It’s understandable for small business owners to balk at the idea of learning basic accounting terms and principles . “Isn’t that why I hired an accountant?” you might think. Yes, no one has to know this information better than your accountant or bookkeeper. You wouldn’t have hired them if they didn’t earn your trust, so it’s not as if you have to worry about being deceived.
But consider how you’d feel about discussing your business’s finances if accounting terms and principles sounded like Greek to you. As if your life wasn’t already stressful enough, you now have one more very important task that induces confusion and discomfort. It’s safe to say that all business owners would welcome anything that could significantly diminish the stress of their day-to-day routines.
Why You Need to Know Accounting Terms and Principles
Learning the meaning of accounting terms and principles increases your sense of control over your business. You will realize which pieces of data deserve the most attention, and know which questions to ask when assessing your overall financial health. The less time it takes you to interpret your accountant’s reports, the quicker you can collectively plot your next move.
In this guide, we’ll explain 18 accounting terms and principles from the set of rules known as GAAP: generally accepted accounting principles.
1. Economic Entity Assumption
After starting your business, you meet with your accountant and ask for the most important rule for staying on top of your finances. Luckily, virtually every accountant will have the same answer: keep your business and personal transactions separate. We put this accounting principle at the top of the list because it’s essentially rule number one for starting a business.
Accountants sometimes refer to this concept as the economic entity assumption principle, or the separate entity assumption principle. Following this rule essentially means viewing your business as its own entity, as opposed to an extension of your own finances. If your accountant hammers the economic entity assumption principle into you, it’s because neglecting it makes you vulnerable to countless financial mishaps and penalties. It also makes your accountant’s job much, much easier.
Believe it or not, business owners everywhere continue to commit this careless error, even though it seems like common sense. Their banks might require minimum monthly deposits or daily balances in order to avoid fees. In this case, your accountant will likely recommend simply opening another personal bank account and using it exclusively for business transactions.
2. Monetary Unit Assumption
Companies that do business overseas sometimes accept foreign currency. When they complete their books, however, they must convert the foreign currency into their own currency, and record it as such in order to stay organized. That’s the basis of the monetary unit assumption principle: the need for additional measures to record all transactions in the same currency.
The monetary unit assumption principle also prevents businesses from taking inflation into account when completing and reviewing their financial reports. While the value of currency does change dramatically over time, this principle says businesses cannot claim they earned more or less money than what’s on paper.
3. Specific Time Period Assumption
This accounting principle simply states that all financial statements (profit and loss statements, balance sheets, cash flow statements) must only contain information from certain time frames and must clearly indicate these time frames. Without specified time frames, the business cannot draw meaningful conclusions from the data and accurately track the business’s progress.
The importance of the specific time period assumption principle stems from the various time frames used in financial statements. Depending on your industry or the task at hand (applying for business loans, compiling marketing data, etc.) you might need statements from the past month, the past financial quarter, or the full calendar year.
Utilizing different date ranges can also prevent businesses from drawing inaccurate conclusions and making rash decisions afterwards. For example, while data from this past month might not look too good, data from this past quarter might show an improvement compared to this quarter in the previous year.
4. Cost Principle
The cost principle functions very similarly to the monetary unit assumption principle. According to the cost principle, the cost of an item always stays the same on financial reports, even if its value has changed. In other words, even the most dramatic changes in an item’s market value will not affect the way your accountant reports the item on financial statements. The document will only report the item’s value at that specific time.
Accountants often cite the cost principle when reminding business owners not to confuse cost with value. Fluctuations in the value of your assets will certainly come into play, just not on your financial statements. For this reason, businesses typically cannot rely on their own records to determine the business’s valuation and should therefore enlist the help of an expert.
5. Full Disclosure Principle
Of all accounting terms and principles, this one appears most often in headline news. The full disclosure principle plays the biggest role in businesses with stockholders or investors. It states that businesses must disclose any information that directly relates to the data on their financial statements. For example, if the business’s financial statements contain confusing or surprising information, this accounting principle requires the business to explain the reasoning for this information in separate notes. Were it not for the full disclosure principle, stockholders or investors would likely draw incorrect conclusions from misleading numerical data.
6. Going Concern Principle
The going concern principle assumes that your business has no foreseeable end date and will not shut down anytime soon. In order for the going concern principle to apply, your accountant must have no reason to believe your business might have to liquidate its assets to pay off its debts in the near future.
