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10 basic accounting terms every business owner should know

10 basic accounting terms every business owner should know

Finance & Accounting

Lion Amir Virani

Lion Amir Virani

23 Oct 2020, 10:51 — 10 min read

One of the key tasks that every business owner has to deal with – whether on their own or through outsourcing – is Accounting.

 

Small business owners, entrepreneurs, solopreneurs and freelancers who cannot afford to hire a professional book-keeping or accountancy firm for their business often do their own book-keeping.

 

Do you belong to one of these groups? Then you need to know some basic accounting terms!

 

In this short guide, I provide some quick info about the most common terms you will need to familiarise yourself with as you keep your own books. We have grouped these terms into 3 broad groups for readability and ease of understanding. Feel free to dive into the section that is most relevant to you!

 

Accounting methods

 

1. Mercantile (accrual) accounting 

This is one of two methods of accounting permitted under India’s Income Tax Act.

Under this method, income and expenses are accounted for as and when the right to receive OR the right to pay arises. In other words, you record income as soon as you ‘earn’ it, even if you do not physically ‘receive’ any money. Similarly, you record expenses as soon as you incur them instead of when you pay for them.

 

Accrual accounting gives a fairly accurate picture of the long-term health of a business.

 

Also read: Clarifications about end of financial year, income tax filing, compliances & GST due dates

 

2. Credit and debit 

The double-entry bookkeeping method is used to record income and expenses under the accrual accounting method. You record two entries for every transaction your business makes, which are equal and opposite. One increases the amount in an account and the other entry decreases it. These increases and decreases are determined by recording credits and debits.

 

Some accounts are increased by debits and others are increased by credits. For example:

Account

Increased by

Decreased by

Assets

Debit

Credit

Liabilities

Credit

Debit

Expenses

Debit

Credit

Revenue

Credit

Debit

Equity

Credit

Debit

 

3. Cash accounting 

Under this method, income and expenses are accounted for on actual receipt of payment. It postpones a recipient’s tax liability to the year of actual receipt of income, although it does not permanently reduce it.

 

Financial statements

 

4. Balance sheet  

A balance sheet is one of the most commonly-used financial statements by businesses everywhere. It offers a snapshot of a company’s financial status at a particular point in time. It is organised into two columns, with assets in one, and liabilities and equity in the other.

 

The two sides must always be equal to each other. In other words, they must ‘balance’.

 

  • Asset

Anything your company owns (e.g. furniture, inventory, cash, real estate, etc.) that has monetary value is counted as an asset. On the balance sheet, assets are usually listed from most liquids (cash) to the least liquid (e.g. land or other immovable property).

 

Current Assets are those that will be used within 12 months.

 

Fixed Assets are assets (e.g. furniture, land, property, etc.) that are usually not used within a year and which usually depreciate in value (see #8 below).

 

Inventory is a type of asset that a company purchases or produces for sale but remains unsold at the time of accounting

 

In the simplest terms, liability indicates something you own.

 

Also read: Everything to know about Capital Gains Tax

 

  • Liabilities  

Liabilities are financial obligations owed by a company. These may include salaries, taxes, rents, utilities, interest payments, supplier payments, etc. Liabilities can be short or long term.

 

In the simplest terms, liability indicates something you owe.

 

  • Equity

Equity is the money invested in the company by its owners or shareholders plus any earnings that are retained (i.e. not ‘paid out’ to owners or shareholders) minus any liabilities or any money taken out in the form of draws.

 

Equity refers to your company’s net worth.

 

Also, Equity = Assets – Liabilities

 

  •  Accounts Payable (AP)

Accounts Payable includes all the expenses a business has incurred but not yet paid. This account is recorded as a liability on the balance sheet because it is a debt owed by the company.

 

  • Accounts Receivable (AR)

Accounts Receivable includes all the revenues/sales that a company has provided but has not yet collected payment on. It is recorded as an asset on the balance sheet since it will likely convert to cash in the short-term.

 

5. Income statement

The income statement shows a company’s revenues, expenses and profits for a particular accounting period (unlike a balance sheet which is a snapshot at a particular point in time). This period is often the financial year (FY). In India, the financial year runs from 1st April to 31st March, which means that it does not correspond with the calendar year. For example, FY2020-21 refers to the period from 1st April 2020 to 31st March 2021.

 

The income statement is also known as a Profit and Loss (P&L) statement and shows whether or not a business is profitable at that point in time.

 

  • Revenues

A business’ revenue is the sum of all monies generated through the sale of goods and services, interest earned, royalties, assets sales, rents, etc. In other words, it is any money earned by the business.

 

  • Expenses or costs

Every company incurs some expenses as it tries to generate income. Expenses are costs incurred by a company. They can be fixed (e.g. rents or salaries) or variable (e.g. utility payments).

 

Costs can also be overhead. These are the expenses that relate to running the business but not to actual production or delivery. Rents, utilities and executive salaries are counted as overheads.

 

On an income statement, Profit or Net Income (or Loss) = Revenues – Expenses

 

  • General ledger 

This is a complete recording of a company’s financial transactions over its lifetime. It shows assets, liabilities, revenue, expenses and equity.

 

6. Cash flow statement 

The cash flow statement shows the movements of cash (and cash equivalents) into and out of the business.

 

It is an important tool for evaluating the health of a business, as it is possible to show a profit on the income statement even though cash is draining out of the business. Many companies fold not because they fail to generate profits but because they suffer from chronic cash flow problems. In other words, it is possible for a company to fail even if it appears profitable.

 

Also read: Managing cash flows during a period of crisis.

 

Other must-know terms

7. Capital (aka Working Capital)

Capital is the money available to a company to pay bills or salaries or to reinvest. Like cash flow, capital is also considered a key measure of a business’ health.

 

Working Capital = Current Assets – Current Liabilities

 

Also read: 7 working capital mistakes to avoid at all costs.

 

8. Depreciation

When business assets lose value over time, they are said to depreciate.

 

Depreciation is an important tax deduction. A percentage of the original value of the asset can be ‘written off’ every year based on the depreciation rate, which then lowers the company’s tax burden.

 

Asset Book Value = Original Value – Depreciation

 

9. Dividend

A dividend is the distribution of a portion of the company’s earnings to its owners or shareholders.

 

It can be issued on a regular or non-regular basis and may consist of cash, additional shares in the business or both.

 

10. Return on Investment (ROI)

ROI refers to a company’s profits (return) divided by the investment made to generate those profits.

 

It is an important measure that is very useful for evaluating the efficiency of an investment (or investments). ROI is also used to compare the efficiency of different investments relative to their cost.

 

ROI is always expressed as a percentage or a ratio.

 

ROI = Current value of investment – Cost of investment

 

Conclusion

So these are the 10 most important accountancy/book-keeping terms you should definitely know as a business owner.

 

Of course, Accountancy is a vast field and there are dozens of other terms you might find useful. If you’d like to see a follow-up article explaining some more terms, drop us a comment below!

 

Also read: Financial expertise required by an accountant, manager and business owner.

 

To explore business opportunities, link with me by clicking on the 'Connect' button on my eBiz Card.

 

Image source: shutterstock.com 

 

Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views, official policy or position of GlobalLinker. 

Posted by

Lion Amir Virani

Tech Evangelist| Thought Leader | Social Entrepreneur | Enthusiastic Networker | Speaker| Startup Mentor

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