Understanding Accounting
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| Assets = Liabilities + Owner's Equity |
Accounts Receivable is the current asset listed on the balance sheet that shows the amount owed to the company from customers who purchased products or services on credit.
Accounts Receivable Turnover measures how quickly a business collects cash for sales on credit, or "turned over" the Accounts Receivable Balance, for the accounting period measured. Accounts Receivable Turnover is calculated as
| Net Credit Sales/Average Net Receivables, |
| where Average Receivables = (Beginning Net Receivables Balance + Ending Net Receivables Balance)/2 |
or as (year example) 365/Average Collection Period:
| Average Sales Per Day = Credit Sales or Total Sales/365 |
| Average Collection Period = Accounts Receivable/Average Sales Per Day |
Accrual Accounting Method is an accounting term that refers to the method of recognizing and reporting revenues when earned, whether or not cash is actually received, and expenses when incurred, whether or not cash is actually paid. Compare with the accounting term Cash Accounting Method.
Adjusting Journal Entries are accounting entries made at the end of an accounting period (e.g. a month, a quarter, or a year) to report transactions that occurred but were not recorded during the normal course of business. Adjusting Journal Entries are necessary to more accurately represent the financial statements for the reporting period. Adjusting Journal Entries are classified as Prepayments, Accruals, and Estimated Items.
Aging of Accounts Receivable bases the estimate for uncollectible accounts on the Ending Accounts Receivable balance and the computation that the longer an account is outstanding, the higher the likelihood that it will not be collected.
Allowance for Doubtful Accounts is a contra account on the Balance Sheet that reduces Accounts Receivable to its net realizable value by subtracting the amount estimated to be uncollectible. When an estimated amount is entered as a journal entry for allowance for doubtful accounts, the associated debit entry, bad debt expense, reduces net income by the same amount for the reporting period.
An Asset is a probable economic benefit obtained or controlled by a business as a result of a past transaction. In accounting terms, assets do not need to be owned to be controlled by a business. The accounting equation shows us that assets may be owned (called equity), or financed (a liability).
Assets are categorized as Current Assets and NonCurrent Assets.
- Current Assets, or Short-Term Assets, are cash or other assets that a business reasonably expects to convert to cash or consume during the year. Examples are cash, inventory, and accounts receivable.
- NonCurrent Assets, or Long-Term Assets, are not expected to be consumed or converted to cash within a year. Examples are equipment, buildings, and land.
*see also Property Plant and Equipment*- Intangible Assets are assets that do not have physical substance, but add long-term value because of the rights and privileges they convey to the business. Intangible Assets are classified as NonCurrent Assets. Examples are patents, copyrights, and trademarks.
Asset Turnover Ratio measures the amount of total sales generated from each dollar of assets employed in the business. It is calculated as:
| Total Revenue/Average Assets for Period |
| where Average Assets for Period = (Beginning Assets + Ending Assets)/2 |
Average Collection Period is an accounting term that refers to the average number of days it takes a business to collect on Accounts Receivable. The Average Collection Period measures how well a company is collecting amounts due based on terms of credit (e.g. 30 days, 60 days, 90 days, etc.).
Average Cost is an accounting term that refers to the simplest of the four main inventory valuation cost flow methods. Under this method the amount of goods made available for sale (Beginning Inventory + Net Purchases) is divided by the number of units available for sale to determine the average price. The average price is then applied to items sold and items in inventory to determine the amount of cost of goods sold and Ending Inventory.
Bad Debt Expense is a category on the Income Statement used to expense the estimate for Uncollectible Accounts Receivable. The expense is required to match the bad debt with the same credit sales reported for the same period. The entry is also deducted from the Accounts Receivable Balance on the balance sheet with the equivalent account, allowance for doubtful accounts.
The Balance Sheet is one of the main financial statements reported by businesses. The Balance Sheet lists the Assets, Liabilities, and Owner's Equity of the business, thereby presenting a "snapshot" of the business as of a particular point in time. The Balance Sheet balances the listed accounts with the Accounting Equation:
| Assets = Liabilities + Owner's Equity |
Book Value is a long-term measure of the financial condition and liquidity of the company. In accounting terms for a company, it is a measure of assets owned by the business debt-free, and is calculated as
| Assets - Liabilities = Owner's Equity or Book Value |
Cash Accounting Method is an accounting term that refers to the method of recognizing and reporting revenue only when cash is actually received, and expenses only when cash is actually paid. The Cash Accounting Method is used primarily by small businesses and individuals.
The Cash Flow Statement is one of the main financial statements that shows actual cash inflows and outflows by operating, investing, and financing activities for the reporting period.
Chart of Accounts lists every general ledger account name and account number that a business uses in its Accounting System. It categorizes each account into five major groups: Asset Accounts, Liability Accounts, Equity Accounts, Revenue and Gain Accounts, and Expense and Loss Accounts.
Closing Journal Entries are made at the end of a reporting period to bring the Income Statement Accounts to zero so the new reporting period will start with zero balances. The difference between revenue and expenses, called Net Income (or Loss), is also closed to Retained Earnings.