Businesses often cite this accounting principle (a.k.a. the “non-death principle”) when deferring the recognition of certain recent expenses into future accounting periods. As long as the accountant has no evidence to suggest that the business will shut down before the next accounting period, he or she can save the expenses for another report. If such evidence does exist, the going concern principle states that the accountant must disclose this information to the business owner.
7. Accruals Concept
Most businesses use one of two accounting methods to track revenue and expenses: cash basis accounting or accrual basis accounting. With cash basis accounting, the business reports revenue when it receives cash, and reports expenses when it spends cash or accrues credit card debt. With accrual basis accounting, on the other hand, the business reports revenue along with the expenses used to generate that revenue at the same time. This accounting principal ultimately allows businesses to see the cause-and-effect relationship between expenses and revenue.
For example, let’s say you send an invoice on March 15 that gives the customer 30 days to pay. The invoice should therefore arrive on April 15, the latest. If you used cash basis accounting, the revenue wouldn’t appear on your financial statements until the day you receive it (early to mid-April). If you used accrual basis accounting, the revenue would appear in March, when you made the sale and increased your accounts receivables.
Now for suppliers and expenses: Let’s say your supplier billed you on March 31 for the products you used to make the aforementioned sale. The supplier gives you 45 days to pay. If you used cash basis accounting, the expense would appear on your financial statements in May, when you pay the supplier. If you used accrual basis accounting, the expense would appear in March, when you invoiced your customer.
As you can see, accrual basis accounting shows the date in which you incurred the expense, instead of the date you paid the expense. Businesses often start out using cash basis accounting and eventually move on to accrual basis accounting. Compared to cash basis accounting, accrual basis accounting provides more insight in terms of profitability and overall performance.
8. Matching Principle
The matching principle merely refers to the foundation of accrual basis accounting. Remember, cash basis accounting only reports revenue when you receive cash and expenses when you spend cash (or accrue credit card debt). Since these two actions usually don’t occur at the same time, revenue and expenses appear in separate reports. With accrual basis accounting, revenue and the expenses used to generate that revenue appear on reports together. The matching principle reflects this system: reporting revenue with its “matching” expenses.
9. Revenue Recognition Principle
The revenue recognition principle reflects another aspect of accrual basis accounting. Regardless of when you actually receive the revenue, accrual basis accounting reports revenue when you make the sale, or “recognize” the revenue. This accounting principle represents the act of reporting revenue at this stage, when the real transaction actually takes place.
10. Materiality Principle
To better understand the materiality principle, replace “materiality” with “significance.” This accounting principle states that accountants should record any financial transaction or discrepancy that could significantly affect its financial health. The transaction or discrepancy could seem minor at first, but the materiality principle gives accountants the authority to distinguish the material from the immaterial, or insignificant. This decision often comes down to the size of the business and/or its expenses. What’s immaterial to one business could have major consequences for another.
Thanks to business accounting software, however, it’s very easy to record even the smallest transactions. Simplifying the task of recording transactions will likely loosen the generally accepted criteria for “material.”
11. Principle of Conservatism
Like the materiality principle, the principle of conservatism affirms the accountant’s authority to make spur-of-the-moment decisions when recording transactions. Accountants consider this principle when faced with two acceptable options for recording the transaction at hand. The principle of conservatism tells the accountant to choose the option that’s best for this individual business.
These decisions only arise when the accountant has two clearly acceptable options to choose from. If the principle of conservatism didn’t exist, the accountant wouldn’t necessarily have the authority to even think of another recording method, and would likely just choose the same method he or she has used thus far.
12. Accounts Receivable and Accounts Payable
If only there were better terms for describing these two concepts. Accounts receivable refers to money your partner or customer owes you. Accounts payable refers to money you owe to your partner or customer. But it’s not the definitions that people find confusing. It’s which department to ask for when communicating with another company.
Let’s say you call one of your vendors to talk about the terms of an invoice. Since this partnership revolves around you paying the vendor, you would ask to speak to the vendor’s accounts receivable department. If the vendor wanted to discuss an invoice with your company, they would instead ask for your accounts payable department, because the question concerns money you owe them. Your company would likely never need to speak to the vendor’s accounts payable department.
It helps to remember that in virtually every business partnership, one company represents accounts receivable and the other represents accounts payable. So, if you represent accounts receivable, you would always ask to the speak to your partner’s accounts payable department.
