Accounting is often dubbed the language of business. Accounting plays a crucial role in financial management and decision-making. However, for many students, learning accounting can be daunting due to the abundance of technical terms and jargon.
In this guide, we will demystify the complex accounting terminology. Our goal is to make accounting jargon easy-to-understand. We do so with clear explanations and real-world examples to help students grasp the foundational concepts of this essential field.
Understanding the Accounting Equation
The accounting equation lies at the heart of financial accounting. The equation is:
Assets = Liabilities + Equity
Let’s break down each of these three terms.
Assets: These are resources owned or controlled by a company that have economic value. An example of an asset for most businesses is cash. A manufacturing firm will also have buildings and machinery listed under their assets.
Liabilities: Liabilities are the debts of a company to external parties. This includes loans, accounts payable, and other financial obligations.
Equity: Equity represents the intrinsic value of a company. It’s the residual interest in assets after deducting liabilities. Common stock that investors buy on the public market is considered to be equity in the company. When you buy one share of MSFT, you’re purchasing a small equity stake in Microsoft.
For example, ABC Company has $100,000 in assets, owes $40,000 in liabilities, and has $60,000 in equity. According to the accounting equation, $100,000 (assets) = $40,000 (liabilities) + $60,000 (equity).
Unraveling Double-Entry Bookkeeping
Double-entry bookkeeping is the foundation of accurate financial recording. Every transaction has equal debit and credit entries, ensuring the balance between assets, liabilities, and equity.
Debit: When a transaction increases an asset or expense account, it’s recorded as a debit.
Credit: Conversely, when a transaction increases a liability, equity, or revenue account, it’s recorded as a credit.
For instance, suppose XYZ Company purchases new equipment for $10,000 with cash. The entry would be: Debit Equipment (increasing the asset account) $10,000 and Credit Cash (decreasing the asset account) $10,000.
Explaining Financial Statements
Financial statements provide a snapshot of a company’s financial performance and position. The three main statements are:
Income Statement: A financial statement that tells you a company’s top line revenue, cost of goods sold, operating expenses and net income. Usually over a period of one fiscal year.
Balance Sheet: Presents a company’s assets, liabilities, and equity as of a particular date.
Cash Flow Statement: Details the cash inflows and outflows during a specific period. The cash flow statement is often the most difficult financial statements to understand due to the unpredictable nature and line items of cash flow.
For example, XYZ Corporation’s income statement shows $500,000 in revenues, $300,000 in expenses, resulting in a net income of $200,000. Their balance sheet reveals $700,000 in assets, $400,000 in liabilities, and $300,000 in equity.
Check out our ELI5 post on the difference between an income statement and a cash flow statement if you’re still confused.
Decoding Financial Ratios
Financial ratios help assess a company’s performance, liquidity, and profitability. Some essential ratios include:
Current Ratio: Current assets divided by current liabilities, measuring short-term liquidity.
Gross Profit Margin: (Gross Profit / Revenue) x 100, indicating how efficiently a company generates revenue from its direct costs.
Return on Equity (ROE): (Net Income / Average Shareholders’ Equity) x 100, showing the return generated on shareholders’ investments.
For example, ABC Retail has a current ratio of 2.5, indicating good short-term liquidity. Their gross profit margin is 35%, reflecting efficient cost management. The ROE is 15%, implying a satisfactory return for shareholders.
Understanding accounting terminology is a critical step for students aspiring to excel in finance and business. This guide aims to empower students. We break down the jargon and reveal that accounting is actually a simple subject when introduced with simple-to-understand examples.
Accounting and bookkeeping training is important. But it’s pointless to read textbooks and attend accounting courses without a firm grasp on the basics and definitions. Students will be able to interpret financial data and make informed decisions once the finance fundamentals are understood. There are many tools that students should learn to use too. Python and accounting softwares like Xero are some examples. Xero SME accounting software is widely used in Singapore and Xero is almost a requirement for applicants nowadays.
Students will also be able to contribute to the financial success of businesses with greater education in accounting courses and hands-on application of knowledge such as using accounting softwares like Xero.
