Basic Accounting: Terminology and Examples

Accounting is the language of business, as it gives companies a systematic way to record and communicate financial information. Every successful business owner needs to grasp basic accounting terminology to make informed decisions about their company’s financial health and future direction. 

While the terminology might seem overwhelming at first, getting a few basic accounting principles under your belt is all you need to interpret financial data accurately. This will help you tremendously as you evaluate your company’s performance and plan for future growth.

Essential Accounting Terms Every Business Owner Should Know

Being familiar with some basic accounting terms can make a world of difference in your company’s finances. These are ten of the most common terms you’ll find in financial statements and reports:

• Assets: These are the resources owned by a business that have economic value and can generate future benefits. They include things like cash, inventory, equipment, and accounts receivable.
• Liabilities: These are the financial obligations or debts that a company owes to external parties, like accounts payable and loans.
• Revenue: This is the total income generated from business operations like selling goods and services.
• Expenses: These are the costs of doing business. They include rent, salaries, utilities, raw materials, and marketing.
• Equity: This is the ownership stake in a company that belongs to the owners or shareholders. It’s the value that would remain for owners if the company sold all its assets and paid off all its debts.
• Capital: The financial resources invested in a business to fund operations and growth.
• Accounts receivable: This includes the money owed to a business by customers for goods or services delivered on credit. It’s an indication of future cash inflows but needs to be carefully managed to avoid disruptions to daily operations.
• Accounts payable: The money a business owes to suppliers and vendors for goods and services received on credit.
• Depreciation: An asset depreciates as it ages, and accounting spreads the acquisition costs over its useful life. For example, a tool with a lifespan of 10 years will lose roughly one-tenth of its value to depreciation per year.
• Gross profit: Total revenue minus the direct costs of producing goods and services. It doesn’t include taxes or unrelated expenses like debt financing.

The Three Core Financial Statements

Financial statements turn raw transaction data into helpful information that managers and stakeholders can use to make better decisions. Though there are many types of financial statements, just being familiar with the three most important ones will help you better understand your business.

The Balance Sheet

The balance sheet is a quick overview of a company’s financial position at a specific point in time. It follows the basic accounting equation:

• Assets = Liabilities + Equity

This statement shows what a company owns, what it owes, and the ownership interest remaining after all debts are settled. What makes it especially valuable is that you can quickly see a company’s liquidity and solvency. Investors and lenders use this information to assess whether a business can meet its short-term obligations.

The Income Statement

The income statement shows a company’s revenues, expenses, and net income over a specific period. Unlike the balance sheet’s snapshot approach, the income statement tracks financial performance over time to let you see trends in profitability and operational efficiency.

Also known as the profit and loss statement, this document is one of the best at showing how effectively a company generates profit from its operations. By breaking down revenue and expenses into categories, the income statement helps identify which business areas contribute the most to profitability and which need attention.

The Cash Flow Statement

The cash flow statement tracks the actual movement of cash in and out of a business during a specific period. Instead of focusing on profitability, the cash flow statement shows whether a company generates enough cash to sustain its operations.

This statement is very important as it distinguishes between profit and cash flow. A company can be profitable on paper while still dealing with cash shortages, especially if it has small margins or offers a lot of credit. 

Common Accounting Principles

Accounting comes with a few core principles that guide how businesses record and report financial information. Without these principles, companies would be free to record their financial statements as they see fit, which makes it difficult to compare companies. These principles make everything consistent and reliable so you know you’re comparing apples to apples.

Conservatism Principle

The conservatism principle encourages businesses to choose the accounting method that is least likely to overstate assets and income. When faced with uncertainty, companies should err on the side of caution rather than optimism. 

For example, if a company faces a lawsuit that might result in a $100,000 payment, they should record this potential expense immediately. However, if they might receive a $100,000 settlement from a different lawsuit, they shouldn’t record this income until the money is actually received.

The Matching Principle

The matching principle requires businesses to record expenses in the same period as the related revenues. This means if a company sells a product in January but doesn’t pay for the materials until March, they still need to log both the sale and material costs in the January financial statements.

Accrual vs. Cash Accounting

Cash accounting records transactions only when money changes hands, whereas accrual accounting records them when they happen, regardless of payment. Cash accounting works well for small businesses with simple operations and immediate payment terms. On the other hand, most large businesses use accrual accounting because it better matches revenues with related expenses and paints a more complete picture of financial performance.

Practical Examples in Real Business Scenarios 

Accounting principles are everywhere in businesses, even in the smallest actions. Here’s how businesses apply these accounting principles in everyday life:

• Recording daily transactions: A restaurant records each sale immediately, tracking cash payments and credit card payments separately. They also record daily expenses like food and wages to keep track of where the money is going.
• Month-end closing process: Companies reconcile all accounts at month-end so that bank statements match accounting records. They also record accrued expenses like utilities used but not yet billed.
• Financial reporting for stakeholders: Business owners compile monthly financial statements showing revenue, expenses, and profit to share with investors or lenders.

How CFO Hub Can Help

CFO Hub’s experienced team can help you implement proper accounting systems and interpret financial data, even if you don’t have a PhD in economics. Our fractional CFO services help companies like yours keep accurate records while focusing on strategic growth. 

Contact us for a free consultation today.