Financial Accounting Terminology, 21 Basic Accounting Terms Students Should Know

Financial Accounting Terminology:-

To understand the basic accounting terms and definitions clearly, you must grasp the following common financial accounting terminology that is always used in business accounting. 

The main point here is to enable the student to understand basic accounting terms often used concepts before we take off on accounting procedures and rules. 

This financial accounting terminology can be applied to any type of business activity with the same connotation.

Transaction: 

It means an event or business activity involving the exchange of money or money between parties.

The event can be determined in terms of money and changes the financial position of a person e.g. purchase of goods would involve receiving material and making a payment or creating an obligation to pay to the supplier at a future date. 

The transaction may be in a cash transaction or a credit transaction. 

When the parties make payment immediately in cash or by cheque, it is called a cash transaction.

 If payment is settled at a future date as per agreement between the parties, then it is called a credit transaction.

Goods / Services:

These are tangible articles or commodities that have a business deal. 

These articles or items are either bought and sold or produced and sold. 

Many times, a business firm may be classified as goods, another firm may not be shown as goods. For a machine-making company, machines are 'goods' because they are often made and sold. 

But for the buying firm, it is not 'goods' because it is intended to be used as a long-term resource and not to sell.

 Services are intangible in nature with or without the object of making a profit.

Profit: 

The income that exceeds the expenditure is called profit. This can be calculated for each transaction or for the business as a whole.

Loss:

Excess expenditure on income is called loss. This can be calculated for each transaction or for the business as a whole.

Asset: 

The asset is a resource kept by the business with the purpose of using it for generating future profits. Assets can be Tangible and Intangible. 

Tangible Assets are Capital assets that have some physical existence. 

They can be seen, touched, and felt, e.g. Furniture, and Fittings, Land and Buildings, Plant and Machinery, Books, Computers, Vehicles, Motors, etc. 

Intangible Assets are Capital assets that have no physical existence and whose value is limited by the rights and anticipated benefits that the owner is presumed to possess. 

They cannot be seen or felt helping to generate revenue in the future, e.g.  Patents, Goodwill, Brand Equity, Trade-marks, Designs, Intellectual Property, Copyrights, etc.

Assets can also be divided into Current Assets and Non-Current Assets.

Current Assets – It shall be classified as current when it satisfies any one of the following :

(a) It can be realized for sale or consumption in the firm's normal operating cycle, or is intended,

(b) It is conducted primarily for the purpose of doing business.

(c) This is due to being realized within 12 months of the reporting date, or

(d) It is cash or cash equivalent unless it is prohibited from responding or used to settle the liability for at least 12 months after the reporting date...

Non-Current Assets – All other remaining Assets shall be defined as Non-Current Assets. e.g. Machinery held for the long term etc.

Liability: 

Liability is an obligation of a financial nature to be decided at a future date. 

It represents the amount of money that the business owes to the other parties. 

E.g. when goods are bought on credit, the company will create an obligation to pay the supplier the price of goods on a future date as per agreement or when a loan is taken from the bank, an obligation to pay interest, and the principal amount is created.

These types of obligations could be further divided into Long Term on non-current liabilities and Short Term or current liabilities.

Current Liabilities – It shall be classified as current when satisfies any one of the following points :

(a)   It is expected to settle into the firm's normal operating cycle,

(b) It happens primarily for the purpose of being traded,

(c) The due has to be settled within 12 months after the Reporting Date, or

(d) The company does not have an unconditional right to remove the liability for at least 12 months after the reporting date (The terms of liability at the option of the counterparty do not affect its classification as a result of the settlement of the issue of equity instrument).

Non-Current Liabilities – All other remaining Liabilities shall be divided into Non-Current Liabilities. E.g. Loan taken for 5 years, Debentures issued, etc.

Internal Liability: 

These represent the proprietor's equity, ie all the amounts that the proprietor is entitled to, e.g. Reserves, Capital, Undistributed Profits, etc.

Working Capital: 

In order to maintain flows of revenue from the operation, every firm needs a certain amount of current assets. 

For example, cash is required either to pay for expenses or to meet the obligation for service received or goods purchased, etc. by a firm. 

For identical reasons, inventories are required to provide a link between production and sale. 

Similarly, accounts receivables arise when goods are sold on credit. Bank, Prepayments, Cash, Bills Receivable, Debtors, Closing Stock, etc. represent the current assets of the firm. 

The whole of these current assets forms the working capital of a firm which is termed as Gross Working Capital.

Gross Working Capital = Total Current Assets

 =(Long term internal liabilities)+ (long term debts) + (the current liabilities) - (the amount blocked in the fixed assets).

There is another concept of working capital. 

The working capital is the excess of current assets over current liabilities. 

It is the number of current assets that remain in a firm if all its current liabilities are paid. 

This concept of working capital is known as Net Working Capital which is a more realistic concept.

Working Capital (Net) = Current Assets – Currents Liabilities.

Contingent liability: 

It represents a potential liability that can be created based on the outcome of an event. 

E.g. if the supplier of the business files a legal suit, it will not be treated as a liability because no obligation is created immediately. 

If the verdict of the case is given in favor of the supplier then only the obligation is created. Till then it is considered as a contingent liability. 

Please note that contingent liability is not recorded in the books of account, but is disclosed through a note to the financial statements.

Capital: 

It is the amount invested in the business by its owners. It may be in the form of cash, goods, or any other asset in which the proprietor or partners of the business invest in the business activity. 

From a business point of view, the capital of owners is a liability that is to be settled only in the event of closure or transfer of the business. 

Therefore, it is not classified as general liability. For corporate bodies, capital is usually represented as share capital.

Drawings: 

It represents an amount of cash, goods, or any other assets which the owner withdraws from the business for his or her personal use. 