A Contra Account is used to reduce or increase the value of the related asset or liability account on the balance sheet.
- A contra asset account is a credit account used to adjust the value of its related asset (debit) account. (also see accounting definition for allowance for doubtful accounts).
- A contra liability account is debit account used to adjust the balance of the main liability (credit) account.
A contra account is also called a valuation allowance because it is used to adjust the carrying value of the related asset or liability account on the balance sheet.
Cost of Goods Sold is an accounting term that refers to the cost of the inventory that was sold during the accounting period reported on the Income Statement. Cost of Goods Sold is subtracted from total sales to determine Gross Profit.
A credit in accounting terms is an entry made on the right side of an accounting journal or general ledger account. A credit increases liabilities, revenue, and Owner's Equity, and decreases assets and expenses.
Current Ratio
measures the short-term condition and liquidity of a business, and is calculated as
| Current Assets/Current Liabilities |
A company should have more than twice the assets to pay debt obligations, or a ratio equal or greater than two. Anything below one is an indication that the company may not be able to meet its short-term financial obligations.
A debit in accounting terms is an entry made on the left side of an accounting journal or general ledger account. A debit increases assets and expenses, and decreases liabilities, revenue, and Owner's Equity.
Debt Equity Ratio
measures how much of the company is financed by debt, and is calculated as
| Debt/Owner's Equity |
The higher the ratio, the higher the debt. Generally, ratios of higher than 1 indicate more risk in financing assets.
Double-Entry Accounting refers to the accounting system of recording a transaction by debiting one account and crediting another, where total debits of the transaction equal the total credits.
Depreciation is an accounting term that refers to the expense resulting from spreading the cost of an asset over its estimated useful life. A common depreciation method is the straight line method that divides the cost of the asset by its estimated useful life to determine depreciation each year. Depreciation decreases net income, but is a non-cash expense that has no actual cash outflow.
Equity is the ownership interest in an asset, also called Owner's Equity. Equity in accounting terms is the residual interest in the asset after deducting liabilities, represented in the Accounting Equation as:
| Assets - Liabilities = Owner's Equity |
FIFO, or first in first out, is an accounting method based on the assumption that the first goods in are the first goods out for cost of goods sold reporting and inventory valuation purposes. In times of rising inventory prices, FIFO assigns the lower prices to cost of goods sold, and the later, higher prices to inventory. FIFO more closely parallels the actual physical flow of inventory in many industries.
Financial Ratios are numerical values taken from the entity's financial statements to measure its key performance indicators such as profitability, short-term and long-term financial strength and liquidity, and efficiency of operations.
Fixed Assets, see Property Plant and Equipment (PP&E).
GAAP is the acronym for Generally Accepted Accounting Principles, a technical accounting term that refers to conventions, rules, and procedures that set the standard for presenting financial information. GAAP has been adopted by nearly all public and non-public businesses in the U.S. and is thus pervasive in the business community
The General Journal is an accounting term that refers to the book where an accounting transaction is first recorded. The transaction generally consists of the date, the account and explanation, and the amount debited and credited. After the transactions are posted to the general ledger, the reference to the general ledger account number that the transaction was posted to is also entered in the reference column.
The General Ledger is a collection of each individual account in the business. Transactions that are recorded in the General Journal are posted to the General Ledger, which provides a detailed listing of each account balance.
Goodwill, or Goodwill Accounting, is an accounting term that refers to the amount paid for an entity in excess of its net assets (total assets - total liabilities). Goodwill is listed on the balance sheet as an intangible asset at historical cost. Like land, Goodwill is not amortized but is subject to an annual impairment test.
Gross Profit is the difference between Sales and Cost of Goods Sold. It is a measure of a company's core activities, and is an early measure of business strength before subtracting operating and other expenses.
Gross Profit is commonly measured as a percentage of sales, called Gross Profit Margin calculated as
| Gross Profit Margin = Gross Profit/Sales |
Historical Cost is an accounting term that refers to recording assets on the balance sheet at the original cost paid, or the historical cost. In the U.S., assets are currently not written up to market value as is commonly done in other countries, but rather carried at the historical cost until sold. The historical cost principle follows the accounting quality of reliability since the original cost of an asset is more easily verified than its current fair market value.
Income Statement is one of the main financial statements, and summarizes the revenue, expenses, and net income for the reporting period.
Interest Coverage Ratio is an accounting term that measures the ability of a firm to meet its interest payments. The ratio divides Operating Income (income before interest and taxes) by interest expense.
| Operating Income/Interest Expense |
The larger the ratio, the more likely the firm can meet its payments. The lower the ratio, the greater the risk that the company may default on its loans.
Inventory Turnover Ratio represents the number of times the inventory "turned over" during the period measured.
The Inventory Turnover Ratio is used to determine whether or not a business is maintaining adequate levels of inventory.
| Inventory Turnover Ratio = Cost of Goods Sold/Average Inventory |
| where Average Inventory = (Beginning Inventory + Ending Inventory)/2 |
Inventory Valuation Methods is an accounting term that refers to the cost flow assumptions used to value cost of goods sold and ending inventory. The four most common inventory valuation methods are first in first out (FIFO), Last in first out (LIFO), Average Cost, and Specific Identification.
