Einstein is reported to have complained to his accountant that “the hardest thing to understand in the world is income tax”. Running your own business and doing your own accounting is difficult, but Zervant doesn’t think it is as hard as the Theory of Relativity!
Which is why we’ve put together a glossary of 15 essential accounting terms for small businesses, sole traders and freelancers. If you find it useful why not try our online invoicing software too!?
1. PROFIT & LOSS STATEMENT
Or ‘P&L’ for short. A record of your business’ profits and losses, over a defined period of time (eg. quarterly). We recently wrote an article all about P&Ls, so be sure to check that out too.
2. BALANCE SHEET
A balance sheet shows what a business owns, what it owes, and how much the owner has invested in it. Read our beginner’s guide on balance sheets for more detail.
3. ACCOUNTS RECEIVABLE
Money that you’re owed by customers for any goods or services. On a balance sheet these come under “assets” as it is assumed that your customer will pay you the money.
4. ACCOUNTS PAYABLE
Money that your business owes its creditors. Here creditors can include suppliers, or your phone or energy company, for example. Anyone who provides you with a service and bills you for it afterwards. Listed as “liabilities” on a balance sheet.
Everything that a business owes and for which it is legally bound. Think of loans, mortgages, money owed to staff and so on.
Quite simply, everything that a company owns. They can be divided into tangible assets such as computers or office furniture, and intangible assets such as patents or trademarks.
Fixed assets (also known as capital assets) are assets with a lasting benefit, that cost more than your daily running costs. They can also be classified as tangible, eg. property, or intangible, such as an expensive internet domain name.
7. CASH-BASED OR ACCRUAL ACCOUNTING?
In small business you’re likely to encounter two main types of accounting. Cash accounting is the most useful type of accounting for entrepreneurs. Revenues are entered on the P&L when they are actually received and the money is physically in your bank account. The same applies to any expenses – they are only recorded on your P&L when the money is paid out.
The other type of accounting is called accrual accounting, also known as G.A.P.P. (Generally Accepted Accounting Principles). Revenues are entered on the P&L when they are earned, which can be before customers actually pay (we all know about the problem of late payments!). Expenses are also entered on the P&L when they occur, not when you pay them (which may well be at a later date too).
From a tax perspective cash accounting is handy for entrepreneurs as you only need to declare money as and when it comes in or out of your business. There’s no need to calculate creditors, debtors, or do a stock take at your year-end (which you do need to do with accrual accounting).
If you need more information on this be sure to read our dedicated article on the differences between cash and accrual accounting.
8. THE MATCHING PRINCIPLE
One of the “Golden Rules” of accounting – essentially a combination of accrual accounting (as discussed above) and revenue recognition. Revenue recognition states that business revenues should be recorded when they are earned by a business, regardless of when a customer actually pays for them.
The decrease in value of an item over time. A car, for example, loses value the older it gets. Depreciation is a way of spreading the cost of a fixed asset over the period of time it is used by your business. If, for example, you buy a computer for £1,000 and estimate that it will be useful to your business for 5 years, the depreciation is £200 per year (£1,000 divided by 5 gives you £200). Read more about depreciation here.
Investopedia defines equity as “stock or any other security representing an ownership interest” in a business. Broadly speaking, the term relates to an owner’s financial involvement in a business.
This term refers to any cost that a business incurs through operations that generate revenue. This includes fixed costs, which remain constant and do not vary with output, such as rent or loan repayments. Variable costs depend directly on how your business is performing (be it sales, production volume, level of activity). This includes raw materials and shipping. So the higher your output, the higher the variable costs.
12. GENERAL LEDGER/ NOMINAL LEDGER
There is not a huge difference between the 2 terms, only that general ledger is more common in the US, nominal ledger in the UK. It refers to a complete record of a business’ financial transactions and accounts, including all the information in the P&L and the balance sheet. Think of it as a master database for your business’ finances.
A record of financial transactions by date. Business transactions are posted here before they are transferred to the relevant account in the ledger, which might be “accounts receivable” or “accounts payable”, for example. Journals are a bit like postal sorting depots where all your business’ financial transaction are logged and then distributed to the right place.
14. BAD DEBT
A debt that, unfortunately, will not be paid and as such has to be written off in your company accounts. One way to combat bad debts is by using online invoicing software.
15. SINGLE AND DOUBLE ENTRY ACCOUNTING
It is most likely that as a small business you will use single entry accounting. The system is also ideal for cash accounting. In single entry accounting every financial transaction is recorded with only a single entry in your company’s books eg. the journal or ledger. With double entry accounting every transaction requires two entries in the books, which offset each other. There needs to be a credit and a debit entry. This means that all entries are double-checked for errors and helps to maintain balanced accounts (in much the same way a balance sheet does too).
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