Accounting Vocabulary – What you need to know
Different terms? Oh my!
I recently talked with a client about his financial reports, and he asked “Why can’t all accountants use the same terms?” and “Why does my software not use the accounting vocabulary you use?”
I had many thoughts to list, but one is that I think many companies are trying different ways to appeal to non-accountants.
- Accounting software companies. They use different words that they want to use — probably thinking that they have a better way to connect to non-accountants. But I think this can lead to confusion. To make this even more confusing, I have seen a company who creates two different accounting software programs actually use different terms in each program. So apparently there are different opinions in the same company on terms to use in order to connect with non-accountants . . . Oh my!
- Accountants. I recently read an article by an accountant who stated if his client uses the wrong term, he starts using the wrong term in order to connect with them.
I don’t understand this way of thinking. Here’s a story from my past: Years ago, I never had a van. I never dated anyone with a van. All I ever owned was a car. I started dating my now husband. I called everything a car. He said, in a nice way, “It’s not a car, it’s a van!” Sure, he could have let me get away with it, but his family also had vans and if I kept calling everything a car sooner or later more people would have been annoyed with me. I started using the correct term.
My thoughts: Let’s use the basic terms of accounting. I don’t think we accountants have to get overly complex, but I do think we should tell you some key terms that are used throughout the accounting community to help this be less confusing.
Here’s some basic key accounting vocabulary.
Let’s take the mystery out of accounting vocabulary.
The Income Statement is one of the key reports of a business. It shows the activity for a period of time. They key phrase: period of time. We can create the Income Statement for a month, quarter, year, etc. This report:
- Helps us make decisions by showing how the business is doing.
- Is one of the first reports a tax CPA will ask for.
- Will be one of the reports the bank requests when we want a loan.
In addition to Income Statement, it may be called
- Profit and Loss report
- P&L (just a “short-cut” way of saying it)
Income Statement – Vocabulary
Let’s now work through some key terms on the Income Statement.
We sell a product or service. This is Sales. Another word you can use is Revenue.
I know, QuickBooks (which I usually like) uses the word Income instead of Sales or Revenue as the first item on the Income Statement. My preference is not calling this Income. I think it makes things too confusing. I formally call this Sales or Revenue. (Keep reading, the final result is Net Income, so I don’t like using the word “Income” first thing).
Cost Of Goods Sold
Cost of Goods Sold is exactly that: the cost of the goods (i.e. products) we sold — how much it costs to buy/make the stuff we sold.
- It is the cost of the products actually sold.
- It is not the total cost of the products. Some items have not sold yet. They are sitting in inventory.
- This is where a good accounting software is very helpful: We track the SALE of product sold and the related COST of that product.
If we sell products, this is a common term. If we sell services, it is not used as much (there is a variation of Cost of Goods Sold for service companies that may be appropriate, but for now let’s keep this basic.)
Gross Profit is then how much we made on the products sold: Sales – Cost of Goods Sold.
- It is a key calculation if we sell products. It isolates information by telling us before other expenses (which we will talk about soon), how much we made on those products sold.
- In our example: for the $100 product sold, it cost us $60, and we get to keep $40.
Ratio: A good ratio to calculate is Gross Margin which is Gross Profit / Sales. In our example it is $40/$100 = 40%
- This says for every dollar we sell, we get to keep 40 cents.
- This is key information. We can then start thinking:
- How would this look if we raised prices?
- How would this look if we could lower the cost of the product?
But Wait . . . we still have other expenses . . .
$100 – $60=
Income Statement - Few more terms
There are many different types of expenses. It is in our best interest to track these monthly so we can get a better understanding of how our business is doing. But, for sure, we want to track these for taxes so we can get legitimate tax deductions. Here are some examples:
- salaries of employees
- phone costs
- office rent
- professional fees from accountants and lawyers
- internet fees
- marketing, social media ad costs
- and the list goes on
Net Income / Loss
Profit / Loss
“Show me the bottom line”
Yes, this is the number we have been looking for. How did we do? Did we have Net Income (or “make a profit”) or did we have a loss?
Take the Gross Profit (the subtotal above) – Expenses =
Net Income or Loss.
Ratio: A good ratio to calculate is Net Margin (yes, “Net” margin this time instead of “Gross” margin) which is Net Income / Sales. In our example it is $15/$100 = 15%
- This says for every dollar we sell, after all the expenses, we get to keep 15 cents.
- It helps us ask questions like: How would this look if we could lower rent?
$40 – $25 =
Accounting Vocabulary Summary
Accounting reports can get long and detailed. If you are overwhelmed because your accountant is giving you papers of detail, ask them: “Can we start with the big picture and then burrow down through detail when we need to?”
Here’s an example of the big picture of what we just talked about.
As I work with small business owners, some don’t want a lot of accounting reports and accounting talk. They immediately want to see the Net Income and then work through the detail as needed. Other small business owners want to see more detail immediately.
But either way, you ultimately need to understand your Income Statement. Accounting vocabulary can be simplified and understanding these terms is a great starting point.