Journal Entries are accounting entries made in the general journal to record an economic event. The journal entry follows the double-entry accounting system where a debit in one account equals a credit made in another account.
The Leverage Ratio calculates the portion of Assets that are not owned by the business.
| Assets/Owner's Equity |
The higher the ratio, the higher the debt of the business. The Leverage Ratio is useful because it captures all liabilities on the Balance Sheet, regardless of where or how they are listed. Generally, ratios of higher than 15 are a warning signal that the company has taken on too much debt to finance its assets.
Liabilities in accounting terms are probable future sacrifices of economic benefits from obligations to provide assets or services as a result of a past transaction or event. Liabilities are categorized as Current Liabilities and NonCurrent Liabilities.
- Current Liabilities, or Short-Term Liabilities, are those liabilities that are expected to be paid within a year. Examples are accounts payable, current portions of long-term debt, and short term notes payable.
- NonCurrent Liabilities, or Long-Term Liabilities, are not expected to be paid within a year. Examples are long-term notes such as a mortgage or a lease. For corporations, long-term liabilities may also include bonds payable, pensions payable, and deferred taxes.
LIFO, or last in first out, is an accounting method based on the assumption that the last goods in are the first goods out for cost of goods sold reporting and inventory valuation purposes. In times of rising inventory prices, LIFO assigns the higher prices to cost of goods sold, and the earlier, lower prices to inventory. For this reason, LIFO is often used for tax purposes to lower net income and reportable earnings.
Net Income is equal to the income that a company has earned after subtracting all expenses from total revenue. Net Income is commonly measured as a percentage of sales, called Net Profit Margin calculated as
| Net Profit Margin = Net Income/Sales |
Net Operating Income is income left after deducting the expenses necessary for operating the business, also called EBIT (earnings before interest and income taxes). Net Operating Income is commonly measured as a percentage of sales, called Operating Margin calculated as
| Operating Margin = Operating Income/Sales |
Net Realizable Value (NRV) is an accounting term that has different meanings for different contexts. NRV generally refers to amount of cash expected to be received from the selling of an asset. NRV is also used in the process of valuing inventory at the lower of cost or market (LCM). In this context, NRV is defined specifically as the estimated selling price of an inventory item minus all estimated selling costs and costs to complete the product.
The Periodic Inventory System records the amount of Inventory on hand periodically, usually once at the end of the year. It maintains the beginning inventory balance throughout the year, and records new inventory purchases in the "Purchases" account. At year end a physical count of the inventory is taken to determine the Ending Inventory Balance and the Cost of Goods Sold.
The Perpetual Inventory System maintains a continuous or perpetual record of Inventory by recording all Purchases, Sales, Returns, and Discounts directly into the Inventory Account. The Perpetual Inventory System allows companies to more closely monitor Inventory levels throughout the year.
Property Plant and Equipment is an accounting term that refers to those assets that are used for a company's benefit for longer than one year. Examples include vehicles, furniture, land, and equipment.
The Quick Ratio, also called the "Acid Test," is a more stringent measure of short-term liquidity than the Current Ratio. The Quick Ratio subtracts Inventories and Prepaid Expenses from Current Assets before dividing by Current Liabilities:
| (Current Assets - Inventory - Prepaid Expenses)/Current Liabilities |
Real or Permanent Accounts in accounting terms are those accounts listed as Assets, Liabilities, or Owner's Equity on the Balance Sheet. Unlike Nominal Accounts, Real Accounts accumulate balances in the account for the life of the account, and are not closed at the end of a reporting period. Examples of Real Accounts are Cash, Accounts Receivable, Accounts Payable, and Retained Earnings.
Return on Assets measures how well a company has invested its assets to return a profit, calculated by dividing net earnings by total assets:
| Net Income/Total Assets |
Return on Equity measures how well the company used Owner's Equity to return a profit in the business, calculated as
| ROE = Net Income/Average Stockholders or Owners Equity |
| where Average Equity = (Beginning Equity + Ending Equity)/2 |
Reversing Journal Entries are optional journal entries made at the beginning of the next accounting period to maintain consistency in the Accounting Cycle. Reversing Entries reverse an Adjusting Entry made at the end of the prior period if the Adjusting Entry Increased an Asset or a Liability Account.
The Trial Balance provides a listing of the account balances in the General Ledger to verify the equality of total debits and credits, and to facilitate the next step in the Accounting Cycle. Generally there are three Trial Balances produced during the Accounting Cycle:
- The Unadjusted Trial Balance verifies the equality of total debits and credits before Adjusting Entries are made, and lists each account balance for the reporting period to facilitate the Adjusting Entry Process.
- The Adjusted Trial Balance verifies the equality of total debits and credits after Adjusting Entries are made, and lists the account balances to facilitate the period close.
- The Final Trial Balance verifies the equality of total debits and credits after Closing Entries are made, and provides a listing of each account balance that is carried forward to the next reporting period.
Working Capital measures immediate liquidity of a business, and is calculated by subtracting current debt from current assets,
| Working Capital = Current Assets - Current Liabilities |
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