Understanding the basics behind Accounting terminology will give you the keys to business success!

Stop worrying about how complex accounting seems, lots of terms; cut through financial jargon…
Take a different approach.
Accounting is a convention just like driving on either the left or right side of the road, or using one type of Alphabet or another – and, as with many conventions; terms and names differ from country to country and region to region.
Even different English speaking countries, England, US, Canada, Australia use different accounting terms to mean exactly the same thing. Worse, a single person, such as your own accountant, will happily, and consistently, be inconsistent in their jargon!
So, rather than thinking about how unfriendly it all is, go with the flow. – You don’t need to get all the terms right, or know every title!
However, you do need some basic concepts under your belt, and ideally over time to become familiar with a broad range of possibilities. Luckily although there are a lot of terms these terms do not refer to very many things, in fact there are only a few fundamentals – all you need to do is comprehend the basics and the jargon mostly becomes irrelevant.
 

So what are Financial Statements?

In most western countries Financial Statements are a set of between 2 and 4 reports:

  1. Statement of Comprehensive Income – also known as a Profit and Loss, and/or a P&L
  2. Statement of Financial Position – also known as a Balance Sheet, and/or a B/S
  3. Statement of Cashflows – also known as a Cashflow statement, or Cashflow
  4. Statement of Changes in Equity – also known as an Equity Statement, or Statement of Retained Earnings or Statement of Owners Equity

The first two reports, about Profit and Financial Position are the most commonly used, and are always relevant in accounting for making good business decisions.
The Cashflow is a tool for evaluating a company’s ability to pay its bills as they fall due, and thus gauges the company’s solvency and high-lights operating, investing and financing activities.
The Equity Statement explains the changes of the company’s equity throughout the reporting period.
 

Background – How did messy naming come about?

The main objective of any, and every, report is to provide useful information for making informed decisions. As a business operates opens their doors, then grows the ability to simply KNOW, and remember, what went on, and what resulted, becomes harder and harder…There are staff to monitor, more customers and clients and products and services in the mix and the larger the mix the greater the need for some way of keeping track.
Accounting was invented to record information about both:

  1. What is going on in a business – money earned and money spent
  2. Outcomes and Results of what has gone on – what money was banked, how much was borrowed and paid back, and what was invested in equipment etc.

THIS IS HOW DOUBLE ENTRY BOOKKEEPING EVOLVED

Double Entry Bookkeeping is the process that links these two reports – for every money transaction that goes in or out, it had a corresponding effect on what was owned or owed. For every change to the income statement there has to be a corresponding effect on the Balance Sheet. The concept is simply a process of record keeping – nothing tricky or magical.
cut through financial jargon image

You can think of Accounting as just like Newton’s 3rd Law – “for every action there is an equal and opposite re-action”.
[box border=”full”] Put another Way…
THE INCOME STATEMENT (P&L) gives a history – it records all the “IN and OUTs” of a business – sales are “Ins” and expenses are “Outs”. Income Statements are always displayed to show activity over a period of time, a week, a month, a year – It is telling a story “between this date and that date this is what has happened…”
THE STATEMENT OF FINANCIAL POSITION (Balance Sheet) – gives a snapshot – after selling goods and operating a business for a while, it ends up with whatever is left over. Balance Sheets are displayed at a fixed point in time– this report balances up the things owned with what is owed; preferably showing the scales are tipping favourably.
THE STATEMENT OF CASHFLOWS (Cashflow) – summarizes sources and uses of cash reporting where the firm obtained its cash and what it did with it. Cash availability can be affected by day to day operating activities, but also by lending and investing.
THE STATEMENT OF RETAINED EARNINGS (Equity Statement) – explains the changes in the business owners’ funds, including retained earnings, stock and share issues and buy-backs, and dividend payments.[/box]  
Financial reports should be understandable, relevant, reliable and comparable, which is how accounting standards and conventions came about – being consistent in classification and treatment enabled business owners to review and analyse their results across various years seeing what worked and what didn’t, and making decisions on how to improve moving forward.
Accounting was initially used by Merchants in Venice, back in the early 1400 – as these merchants travelled the world they spread their double entry methods as well. But remember this is a long time ago, and in the next 500 years each region had time to improve, adjust and amend the conventions they began with.
In addition to the localisation of the process, Taxes got included – as each government saw accounting as a method of keeping track of what a business owed in levies. This then meant governments began to dictate exactly how they wanted financial statements kept and what was appropriate.
Now I am not going to begin to get into the vagaries of why and how one government will want one thing and the next government another thing, suffice to say messiness flourished.
Regional specificity was all well and good until the last 120 years as travel and international trade became easier and computers enabled mass sharing of information.  The entire Accounting Industry is in flux as “correct terminology” is argued out agreed and ignored.
Remember, even the best accountants simply check before they assume what someone else means – we can’t encourage you enough to actually confirm you are on the same page as the person you are talking to about finances.
 

So don’t despair! Forget about the debits and credits, leave that to the bean counters, and embrace your Reports as a tool for making more profitable decisions, no-matter what the title at the top of the page!

 
 
 

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For more information see:
Understanding your Business Dashboard – the calculations used for each of the 8 Key Business Indicators[/box]