18 Accounting Terms that every new business owner should know.
When starting a new business, you will be subjected to a variety of financial jargon. This can come from your bank, Revenue Canada or Revenue Quebec, suppliers, customers and various other business partners. If you are unfamiliar with this terminology, these requests which are often quite straightforward, can become stressful when you are not exactly sure what they mean. It is important, therefore, to arm yourself with at least a basic vocabulary of the most common financial and accounting terminology that will not only give you a better understanding of your business but also ensure that you are well equipped to answer any questions that come your way.
Sales/Revenues
Anytime you sell a product or service or earn income for business purposes from another party i.e. a customer or client, you are essentially making a sale. From an accounting perspective, this is referred to as sales or revenues. There are conventional sales such as selling your cupcakes or web design services. Less conventional sales would include ad revenues from Google on your website or YouTube account, affiliate or referral commissions, or payments from a service such as Patreon or a Kickstarter/GoFundme campaign. This also includes payments received in kind i.e. payments which are not received in the form of cash but a product or a free trip or subscription etc for which you would have to determine the fair market value and reflected them as sales.
Cost of Goods Sold
The direct costs of selling your product and sometimes services (if you have significant direct costs) are collectively referred to as cost of goods sold. These will include costs to purchase the raw materials or items that you sell, packaging of your product, shipping and duties, labels etc. They also include the cost of the labour to produce the goods.
Gross Margin
The difference between your total sales and cost of goods sold is referred to as the gross margin. This is also often expressed as a percentage by dividing the gross margin dollar amount by the total sales. The gross margin gives you insights into the direct costs of selling your product and can be used as a comparison to other businesses in your industry and various other types of financial analysis.
Expenses
Costs that you incur that relate to your business and are not included in cost of goods sold are referred to as expenses. These are usually indirect costs or overhead costs that you have to be incurred to run your business. For accounting and tax purposes, expenses are categorized by type of expense. Some of the more popular expense categories include:
Salaries
Rent
Advertising and/or Marketing
Office expenses
Dues and subscriptions
Travel
Utilities
Determining which expense categories are most relevant will depend on the specific requirements of the business. Having meaningful expense categories can provide a great deal of information and are especially useful for analysis.
Check out our Small Business Tax Facts book that details deductible business expenses that every business owner can claim and provides you a comprehensive, yet simple, understanding of your (unincorporated) small business taxes.
Profit-Loss
A profit and loss statement quite simply shows the sales , cost of goods sold and expenses by category to arrive at a net profit, when sales exceed expenses or a net loss when expenses exceed sales.
The profit and loss statement, which is also referred to as the income statement, is one of the most important(and most requested), reports for a business owner. It is used by banks to determine your suitability for a loan or credit and by the tax authorities to determine how much taxes you will pay. It also provides the business owner with significant insights into how their business is doing and provides the data to identify areas that require improvements.
Assets
Anything that your business owns or from which it expects to derive a future benefit is referred to as an asset. For example, the money in your bank or investment accounts are owned by you. The equipment or machinery that are used to run your business or the amounts that customers owe (accounts receivable) you are also assets. Assets may be current i.e. they are available to you within the next year without restriction such as cash in the bank or long term i.e. they are restricted and are not readily available in the short term. For example an investment in another company usually cannot be sold immediately. Or you might loan someone money that is only due in 5 years.
Liabilities
When your business owes money such as a loan to a bank or shareholder, or to suppliers for purchase of goods or services, it is referred to as a liability. Similar to assets, these are also classified as current for amounts that are due within the next year or long term for amounts that are only due after one year or more. An amount due to a supplier or taxes payable to the government are usually current, while a bank loan that has a fixed term exceeding one year is long term.
Equity
When you deduct liabilities from your assets , the result is know as equity (or negative equity if your liabilities exceed your assets). Equity usually comprises the amount of contributions by the owner AND the accumulation of profits and losses since the inception of the company minus any amounts withdrawn by the shareholders or owners in the form of direct withdrawals or dividends.
Balance Sheet
The report that shows the assets, liabilities and equity of a business is referred to as a balance sheet. The reason it is called a balance sheet is that the assets will always equal the liabilities and equity since all accounting uses a system called double entry. This simply means that there are two sides to every transaction which are referred to as debits and credits.
