Glossary of accounting terms

Here are some definitions of terms you’ll need to know to understand the basic accounting principles that affect your business

Account: a place to record the dollar amount and other details of a financial transaction. Example: Postage and Freight account is where you record what you spend for stamps, Fedex, UPS

T-account: a graphical representation of an account (so named because it looks like the letter “t”)

Double entry accounting system: A system in which each transaction is composed of two parts and posted in two or more accounts, making it a self-balancing system

Debit: an entry made on the left side of a t-account (in a double entry accounting system)

Credit: an entry made on the right side of a t-account (in a double entry accounting system)

Note: Debits and credits have no other meaning besides left and right; they’re neither good nor bad; you’re probably used to thinking that a credit to your account is a good thing because it lowers your balance, like when you return something to the store)

Accounting method: a system of rules that defines how and when accounting transactions are recorded

Accrual method: An accounting method that tries to match revenues with the costs incurred to produce them; revenue is recorded when earned and expenses are recorded when incurred (regardless of when these amounts are actually paid)

Cash method: An accounting method in which revenues are recorded when they are received and expenses are recorded when paid

Inventory: Merchandise that is purchased and held for sale in the ordinary course of business; also materials used to produce items held for sale

Asset: Something that you own that has a positive economic value

Liability: An amount that is owed to someone

Owner’s equity: The net difference between your assets and liabilities

Income: Amounts that flow in to your business from sales of products and services; also earnings from interest, dividends, rents, etc.

Expenses: ordinary and necessary costs of operating your business…amounts paid out for items that have a useful life of one year or less

Profit or loss: An accounting number that represents the net difference between your income and your expenses. Note: accounting (or book) profit/loss is often different from profit/loss computed on your tax return

Fixed asset: Something you own (either tangible or intangible) that has an expected useful life greater than one year

Balance sheet: An accounting report that shows your assets, liabilities, and owner’s equity; a snapshot of your business at a particular point in time. Also known as a statement of financial condition.

Income statement: An accounting report that shows income, expenses, and profit/loss: the results of your business operations over a period of time

Accounts receivable: Amounts that others owe you

Accounts payable: Amounts that you owe others

Owner’s draw: Amounts that you (assuming you’re a sole proprietor or single member LLC owner who files a Schedule C with your Form 1040 tax return) draw (or take) out of your business for personal purposes

Payroll: Amounts paid to employees (according to the IRS definitions) who work for you and subject to the laws regulating payroll taxes; amounts paid to independent contractors are not considered payroll; amount of owner’s draw is not considered payroll

Materiality: A concept that defines whether a dollar amount is significant or not (if not, it’s called immaterial); for example, you might find a great bargain (say at a school auction) and be able to purchase a solid wood desk for your office for $5…the desk might have a few scratches but it definitely has a useful life of more than a year and should theoretically be classified as a fixed asset. But the cost is considered immaterial and you’re allowed to expense the purchase instead.