Basic Accounting Terms Every New Business Owner Should Know

Posted by: Madie Rosenbaum at 01/08/2021 4,554 views

If you believe that basic accounting know-how is not necessary for becoming a successful entrepreneur, you’re mistaken. Knowing the principles of accounting can undoubtedly play a significant role in understanding the financial side of a business. However, those who come from more technical, creative, or non-financial educational backgrounds can learn the concepts fairly quickly.

Most of the terminology and concepts might also come naturally to a lot of people. With that said, not everyone is sharp enough to understand complex numerology neatly laid out on a spreadsheet quickly. To make things easier, we have listed some basic accounting terminologies that will assist young entrepreneurs in gaining a better grasp of the work their accountant presents to them. Or at least understand things on their own.

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Terms on Income Statement

Income statements are a snapshot of the business’s earnings and expenses in a specified period. Income statements are also known as profit and loss statements. They determine a breakdown of what the business/company earned versus its expenses.

Cash versus Credit Sales

Not all payments are received instantly after a service is provided or after the delivery of goods. There is a time lag between when a product/service gets delivered, and payment is received against it. The time lag can vary depending on the industry standards, but managing credit is crucial for the business process. Businesses often charge pre-payments to counter this delay in time. These are called credit sales. Cash sales represent transactions where cash payments are received instantly in exchange for a good or service.

Cost of Goods Sold (COGS)

This term is typically used in businesses that deal in manufacturing or the trade of tangible goods. All costs that are incurred directly in the production/acquirement of goods adds up to the total. The total amount is then subtracted from sales (credit and cash) to get net sales. You can also equate COGS with direct expenses. It doesn’t sound too complicated. But if you wish to add accountancy to your bag of skills, consider enrolling in an online masters of accounting to speed up the learning process. Online degrees provide sufficient flexibility to working individuals and entrepreneurs to up-skill and apply the knowledge practically.

Dividends versus Interest Expense

Dividends are portions of net profit given to shareholders as compensation for the risk they take with their capital investment. Businesses and companies pay dividends if they have a surplus in its profit and loss account. Suppose a business/company incurs a loss in a given period. In that case, chances are it will not roll out dividends either.

Gross Profit versus Net Profit

Gross profit is calculated after the COGS is subtracted from net sales. It represents the operating profit available to a business for its indirect expenses such as depreciation, transportation, rent, overheads, and interest. Net profit is the final amount available to a company after it has accounted for all its incomes and expenses.

Terms on Balance Sheet

A balance sheet represents a breakdown of a business’s capital in the form of assets and liabilities. It is called a balance sheet because net assets are always equal to shareholder’s equity and represent a business’s capital structure. 

Long-term Assets 

Any asset that a business possesses for a year or longer falls under its long-term assets. Examples of long-term assets include vehicles, land, and machinery. Depreciation is accounted for on long-term investments and recorded as an expense. 

Current - Assets

These include short-term assets that a business/company can liquidate within a year. Examples of current assets include business inventory, cash and bank balances, accounts receivable, and interest earned. 

Current Liabilities

Current liabilities are short-term accounts payable by the business. These include accounts payable, interest owed, and taxes payable. Any liability that is due within a year is a current liability.

Long-Term Liabilities

As the term suggests, long-term liabilities are long-term loans or bonds issued by the company. The maturity period on long-term liabilities has to be more than a year. However, any interest payments on long-term liabilities are recorded under current liabilities according to the year they accrue in. 

Common versus Preferred Stock

Companies can generally issue two types of stocks: common stocks and preferred stocks. Common shareholders are actual business owners as they share any profits or losses the company makes. In return, common shareholders have the right to vote in managerial matters. Dividends are paid out to common stockholders only when the company makes a profit after all deductions. 

Preferred Stockholders enjoy a preference over common stockholders when it comes to the disbursement of dividends. Preferred stocks have a fixed percentage rate of dividend, unlike common stocks, and preferred stockholders do not get voting rights in the company. In some cases, the dividend amounts of preferred stocks are carried forward (for cumulative preferred stock) to the following years. For non-cumulative preferred stock, there are no dividends in the year of loss.

Retained Earnings

Retained earnings are net profits that a business carries forward into the next financial year/period. Retained earnings denote the leftover profit balance after all interests, taxes, and dividends are paid for by the business. 

Treasury Stock

Treasury stock is a term used to denote the reserves of a business. Reserves are recorded under shareholder’s equity. They represent any surplus amounts the company would have saved for unforeseen circumstances. Retained earnings carried forward every year accumulate in the treasury stock.

Conclusion

After going through the terms mentioned above, it will become easier to understand basic accounting terms. It will, in turn, help in analyzing where a particular business stands in terms of its profitability, liquidity, and existing potential. Financial statements are the crux of any business, big or small. These statements also come in handy when comparing data from other companies to develop market forecasts. Knowing these basics will go a long way in achieving business success.

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