Basic Accounting Terminology and Confusions

Accounting terminology can sometimes be confusing to an experienced analyst, let alone a novice. This is because different authors use different terms to mean the same thing. For example, take the so-called “bottom line” on a firm’s income statement. This is variously referred to as earnings, profit and/or net income. These are not to be confused with operating income, a very different concept. Owners’ equity on one balance sheet (aka statement of change in financial position) might be referred to as stockholders’ equity; it’s also sometimes referred to simply as net worth. Or consider the number derived from subtracting a firm’s cost of goods sold from its revenues. It is sometimes referred to as gross profit. On another income statement it might be listed as gross margin. These are not to be confused with contribution margin, which means something entirely different. To add to the confusion, different writers and financial services sometimes use different formulas in calculating financial ratios such as return on assets. To overcome these potential problems, keep in mind the context in which a term is employed and be consistent in your own analysis.

A description of the basic accounting framework.

• Be aware of the different purposes accounting serves;

• Understand what an account is;

• Understand the difference between accrual and cash accounting;

• Know the two equations which underlie the income statement and balance sheet, respectively;

• Gain insight into a basic income statement, balance sheet, source and use of funds statement and a firm’s operating cycle.

Accounting serves several purposes, all at the same time. The following are some examples:

1- It’s used to keep score. It answers questions like “How are we doing?” Are we making a profit? If so, how much? Are we losing money? How is the West Coast division doing compared to the East Coast division?

2- It directs attention to problems and opportunities. Is our inventory getting too large? Is our product getting out on time? Are we collecting our accounts in a timely fashion? What is happening to our profit margin?

3- It provides information needed to control costs. Before managers can control costs they need to know how much the costs are, how much the costs should be and what it is that causes them. A properly designed accounting system will provide this information.

4- It provides information needed for planning. Before managers can make plans they need to know how costs and profits react to changes in volume and production methods. For example, some costs will change proportionately with changes in production, some will change more than proportionately and some will not change at all.

5- And it provides information for decision making. Should we make this component ourselves or should we outsource it? Should we buy or lease a piece of equipment? Do we want to accept this special order at a price below our normal sales price? Again, a well-designed accounting system can provide a treasure trove of information that will help managers answer these kinds of questions.