13. Burn Rate
Your business’s burn rate represents the average amount of money you spend in a given time frame. Much like profitability or cost of goods sold, improving your burn rate will directly impact your business’s cash flow and overall financial health. For this reason, you should always keep track of this number as you grow and stabilize your business.
To calculate your burn rate, you must first pick a time frame. Most businesses use a quarter (three months) or longer. Then, subtract the cash you had on hand at the beginning of this period from the cash you had on hand at the end. Lastly, divide this number by the amount of months in your chosen time frame to produce your burn rate.
As an example, let’s say your business had $24,000 on hand at the beginning of the quarter, and $12,000 at the end. When you divide $12,000 (24-12) by three months, you get a burn rate of $4,000 per month.
The lower your burn rate, the stronger your cash flow. Thus, you want to shoot for a negative burn rate, which would mean that you have more cash on hand at the end of the quarter than the beginning. Of course, there are certain circumstances where you’d be expected to have a higher than usual burn rate because you are spending more money than usual. When you grow your business, for instance, your burn rate should go up pretty significantly due to your recent investments and/or new expenses.
14. General Ledger
Your general ledger contains every single financial transaction that has occurred since your first day in business. Whenever a transaction takes place, it goes in your general ledger. You can consult your general ledger to create financial statements, prepare your tax returns, track interest payments, etc.
Having an indisputable source of transaction data has countless benefits. If something on your financial statements seems incorrect, for instance, you could just look at your general ledger for an answer. Your general ledger also clearly distinguishes deposits from regular income. Though it’s not recommended to mix personal and business finances, most business owners end up transferring personal funds into their business bank accounts for one reason or another. Thanks to your general ledger, you can mix personal and business finances without confusing one for the other.
15. Chart of Accounts
Your chart of account (COA) is in your general ledger. It lists every account currently registered in your bookkeeping system. Displaying your accounts in this manner allows you to quickly draw conclusions while reviewing the data. Hence, you and your accountant should always make sure your COA stays up-to-date.
16. Cost of Goods Sold
Plenty of people have great ideas for new products. Only some, however, can figure out how to create their products without spending too much money. That amount of money represents your cost of goods sold (COGS). If you spend too much money creating your products, all the revenue in the world won’t keep your business alive.
Lowering your cost of goods sold will increase profitability even if your sales stay the same. The good news? You can always find more ways to lower your cost of goods sold. It’s literally an endless journey. Even something like using smaller boxes to ship your products could eventually save your business thousands per year.
Any experienced business owner knows that high revenue doesn’t automatically denote success. It’s the combination of high revenue and lower than average expenses, which results in high profitability. In addition to your cost of goods sold, these expenses include your bills, payroll, and any other operational costs.
Your business has two kinds of profit margins: net profit margin and gross profit margin.
To calculate net profit margin, subtract your revenue throughout a certain time period from the amount of money you spent in that same period. Then, divide that number by total revenue.
Let’s say your company earned $20 million in sales in a year and spent $15 million in the same time period. In this case, your net profit margin would be 25%.
Gross profit margin refers to the profitability of a single product or service. To calculate gross profit margin, subtract the cost of producing a product or service from its retail price. This includes the cost of materials along with labor. Then, divide that number by the retail price.
For example, if you sell a product for $10 that costs $5 to make, the gross profit margin is 50%.
Failing to monitor profit margins often leads to major cash flow problems going ignored. Business owners also tend to forget that the longer it takes to sell products or receive payments, the less profitable that sale becomes.
The definition of liability depends on the context. In accounting, liability is almost synonymous with debt. In addition to loans and credit card debt, liabilities include sales and payroll taxes. Excluded is the money you owe your vendors every month. So, when assessing your business’s liabilities, you are assessing the combination of debts and these two taxes. Unlike your vendor bills, these debts are paid off over time.
Comparing your liabilities to your assets provides another useful insight your financial health. If you owe more money than you have, the next slow period could prove hazardous. You’ll also likely have trouble qualifying for financing.
Accounting Terms and Principles: Just Another New Language
All entrepreneurs must learn new languages in order to communicate with their industry peers and fellow business owners. Well, think of accounting terms and principles as yet another new language. Once you become fluent, you can communicate with any finance professional. Unfortunately, you might work with the same accountant or bookkeeper throughout your entire career. But that’s why you need to become familiar with accounting terms and principles. This way, you’ll instantly be able to understand your new partners and start the relationship off on the right foot.