Accounting Concepts - Basic Accounting Terms

All of the following accounting terms have precise definitions when used in business:

• Sales or revenue
• Cost of goods sold
• Expenses
• Gross profit
• Fixed assets
• Current assets
• Current liabilities
• Working capital
• Liquidity
• Debtor
• Creditor
• Bad Debt
• Depreciation
• Accrual Accounting

Even though you may be familiar with some of them, it is important to know their exact meanings otherwise you may find yourself becoming confused.

For example, you may hear the terms 'revenues' and 'receipts' used interchangeably in casual office conversation. However, as far as business accounting is concerned they are different things and you need to appreciate the difference.

Read the following definitions carefully and make sure that you understand exactly what is meant by each of these accounting terms. This Accounting Terminology Checklist outlines the terminology, concepts and conventions that are accepted within the accounting profession.

Sales or Revenue
Revenue is the income that flows into an organization, and it is often used almost synonymously with sales. In government and nonprofit organizations it includes taxes and grants.

Don't confuse revenues with receipts. Under the accrual basis of accounting, revenues are shown in the period they are earned, not in the period when the cash is collected. Revenues occur when money is earned; receipts occur when cash is received.

Cost of Goods Sold
This is the purchase cost of the merchandise that was subsequently sold to customers.

Refers to the other costs that are not matched with sales as part of the cost of goods sold. They may be matched with a specific time, usually monthly, quarterly, or annually or they may also be one-off payments. Expenses include: staff wages, rent, utility bills, insurance, equipment, etc.

Gross Profit
Refers to what is left after you subtract the cost of goods sold from the sales. It is also called gross margin. For example, if an organization buys in an item for $50 and sells it for $75 (plus sales tax), then the gross profit will be $25.

Fixed Assets
This refers to all of those things that the business owns which will have a value to the business over a long period. This is usually understood to be any time longer than one year. It includes freehold property, plant, machinery, computers, motor vehicles, and so on.

Current Assets
This refers to assets with the value available entirely in the short term. This is usually understood to be a period of less than a year. This is either because they are what the business sells or because they are money or can quickly be turned into money. Examples of assets include inventory/stock, money owing by customers, money in the bank, or other short-term investments.

Current Liabilities
This refers to those things that the business could be called upon to pay in the short term - within the year. Examples include bank overdrafts and money owing to suppliers.

Working Capital
This is the difference between current assets and current liabilities. An organization without sufficient working capital cannot pay its debts as they fall due. In this situation it may have to stop trading even if it is profitable.

This is the ability to meet current obligations with cash or other assets that can be quickly converted into cash in order to pay bills as they become due. In other words the organization has enough cash or assets that will become cash so that it is able to write checks without running out of money.

A debtor is a person owing money to the business, for example a customer for goods delivered.

A creditor is a person to whom the business owes money, for example a supplier, landlord, or utility organization.

Bad Debt
All reasonable means to collect a debt have been tried and have failed so the amount owed is written off as a loss and becomes categorized as an expense on an income statement. This results in net income being reduced.

Assets have a certain length of time in which they operate efficiently, referred to as 'an asset's useful life.' During this period the value of that asset depreciates due to age, wear and tear, or obsolescence. The loss in value is recorded in accounts as a non-cash expense, which reduces earnings whilst raising cash flow.

Accrual Accounting
Accrual accounting relies on two principles, which have already been alluded to:
The revenue recognition principle states that revenues are recognized when they are realized or realizable, and are earned (usually when goods are transferred or services rendered), no matter when the payment is received.

The matching principle states that expenses are recognized when goods are transferred or services rendered, and offset against recognized revenues, which were generated from those expenses, no matter when the cash is paid out.

These two principles are absolutely central to understanding how accrual accounting works and are described in detail in the next sections.

You may also be interested in:
Accounting Concepts and Conventions | Basic Accounting Concepts and Financial Statements | Cash Accounting | Accrual Accounting | Basic Accounting Terms | Revenue Recognition Principle | Matching Principle | Example Income Statement.

Key Points

  • Terms like 'revenue,' 'expenses,' 'gross profit,' 'depreciation,' 'bad debt,' and 'fixed assets' have precise definitions when used in business accounting.
  • You need to understand exactly what is meant by accounting terms like these.
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