Our Financial Terms Glossary, highlighting some common accounting terms that business owners should know.
(Click on a term to view its definition)
Once the organization begins amortizing an intangible asset, the amount charged to the asset usually does not change unless periodic review of the asset’s value reveals that it is impaired in some way that reduces its value or its useful life. The organization then can take an impairment charge against the intangible asset and reset the new value of the asset or the new term of its expected useful life. The organization then can amortize the new value or new term until it has written off the value of the asset over time.
The purpose of the balance sheet is to report a summary of the details of the accounting equation – Assets = Liabilities + Capital – in a form that states assets at the beginning. On the balance sheet, liabilities and stockholders’ equity are combined and listed second. The purpose of the balance sheet is to balance, of course. The total of all assets and the total of all liabilities plus stockholders’ equity must equal each other. This means that the bottom line total of assets must equal the bottom line total of the liabilities and capital section.
Several other financial accounting reports both contribute to and can be derived from the balance sheet. The balance sheet is not intended to be an exhaustive report of the organization’s full financial activity. Rather, it is designed to be a short summary of the organization’s financial standing as of the date of the balance sheet. Balance sheets can get quite detailed in some industries, but they generally are limited to a single page in keeping with their summary nature.
The asset portion of the balance sheet lists all applicable asset classes. The first part of the asset section reports current assets, which includes cash and cash equivalents, expected accounts receivable and prepaid expenses for services expected to be used within a year or less. Businesses that have inventories also list the value of their inventories in the current assets section.
The second part of the assets section reports noncurrent assets, or those that are longer term than the items contained in the current assets section. Noncurrent assets include fixed assets such as buildings and real property, intangible assets and other financial assets not otherwise listed in the current assets section.
Liabilities also may include separate sections for current liabilities – those that will come due in a year or less – and for noncurrent liabilities. Current liabilities include items such as the total of the organization’s accounts payable, short term debt and revenue received for goods or services that the organization has not yet delivered. Noncurrent liabilities include items such as long term debt and provisions for warranties that will be valid for more than one year.
The equity section reports the value of shareholders’ equity. Shareholders are stockholders in a public company. In a private company, owners’ equity reflects the value of capital that has been supplied by those who own the company.
Cash can come into or leave the organization from operating activities, investing activities or financing activities. The cash flow statement will list each of these categories if they are applicable. The cash flow statement explicitly lists the origins of incoming cash flow and which activity category accounts for reduction in cash. A positive figure in the operating activities category indicates that the organization is making some kind of profit on its business activities. A positive figure in the financing activities category can indicate the arrival of loan proceeds or the offering of new stock.
Lenders and investors have strong interest in seeing positive figures on the cash flow statement. Most believe that given similar external conditions in the next accounting period, the organization will achieve cash flows similar to the present accounting period being reported. Lenders want to ensure that the organization generates enough cash to repay any loan. Investors want to have some assurance that their capital is safe with the organization and that they can expect some return on their investment.
The accrual method is an accounting process that recognizes revenue in the same time period that the organization incurs the expenses associated with the revenues, instead of whenever payment is received or disbursed. Using the accrual method facilitates the effort to include associated expenses and revenues in the same reporting period. The accrual method also facilitates matching revenues with the expenses incurred in creating those revenues.
Of the two accounting methods, the accrual method is by far the most common. Neither one is perfect in providing a true and accurate picture of the financial status of the business, but the accrual method fits better with the way the real world operates and so provides a better reflection of actual business results. Businesses with revenues of under $5 million are free to choose which method they will use, but the IRS requires businesses with revenues of more than $5 million to use the accrual method of accounting. Obviously, any business with revenues of under $5 million that aspire to growing beyond that point will have to change to the accrual method of accounting if they choose to begin with the cash method. This IRS requirement influences many businesses to begin with the accrual method so that they can avoid the costs of changing accounting methods at some time in the future.
When there is a difference between the two in a single account, the result is the account’s balance. Where there are more debits than credits, the account has a debit balance. Where there are more credits than debits, the account has a credit balance. Differences are possible across account types within the organization, but the total of the organization’s account debits and its account credits must balance exactly. If it does not, then there is error that must be rectified.
