Every profession uses its own language with its own definitions and context. Accountants use terminology foreign to many outside of this profession. Understanding the financial condition of the business and the accounting principles used to determine the financial condition is critical for business owners. Understanding the meaning behind basic accounting terms opens the communication between accountants and business owners.
The accounting equation represents the foundation of financial reporting. This equation is written as assets equal liabilities plus stockholders’ equity. The balance sheet financial statement builds on the accounting equation by listing out the company’s assets, liabilities and equity items. Modifying this equation allows the company to determine its net worth by subtracting its total liabilities from its total assets.
Most companies use the accrual accounting method to record its financial transactions and report its financial results. Accrual accounting allows the company to communicate a fair picture of its activities for the period. Accrual accounting requires the company to report revenue at the time it earns the revenue, regardless of whether or not the company collects payment at that time. Accrual accounting also requires the company to report expenses at the time it benefits from those expenses, regardless of whether the company pays for those expenses at that time.
Chart of Accounts
A chart of accounts represents a list of every account a company uses for financial reporting. The company classifies each account as an asset, a liability, an equity account, a revenue account or an expense. The chart of accounts assigns an account number to each account. The company keeps the accounts in order by classification. Assets are first, followed by liabilities and equity accounts. Revenues and expense accounts appear after the equity accounts. The company uses a flexible numbering system and skips numbers in between each assigned account number. This allows the company to add new accounts in the future and maintain the numbering system.
Net income represents the amount of money the company earns after considering its expenses for the period. The calculation of net income appears on the company’s income statement. The income statement lists all of the revenues earned during the period, all of the expenses incurred during the period and the difference between the two. If the revenues exceed the expenses, the company reports a net income. If the expenses exceed the revenues, the company reports a net loss.