Language of Accounting
Here are definitions of some of the jargon used in accounting or by accountants.
A = L + C: This is our basic equation. Assets equal the liabilities and capital. For a corporation capital is shareholders’ equity; for a partnership it is partners’ capital; for an LLC it is members’ capital; and for a not-for-profit it is fund balance, or similar wording. Generically it is referred to as capital.
Debits and credits: A debit is an increase in an asset or decrease in a liability or capital. A credit is an increase in a liability or capital and a decrease in an asset. Do not try to make logic out of the two words; they are simply names and should be accepted as such. The debits always equal the credits. Using A = L + C we have the debits (A) equaling the credits (L+C).
Current assets and current liabilities: A current asset is either cash or other assets that will be converted into cash within the next year in the normal course of business. A current liability is a debt that will be paid within the next year also in the normal course of business. These are indicated as such on the balance sheet.
Working capital: Working capital refers to the amounts used to fund daily operations. It is the excess of current assets over current liabilities. If it is a negative amount, the company or entity is said to have no or negative working capital and is considered to be insolvent. An insolvent entity is one that cannot pay its bills when due in the normal course of business.
Book value: The stockholders’ equity is often referred to as book value. Book value is becoming less meaningful since for many companies a company’s market value, referred to sometimes as market capitalization or market cap, is becoming significantly greater than the book value. Part of the difference is attributed to undervalued long held assets such as land and buildings, fully amortized intangibles such as acquired companies’ goodwill, software, patents and film libraries, and the balance for a capitalization of current and expected earnings, market assigned price earnings ratios and other factors making the stock appear attractive.
Accrual or cash basis: Accrual basis is where the transactions and financial statements and tax returns are reported based on when income is earned and an expense incurred, regardless of when it will be collected or paid. The cash basis is where income is considered earned when collected and an expense incurred when paid. For accounting purposes the accrual basis is the only acceptable method. For tax purposes, there are rules who can and cannot be on the cash basis while any business can be on the accrual basis. It is possible for a company to be on the cash basis for tax purposes while on the accrual basis for financial statement purposes.
Generally accepted accounting principles or “GAAP:” These are the accounting rules or “laws” that determine how a financial statement should be prepared and what disclosures are necessary. These are usually qualified as being in the United States since different countries have their own rules. Many foreign countries use International Financial Reporting Standards or “IFRS” and for which U.S. companies do not follow.
Public Company Accounting Oversight Board or “PCAOB:” This is a Congress mandated board that sets the standards for financial statement preparation, presentation and disclosure that independent accountants must follow when auditing statements of publicly held companies.
Registered Accounting firm: Only accounting firms registered with the PCAOB can perform audits of publicly owned company. Unregistered PCAOB certified public accountants can audit nonpublic companies and other entities. However, both groups of accounting firms have to have their quality control practices reviewed either by PCAOB or a state oversight qualified peer reviewer, as the case may be. The auditor’s report for non-publicly owned companies is substantially similar to those of public companies.
Independence: All auditors must be independent. There are strict rules to assure this and violations are treated seriously either by the PCAOB or the state licensing board. Independent means the firm, its partners and certain family members can have no investment, creditor, management, control or other involvement in the company being audited.
Disclosures: The disclosures are reported in the notes to financial statements which contain descriptions of the accounting principles adopted by the Company; additional back up, expansion, descriptions and explanations of many of the amounts; and coverage of items not necessarily reflected in the numbers on the financial statement.
Goodwill: This is the amount paid when a business is acquired for more than the aggregate value of the business’ individually identifiable assets such as accounts receivable, inventory, equipment and real estate less the liabilities that are assumed.
Depreciation and amortization: This is the accounting terminology for the process that periodically deducts the cost of major asset expenditures supposedly over their estimated useful life. When the property is a tangible asset, such as a machine or building the deduction is called “depreciation.” When the periodic deduction is for an intangible asset such as a patent, copyright or goodwill, it is called amortization. Do not relate the name “depreciation” with any actual wear and tear of an asset – it is not relevant.
Deferred income taxes: Most companies “keep two sets of books.” One for the IRS and one for financial statement purposes. The difference between the income tax expense for GAAP and tax purposes is reflected as deferred taxes. If the difference is an underpayment of tax there is a deferred tax liability. If the difference is an overpayment, there is a deferred tax asset. If Congress reduces the corporate tax rate you will start hearing a lot more about deferred taxes and their effect on net income because of the changes in the deferred tax asset or liability. Actually some companies also have additional sets of books such as for regulatory purposes, contractual obligations, investment banking purposes or employee benefit plan calculations.
Commitments and contingencies: Most balance sheets include these words after the liabilities and immediately before the stockholders’ equity without any amounts. This is to indicate that not all liabilities are reflected on the balance sheet. These refer to liabilities that might have arisen from past transactions that are probable but not definite or quantifiable in any manner. An example is a new car, equipment or software warranty by a manufacturer or developer. They know there will be some claims but have no idea how many and or their scope. A note to financial statement would describe this contingency alerting of the possibility letting a reader apply their own judgment as to the scope. If the amount was able to be reasonably estimated, it would appear in the income statement and balance sheet using that estimated amount. Without that reasonable estimate it is include as a commitment or contingency.
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