Rent payment provides an example. At the beginning of the month in which rent is due, the organization has funds available in a cash account and has a rent payment due in its rent account. The organization makes the payment to another organization, but internally, its double entry accounting system results in debiting the cash account and crediting the rent account. The end result is that the organization’s accounts remain in balance after its rent has been paid for another month.
Double entry accounting systems affect at least two accounts, as seen in the rent payment example above. The double entry system provides indication not only of how finances are used, but also where they originate. It also can provide indication that a given activity consumes more resources than it produces in rewards. It also can highlight another activity that has not received much attention but that has been highly profitable, indicating that the organization needs to give that activity more attention.
When the company as a whole is able to report all debits and credits in equilibrium, the totals arrived at by each can be used as the trial balance. The trial balance is the forerunner of the balance sheet, which presents final balance.
Commonly referred to as the profit and loss (P&L) statement, the income statement illustrates the costs associated with generating the total revenues reported on the balance sheet. Virtually all organizations will have an operating section included in their income statements. Some will have an additional nonoperating section that lists income and expenses from activities other than the focus of the organization’s primary business.
Within the operating section of the income statement are revenue and expenses. Revenue is what the organization receives as a result of sales of its goods or services. This revenue often is referred to as gross revenue.
Items reported in the expense section reduce gross revenue to the net revenue the organization received after paying the costs of generating its gross revenue. Expenses generally are of three types. One is the Cost of Goods Sold (COGS) or the Cost of Sales. A second is Selling and General Administrative (SGA) expenses. A third reflects the costs assigned to depreciation of long term assets. Some organizations may have a fourth form of expense reflecting the costs of research and development (R&D).
COGS reflects the organization’s direct costs in creating, acquiring, manufacturing and transporting the goods or services that provide its revenues. COGS also includes operating overhead as a cost that reduces gross revenues. SGA comprises the costs of selling and administrative support. It includes advertising costs, payroll costs, salaries that are not included in COGS as direct labor, commissions, administrative support and similar items. Depreciation is a charge against gross revenues that allows the organization to account for fixed assets without having to determine an annual market value of those assets.
COGS is the second item appearing on the income statement, immediately after revenues. Subtracting COGS from revenues reveals the organization’s gross margin. If the gross margin is insufficient to support SGA, interest expense and income tax, then either inventory needs to be sold at a higher price or COGS needs to be reduced to a lower level.
The airline industry serves as an example. An entry commonly found on the balance sheets of airline companies is “revenue per passenger seat mile.” This is a ratio that presents revenue in terms of numbers of passengers and the distance those passengers traveled with a specific airline. As the purpose of the balance sheet in light of informing investors is to present a picture of how the organization is performing, those interested in airline companies are better served with the revenue per passenger seat mile entry than with total revenues. It allows individuals to assess the general health of a small, regional airline in terms of the business results of a large, national or international airline. The alternative is to require the individual assessing two or more airline companies to determine management’s effectiveness on their own.
Airlines report revenue per passenger seat mile within the broad guidelines of GAAP. The measure is totally appropriate for airline companies, but obviously irrelevant for any other type of company. GAAP facilitates financial reporting within industries that work under similar conditions. Manufacturing companies often can report well under more conventional practices, but an ecommerce company likely cannot. GAAP establishes broad guidelines and even detailed practices within industries whose competitors share similar conditions.
The statement of retained earnings is understood to be an annual report. Internal records can be produced using much shorter time periods, but the important measure is that annual one. Retained earnings can be used to further the purposes of the company, but dividends paid represent a partial liquidation of the company. Any amount paid in dividends no longer is available for use internally. Though investors will have direct interest in the amount that the organization pays to investors in the form of dividends, they also will want to see that the organization retains capital that will allow it to take advantage of a wider range of choices available to it.
The statement of retained earnings begins with the ending value of retained earnings from the previous accounting period. The ending total becomes the beginning total of retained earnings for the new statement. Added to this beginning retained earnings is the net income determined from the income statement. The new ending value of retained earnings is the result after deducting any dividends paid to shareholders.