The beauty of technology is shifting how the accounting and finance departments work. They’re automating the busy work and focusing on strategy more than ever — meaning less busy work and more opportunity to positively impact the business.
Whether you’re an accountant thinking more strategically, or a non-accountant working more closely with the accounting department, we thought we’d take a minute to cover the basics and how they fit together. From GAAP to the month-end close, here are 16 basic accounting terms you should know:
Generally Accepted Accounting Principles (GAAP)
Accountants follow a consistent set of principles to ensure financial records can be understood easily and compared between companies. Following GAAP is important for creating clear financials and is required in many cases, like at publicly-traded companies. A lot of our other terms reflect the GAAP approach to accounting.
Cash basis accounting tracks income when it’s received and expenses when they’re paid. It’s the simplest option but doesn’t always work well for larger companies. In fact, many companies are required to use the accrual basis instead. Speaking of accrual basis…
Accrual basis accounting records income when it’s earned (not received) and expenses when they’re incurred (not paid). See the difference? For example, the utility expense for August would be recorded in August, even though you don’t actually pay that power bill until September. And the power company will record the income on their books in August even though they don’t get paid until the next month. How do they do it? With AR and AP.
Expenses that have been incurred but haven’t been paid become accounts payable. That August utility bill we mentioned above…yep…accounts payable. It’s a liability account that shows up on the balance sheet because it reflects something the company owes to an outside vendor.
Income that’s been earned but not yet received becomes an account receivable. This is the August utility bill from the utility company’s side of things. For most companies, this would be the accounts of clients who purchased on credit and will pay their balance later on. AR is an asset on the balance sheet because it reflects the future benefit of money the company is owed.
The general ledger is a record of every financial transaction for the company. It used to be a big, dusty book. If it still is…there are better options available. The general ledger will be the proud parent of your financial statements but hold on just a second…
Your trial balance takes all the accounts from the general ledger and makes sure they balance. In other words, the debits and credits need to be equal. This is a quality check to make sure everything was entered correctly because if the debits and credits don’t balance somethin’ ain’t right.
The most common financial statements are the Profit and Loss Statement, the Balance Sheet, and the Statement of Cash Flows. They paint a clear picture of your company’s financial health and current position. Let’s take a quick peek at each.
Profit and Loss Statement
The profit and loss (or income) statement shows your income and expenses. By comparing money in and money out, you can see how profitable the company is over a period of time. If it’s not, don’t panic, the P&L can also help you figure out why so you can fix it.
The balance sheet shows what you own and what you owe. Your assets are listed here and so are your liabilities. Unlike the P&L, the balance sheet shows the business at a specific point in time rather than over an entire period.
Statement of Cash Flows
The statement of cash flows adjusts the P&L to reflect only the actual money that’s gone in and out of the business for the period. Changes to accounts receivable and accounts payable are taken into account (pun intended) to show what actually changed hands. It’s especially important if you track income on an accrual basis because you need cold, hard cash to pay your expenses. If you’re not collecting it, you could be in trouble.
When we say “accounting period” in reference to statements, it’s not a new kind of punctuation. Accounting details are measured in periods (typically months and years) and everything needs to be recorded in the correct period. The Matching Principle of accounting requires expenses to be accrued in the period the company benefited from those expenses.
Accountants allocate amounts to different accounts or different periods. In some cases, they may need to allocate an expense over several periods or allocate budget items across several departments. When they allocate costs over several periods to reflect the long-term use of an asset (matching the expense to the benefit provided) it’s called depreciation.
Depreciation — it’s why your dad told you a car’s value drops the second it leaves the lot. But in accounting, it’s something slightly different. Depreciation is used to allocate the useful life of an asset over several periods. For instance, if you buy an expensive piece of equipment that will last 10 years, you might use straight-line depreciation to expense 10 percent of the cost each year. This provides a much more accurate financial picture than one big expense in year one and no expense in the remaining nine years.
Reconciliations are like a mini internal audit of your accounts. You reconcile to make sure every transaction is included and that the amounts are correct. You do that by matching opening and closing balances in your accounts against an external source like a bank statement. If something doesn’t match, it’s time to dig down and see what’s throwing off the math.
The month-end close is the perfect way to wrap up the period. The closing process involves reconciling as many accounts as possible and verifying information so accurate financial reports can be created.
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