This article contains general information and is not intended to provide information that is specific to American Express, or its products and services. Similar products and services offered by different companies will have different features and you should always read about product details before acquiring any financial product.
Accounting is the language of business. It’s the common vocabulary that helps owners, suppliers, customers, investors, and lenders communicate more easily. But like learning any new language, understanding accounting terminology may feel overwhelming.
This article outlines some essential accounting terms that may help you better navigate financial discussions.
The Power of Accounting
While a business’s products or services may be uniquely tailored for its customers, accounting is the process that translates and organizes its financial information into a standardized set of books and records.
Expressing information could make it easier for potential and current investors to evaluate the business and help lenders assess creditworthiness. It could also enable managers to readily analyze the business’s financial health.
Types of Accounting Methods
An accounting method is the fundamental way a business records and reports its financial transactions. The two primary methods that business owners can add to their accounting vocabulary are cash-basis accounting and accrual-basis accounting.
1. Cash-basis accounting: Cash-basis follows the flow of cash in and out of a business, much like a personal checkbook register. This method recognizes revenue when cash is received and expenses when they are paid. Cash-basis accounting doesn’t offer the benefits of standardization.
2. Accrual-basis accounting: Accrual-basis focuses on economic events rather than cash flow. Specifically, it recognizes revenue when it’s earned and expenses when they’re incurred, regardless of when cash is exchanged. This method may provide a more accurate picture of a company’s financial position over time and must adhere to standardized guidelines.
Standard Accounting Financial Statements
Financial statements are standardized reports that convey a business’s financial activities. They can provide a clear snapshot of a company’s financial position, which can be essential for both internal and external stakeholders. Internally, they can form the basis for financial analysis, helping managers make more informed decisions. Externally, lenders, investors, and partners may use these statements to assess creditworthiness and investment potential.
Accurate preparation of financial statements is crucial. The process occurs at the end of a company’s monthly, quarterly, and annual financial closing process. The three core financial statements are the balance sheet, the income statement, and the cash-flow statement.
3. Balance sheet: Summarizes a company’s assets, liabilities, and equity, presenting a snapshot of the values at a specific point in time.
4. Income statement: Known as the profit and loss statement or P&L, this statement summarizes a company’s revenues, expenses, and income over a period of time.
5. Cash-flow statement: Provides a detailed view of cash inflows and outflows over a period of time, showing how cash moves in and out of a business.
Each statement serves a unique purpose but may offer more insight when analyzed together. Public companies are also required to prepare two additional financial statements: the statement of changes in equity and the notes to the financial statements.
6. Statement of changes in equity: Tracks changes in owners' equity over a period, detailing how profits, dividends, and other adjustments affect shareholder equity.
7. Notes to the financial statements: These notes provide context by explaining accounting policies, methodologies, and additional details that help enhance transparency and support the information in the statements.
While private companies may have more flexibility than public companies in financial reporting, they may consider following the established standards to maintain credibility with financial reviewers.
Balance Sheet Accounting Terms
The balance sheet summarizes a company’s assets, liabilities, and equity to provide a snapshot of these values at a specific point in time. Based on the accounting equation (Assets = Liabilities + Equity), the balance sheet must remain balanced.
8. Assets: Resources owned by a business that have economic value and are expected to provide future benefits. Common examples can include cash, accounts receivable, inventory, and property.
9. Liabilities: Amounts a business owes to others. Loans, accounts payable, accrued expenses, and leases can be examples of liabilities.
10. Equity: The owner’s interest in the business, including funds invested by owners and reinvested profits. Mathematically, equity is the residual value of the company’s assets after deducting liabilities, reflecting its net worth.
Certain terms within assets and liabilities, like accounts receivable, accounts payable, and accrued expenses, can provide deeper insight into the timing of cash flows and obligations. Together, these components help measure a company’s working capital and liquidity, which are key indicators of short-term financial health. Additional descriptors, such as “current,” can further clarify when certain assets and liabilities are expected to be used or settled.
11. Accounts receivable: An asset representing money owed to a company by its customers for goods or services delivered but not yet paid for. This arises when a company allows customers to buy on credit, and is applicable only under the accrual accounting method.
12. Accounts payable: A liability representing unpaid money a company owes to suppliers or vendors for goods and services purchased on credit. Supported by vendor bills that have been received, accounts payable includes raw materials, utility bills, rent, professional services received, and office supplies. It only applies to the accrual method.
13. Accrued expenses: Costs that a company has incurred but hasn’t yet paid or been billed for. These are recorded on the books before payment, as per accrual accounting. Unlike accounts payable, accrued expenses are recorded before a bill is received, so the exact amount may require estimation. Accrued wages are a common example, and occur when employees work but haven’t yet been paid by the balance sheet date.
