CPA Bill Kennedy shares a list of common accounting terms you’ll hear in financial analysis, along with warnings about what actions you should take.
When an accountant or treasurer finishes their report, are you left wondering whether you just heard good news or bad news? In its quest for precision and accuracy, the secret language of accountants can start to sound like jargon to the untrained ear. Those in the financial world frequently use terms that others never utter. Get to know some common accounting terms so you don’t feel lost.
Accrue / Accrual
This term simply means that the paperwork has not caught up to the transaction. For example, if your lawyer has done work for the organization and has not yet submitted an invoice, the accountant accrues the legal fees. The term also applies to revenue. If your company ships a product to a customer but hasn’t yet sent out the invoice, your accountant accrues the revenue and any associated costs.
Action Required? This is just the accountant attempting to capture all of the transactions that occur in the period to the precise penny so you get a clear and accurate look at your financial situation. However, if the word keeps showing up repeatedly, you should question why the paperwork is taking so long to catch up to the transaction.
Defer / Deferral
When the organization receives money for a particular purpose without yet fulfilling its end of the bargain, you can’t recognize the money as income. The payment is deferred. When the organization performs its obligation, the money is included as income. This is a confusing concept that can lead to disputes between the revenue generation staff and the financial staff.
Imagine that you own a gym and sell a 12-month membership to Ms. Jones for $1,200. In return for the money, Ms. Jones has access to the gym for one year. At the beginning of the year, your company has done nothing for Ms. Jones, so the whole amount is deferred. With the passing of each month, your business can bring $100, or 1/12 of the annual amount, into income. It’s assumed that Ms. Jones is now utilizing the membership.
Action Required? Yes. Deferrals can cause issues between the revenue generation team and the finance team unless the differences are understood. In the simplistic example above, assume that the membership sale occurs at the end of the year.
The revenue generation team may think it meets its objective by bringing in the membership, but the finance team can argue that the money belongs in the next year, not the current year. This is because Ms. Jones has yet to use any portion of your company’s services.
Amortize / Depreciate
This is the simple idea of spreading the cost of something over its useful life, with the added wrinkle that if the something is a mortgage, the payments are divided into principal and interest. In this case, only the interest is an expense. Learn more about amortization here.
Action Required? None, except that if the amortization amounts are high, they can obscure other results. If you have a lot of amortization, especially when both revenues and expenses are affected, you should pay careful attention to the cash flow statement to be sure that you have more cash coming into the organization than you are paying out. This is one word in the secret language of the accounting world that can earn you a deduction at tax time.
The difference between the actual amount and the budgeted amount is referred to as a variance. The budget represents the organization’s plan at the beginning of the year. A variance analysis offers a way to identify the changes that occur, such as unexpected expenses or events that happen later than planned.
Action Required? Yes. It’s too easy for a financial analysis to get lost in the detail and miss the overall message. The prime concern of any financial statement reader is the future of the organization. Is it sustainable and on the right course? Does management understand the situation and know what to do? The pluses and minuses of individual lines on the financial statement must provide an overall context.
In addition, make sure the accountant designs the formulas so that a negative variance is “bad” and a positive one is “good,” otherwise they can be confusing to read.
Often the reason given for an item being over or under budget is timing. This means that your business met the budgeted amount more quickly or slowly than planned.
Action required? No, unless this explanation is over-used, in which case, you should question why there are so many timing differences.
Equity (Net Assets)
In a for-profit company, the equity is theoretically what is left over for the owner(s) should the company shut down, sell all the assets, and pay all the liabilities. In practice, it’s a balancing number that has no use in the financial statements.
Action required? No. Just be sure that nobody thinks that the equity or net assets line represents cash the organization can use.
In the secret language of the accountant, cash flow is the one to know. A cash flow calculation determines whether the money your company receives is greater than the money you spend. Cash flow is also important because of the emphasis many business professionals put on it.
Classic accounting theory says that accrual accounting is the best predictor of future cash flows because it includes all of the costs incurred. In the short run, however, you need to have enough money on hand to fund the operations. Otherwise, the organization can’t survive into the long-term.
Action required? None, except you need to ensure that the details don’t obscure the overall message. If, for example, in a given year, the cash flow is negative, i.e. more money is spent than received, then it’s important to look at what the organization spends money on.
If you construct a building or purchase major equipment for your business, then the cash flow could turn negative in an otherwise healthy organization. Be sure that your business has money to pay its staff and contractors in this interim period.
Qualified (Audit) Opinion
The word itself is confusing. You want an unqualified opinion from a qualified auditor. In this case, qualified means limited, restricted, or modified. In other words, if the auditor’s opinion remarks that the financial statements adhere to accounting standards except for, you have a qualified statement.
Action required? Because it’s impossible to determine whether charitable organizations receive all intended donations, many such organizations get a qualified audit opinion. If this is the case, don’t worry. Only talk to the auditors about what changes need to be made in order for them to issue an unqualified opinion.
A financial statement is a written record that presents the financial information for an organization. There are four major financial statements that, when used together, convey the full story of a business’s financial activities and conditions. They are:
- Balance sheet, which provides an overview of assets, liabilities, and owners’ equity.
- Income statement, which reports revenues and expenses.
- Cash flow statement, which shows inflows and outflows of cash.
- Statement of shareholders’ equity, which reflects ownership stake in the company.
Action required? Yes. It takes careful planning to create a set of financial statements that adhere to the appropriate accounting standards while still offering a reasonably financially literate reader a view of the organization’s activities. But it’s worth doing. A clear financial picture of the past year helps your stakeholders make informed decisions about supporting you in the future, as well as confirming the value of their past support.
While you may not learn every accounting term without four years at a qualified college, it’s essential that you understand the basics to help your company’s financial growth and ensure its viability.
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