how long the process may take. A typical timeline for accountants to close the books and deliver reports to stakeholders is anywhere from 5 – 10 business days.
- It is recommended that a degreed and/or licensed financial accountant handle your month-end close process.
#8. “OWNER’S DRAWS/DISTRIBUTIONS”
Layman definition: Any cash the business owner pulls out of the company that is not considered a loan.
Why should you care about Owner’s Draws: If you are a Sole Proprietor, Partnership, or LLC it is not mandatory to be an actual employee of the company, instead you remain the owner. Therefore, instead of paying yourself a salary, you would instead make an owner’s draw to yourself. The Accounting Equation is Assets – Liabilities = Equity. You cannot withdraw more than is in your Equity balance.
Special notes about Owner’s Draws/Distributions:
- This term is typically used for Sole Proprietors, Partnerships, and LLCs.
- If you do not take a salary as a W-2 employee through your business with associated statutory taxes deducted, you will be responsible for paying all taxes when you file your annual household return. Strategize your tax bill with each distribution you disburse.
#9. “NET 30”
Layman definition: An invoice payment term most business owners adopt. It tells your customer that they have 30 days to pay their invoice before it is considered late.
Why should you care about “Net 30”:
While having 30 days to pay for a service/product is beneficial to your customer, it’s not as great for your cash flow because you have immediately paid your operating and indirect expenses. If you don’t have strong collection procedures, your business can easily fall into a cycle of poor cash flow.
Special notes about “Net 30”:
- When you offer Net 30 terms, you are extending credit to your customer. The typical procedure to perform before extending credit to anyone is to run a credit application to determine any risk factors that they may not pay on time.
- If at all possible, apply “Due Upon Receipt” terms unless your client has negotiated Net 30 terms, or your industry has standardized it.
#10. “OUT OF BUSINESS”
Layman definition: This terms applies when a business has run out of cash/credit to pay its obligations, also coined “Bankrupt”.
Why should you care about being “Out of Business”:
Millions of households around the world live paycheck to paycheck, with perhaps no more than $600 in their savings account. Some entrepreneurs convert this lifestyle into their business, 30 days away from bankruptcy. Never allow your business to be in the situation where it cannot meet payroll, keep on the utilities, or pay off your subcontractors and vendors.
Special notes about being “Out of Business”:
- Just because you earn a profit doesn’t mean you won’t run out of cash before that profit converts into cash.
- The fastest ways to burn through your cash:
- Unable to obtain a business line of credit or business credit card. If you cannot you’ll begin disbursing cash faster than you receive it. Take a look at your DUNS credit file and keep it in great condition, the same way you would monitor your own credit reports.
- Hurtful customer invoice payment terms: If you have Net 30 or Net 60 terms, it is critical that you always maintain a cash reserve to cover your overhead costs for that length of time.
- High overhead: expensive rent, too many executives with expensive compensation packages, too many owner draws.
- The lack of insurance: Lawsuit settlements can ruin a business overnight if you aren’t covered by insurance or a reserve savings.
There are many more financial terms used throughout business, but if you at least understand these 10 basic terms, you can make it through most fundamental conversations around your finances!