14. Working capital: A calculation that measures liquidity, using information from the balance sheet. It’s computed by subtracting current liabilities from current assets.
15. Liquidity: How much money a business has available for its daily operations.
16. Current: Refers to assets or liabilities expected to be converted, used, or settled within one year.
All of these elements can be integral parts of the balance sheet, working together to help provide a comprehensive look at a company’s financial position at a given time.
Income Statement Accounting Terminology
The income statement can provide business managers with a clear picture of their organization's financial performance, highlighting whether the business is generating a profit or incurring a loss. While it may be tempting to focus solely on the “bottom line,” other elements of the income statement can be equally valuable for managing pricing, cost control, and overall business strategy.
Basic income statement terms to know can include:
17. Revenue: Money a business earns from selling goods or services. Sometimes referred to as “the top line,” revenue can be an indicator of market demand and the company's ability to attract and retain customers. Although “revenue” and “sales” are often used interchangeably, revenue is a broader term that also includes other sources, such as interest earned on investments or royalties.
18. Expenses: Costs incurred in generating revenue, such as salaries, rent, inventory, supplies, and utilities. Expenses can directly impact profitability – higher expenses lead to lower profits.
19. Net income: The profit of a business, calculated as the difference between total revenue and total expenses. Also known as net profit, net earnings, or “the bottom line,” since it appears at the end of the income statement. When expenses are greater than revenue, it’s called a net loss.
20. Cost of goods sold (COGS): A subset of expenses that combines all direct costs of producing or purchasing goods sold by a company. For a manufacturer, COGS can include raw materials, labor, and factory overhead, while for a retailer, it can include purchase price of merchandise and in-bound shipping costs. In service businesses, the direct costs like salaries for billable hours are referred to as “cost of sales.”
21. Gross profit: This subtotal is the difference between revenue and COGS. It can be a critical metric for assessing whether revenue covers basic costs, even before other expenses are deducted. Gross profit can be especially useful for setting prices and managing production efficiency.
22. Depreciation: The systematic allocation of the cost of a tangible, long-term asset (like a truck) over its useful life. Depreciation isn’t a cash expense paid to an outside company, but an accounting convention meant to reflect an asset’s decline in value over time. There are several ways to calculate depreciation.
23. Amortization: Similar to depreciation, but applied to intangible assets. Amortization spreads the cost of non-physical assets, such as patents and copyrights, over time. Not all intangible assets are reflected on the balance sheet or amortized. For example, a skilled workforce and strong brand recognition hold value but do not meet accounting criteria.
24. Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA): A financial metric derived from the income statement. EBITDA is calculated by starting with net income and adding back interest expenses, taxes, depreciation, and amortization. This metric can provide a clear view of profitability because it removes the effects of financing decisions and accounting practices. It can be used to make comparisons with other companies.
Cash-Flow Statement Accounting Terminology
The cash-flow statement translates the accrual-based activities on the balance sheet and income statement into changes in cash balance. It shows the company’s ability to generate cash to pay debts, fund operations, and invest in growth.
The cash-flow statement is divided into three main sections: operating activities, investing activities, and financing activities. Each section offers insights into how different areas of the business impact cash reserves.
25. Operating activities: This section shows cash generated from or used in core business operations, such as cash received from customers, cash paid to suppliers, and wages paid to employees. Positive operating cash flow can be particularly important, as it can indicate that the core business generates enough cash to maintain and grow operations without external financing.
26. Investing activities: Cash flows from buying or selling long-term assets, such as purchasing equipment, selling property, or buying and selling investments. This section shows how much was invested in the business’s long-term health or if assets are being divested for cash.
27. Financing activities: Cash flows related to debt, equity, and dividend payments. Examples of cash inflows can include proceeds from loans, issuing shares, or owner contributions, while outflows can include repaying loans, buying back shares, and paying dividends. This section can show how a business is financed outside of operations.
The overall result of these activities culminates in the net cash flow, which can be either positive or negative.
28. Net cash flow: The “bottom line” of the cash-flow statement, representing the overall change in cash balance during the reporting period. It’s the sum of cash flows from all three sections, providing a comprehensive view of whether the company’s cash position has increased or decreased.
29. Positive cash flow: Occurs when cash inflows exceed outflows, which is the desired outcome.
30. Negative cash flow: When outflows exceed inflows. Negative cash flow can be common in the short-term but may be unsustainable if it persists.
Photo: Getty Images
The material made available for you on this website is for informational purposes only and is not intended to provide legal, tax or financial advice. If you have questions, please consult your own professional legal, tax and financial advisors.