Accounts Receivable
The accounting term for when customers owe you money is accounts receivable. This is also referred to as customers receivables or simply by its acronym which is AR. If you have an accounting software where you enter your invoices to customers and corresponding payments, you will be able to produce what is known as an AR Aging Summary, which is a report that lists all the amounts that customers owe you categorized in 30 day increments. The AR Aging Summary has the receivables that are the newest, referred to as current, in the first column. Each subsequent column is increased by 30 days i.e current, 30 days, 60 days, 90 days and anything over 90 days . For example, a customer that you invoiced 2 months ago who has not yet paid you will show up under the 60 days field. The older the accounts receivable, the more problematic it is since there is a lower chance that it will be collected. It is important to know exactly which customers owe you money at any given time and follow up with them regularly to increase the chances of being paid. Anyone analyzing your business such as a bank who is determining if you are creditworthy will assess the age of the receivables and assign a lower value to them. Accounts receivable are an asset.
Accounts Payable
Similar to accounts receivable, accounts payable refers to list of supplies to whom the business owes money. These may also be referred to as supplier or vendor payables. This report provides valuable information how much you owe to your suppliers and the aging can provide insights as to when you can make payments which can help with cash flow considerations. Accounts payable are a liability.
Inventory
If you sell goods, you usually have items that you have on hand but have not yet sold. Inventory essentially includes items that have either been purchased, but not yet assembled and/or items that are fully assembled and ready to be sold. Inventory is an asset.
Fixed Assets and Depreciation
Items that are purchased for the business, that will likely last for at least one year and possibly much longer are referred to as fixed assets. These include machinery, equipment, computers, furniture and improvements. It also includes intangible items that provide long term benefits such as a customer list or a brand name or a special software/app that may have cost thousands to create and will last for several years.
Accounting recognizes that when you purchase a fixed asset, it will not hold on to its value for ever. Rather the value of most assets diminishes with the passage of time. This reduction in value in accounting terms is known as depreciation (also known as capital cost allowance for tax purposes). There are several methods of depreciation which can be used to most accurately capture the loss in value of the asset.
Shareholder/Owner Loan
The term shareholder applies specifically to corporations (as you can only be a holder of shares in a corporation) while the equivalent term for a sole proprietorship would simply be owner. Often shareholders will lend or borrow money from their businesses. If they lend money to a corporation, it means that the corporation has to pay them back which is referred to as a shareholder loan payable. Conversely, amounts borrowed by the shareholder from the corporation are referred to as shareholder loans receivable. The loan may be treated similarly to a third party loan where interest is charged and/or there are specific payment terms. It should be noted that shareholder loans receivable from a corporation have tax consequences if not repaid within a specific period of time.
Retained Earnings/Owner’s Equity
The accumulation of profits and losses, minus any dividends or distributions to shareholders, is referred to as retained earnings which is a term that only applies to corporations. A sole proprietorship would simply reflect the accumulation of earnings as owners equity on their balance sheet.
Statement of Cash Flows
The profit and loss statement while showing you the performance of the business, is not an accurate reflection of the cash that was generated or spent by the business. This is because the profit and loss includes sales and purchases made on credit (accounts receivable and accounts payable) , depreciation and other items that have no impact on cash. There are many profitable businesses that have a negative cash flow or net cash outflows.
The statement of cash flows shows exactly how much net cash was spent or generated by a business. A typical cash flow statement would show how much cash was generated by the regular operations of the business i.e. operating activities, how much cash was invested (or investments sold) i.e. investing activities and how much cash was generated or repaid from loans or equity i.e. financing activities.
Financial Statements
A typical financial statement comprises the following:
Profit-loss statement
Balance sheet
Statement of cash flows
Notes to the financial statements
When you are a small business , you might only have to provide balance sheet, profit and loss and sometimes the statement of cash flows. Notes to the financial statements are generally prepared by accountants at the year end depending on the nature of your mandate with the accountant.
Budget or forecast
When you want to predict your business performance over a specific period of time in the future, you will need to prepare a budget or a forecast. This is a very useful exercise for many business owners even if only for their own purposes as it allows them to see how they expect their businesses to perform. This can then be compared to their actual results and analysed to determine the reasons for the difference. You can use the profit-loss as a template to predict your sales and expenses for one year or even 5 years. For more granularity, you can make these estimates on a monthly basis. Many business owners find it difficult to make estimates particularly when they are just starting their businesses, but if you do it regularly your skills improve over time.
A lot of accounting jargon is intuitive once you own a business. As a business owner, you naturally want certain information such as your total sales for a month or how much you spent on a certain category of expenses or how much you have loaned to the company since inception. A good accounting system makes all of this information, and much more, available to you so that you can analyze to your hearts content.
Ronika Khanna is an accounting and finance professional who helps small businesses achieve their financial goals. She is the author of several books for small businesses and also provides financial consulting services.
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