E.g. if the life insurance premium of the proprietor or a partner of business is paid from the business cash, it is called drawings. 

Drawings will result in a reduction in the owners’ capital. The concept of the drawing is not applicable to corporate bodies like limited companies.

Net worth: 

It represents the excess of total assets over total liabilities of the business. 

Technically, this amount is available to be disbursed to the owners in the event of the business closing after payment of all liabilities.

 That is why it is also called owner's equity. A profit-making business will result in an increase in the owner’s equity whereas losses will reduce it.

Non-current investments: 

Non-current investments are investments that are beyond the current period in the form of sale or disposal. e. g. Fixed Deposit for 5 years.

Current Investments:

Current investments are investments that can be easily realized by their nature and are intended to be held for more than one year from the date on which such investment is made. e. g. 11 months Commercial Paper.

Debtors:

The amount or total amount that a customer owes to a business for lending or buying goods on services or for other contractual obligations, is known as Sundry Debtors or Trade Debtors, or Trade Receivable, or Book-Debts or Debtors. 

In other words, Debtors are individuals from whom a business has to recover money on the basis of goods sold or services rendered on credit. These debtors may again be classified as under:

(i) Good debts: Loans that are realized are called good debts.

(ii) Doubtful Debt: Loans that can be realized or not are called doubtful debts.

(iii) Bad debt: Loans that cannot be realized are called bad debts.

It should be remembered that some adjustments can be made at the end of the period when locating lenders, e.g. Bad Debts, Discount Allowed, Returns Inwards, etc.

Creditor: 

A creditor is a person who has value for money or money for the business. e.g. money payable to suppliers of goods or providers of service. 

Creditors are generally classified as Current Liabilities.

Capital Expenditure: 

It represents expenditure incurred for the purpose of acquiring a fixed asset, which is intended to be used for the long term to earn profits therefrom. 

E. g.The amount paid to purchase a computer for office use is a capital expenditure.

Many a time may be expended to increase the production capacity of the machine. It will also be a capital expenditure. Capital expenditure is part of the balance sheet.

Revenue expenditure: 

It shows the expenditure incurred to earn revenue for the current period. 

The benefit of revenue expenditure expires within a year. e.g. insurance, repairs, travel, salary & wages to employees,  etc. 

Revenue expenditure results in a loss of profit or surplus. This is part of the income statement.

Balance Sheet: 

This is a statement of the financial position of a business unit on a particular date. It lists all assets, liabilities, and capital. 

It is important to note that this statement only displays the status of business matters on a particular date. 

It describes what the business owns and what the business is to outsiders (it denotes liabilities) and owners (it denotes capital). 

It is prepared after incorporating the resulting profit/loss in the income statement.

Profit and Loss Account or Income Statement:

This account refers to the revenue earned by the business and the expenditure incurred by the business to earn that revenue. 

It is usually prepared for a particular accounting period, which can be one month, a quarter, one-half year, or one year. 

The net result of the profit and loss account will show the profit or loss earned by the business entity.

Trade Discount:

 It is a discount given by the wholesaler to the retailer calculated on the list price or invoice price. 

For example, the list price of TV sets can be 15000. The wholesaler may offer a discount of 20% to the retailer.

This means that the retailer will get it for 12000 and it is expected that it will be sold to the end customer at the list price. 

Thus the trade discount enables the retailer to make a profit by selling at the list price. It is not recorded in the books of accounts. 

Transactions are recorded only at net values. In the above example, the transaction will only be recorded at 12000.

Cash Discount: 

It is permitted by the debtor to encourage prompt payment. It must record in the books of accounts. It is calculated after deducting trade discounts. 

For example, if the list price is 16000, to which a trade discount of 20% and a cash discount of 2% apply, then the trade discount before 3200 (20% of 16000) will be deducted and a cash discount of 2% will be calculated. 12800 (16000 - 3200).

 Hence the cash discount will be 256 / - (2% of 12800) and the net payment will be 12,544 (12,800 - 256).

Let us see if we can apply basic accounting terms and definitions in the following parables:--

Fill in the blanks:

(a) Cash discounts are allowed from _________ to _________.

(b) Profit means excess of _________ over _________.

(c) A ________ is a person who owes to others.

(d) In a credit transaction, a _________ facility is offered to the buyer.

(e) Fixed asset is generally held for _________.

(f) The current liabilities are obligations to be settled in _________ period.

(g) Withdrawal of funds by the business owner is called _________.

(h) The amount invested by the owners in the business is called _________.

(i) The amount invested by the owners into the business is called _________.

(j) The net result of an income statement is _________ or _________.

(k) The _________ shows the financial position of the business as on a particular date.

(l) _________ discount is never recorded in the books of accounts.

(m) Vehicles represent _________ expense while vehicle repair will mean _________ expense.

(n) Net worth exceeds _________ _________ over _________ _________.

Solution:

(a) creditor, debtor

(b) income, expenditure

(c) Debtor

(d) Credit

(e) Longer period

(f) Short

(g) Drawings

(h) Capital

(i) Value

(j) Profit, loss

(k) Balance sheet

(l) Trade

(m) Capital, revenue

(n) Total assets, total liabilities

Give a word or a word to describe on the basis of basic accounting terms and definitions:--

(a) An exchange of benefit for value.

(b) A transaction without an immediate cash settlement.

(c) Commodities in which business deals.

(d) Excess of expenditure over income.

(e) Things of value owned by the business to earn future profits.

(f) Amount owed by a business to others.

(g) An obligation that may or may not be material.

(h) An allowance by a creditor to the debtor for prompt payment.

(i) Assets like brand value, copyrights, goodwill.

Solution:

(a) Transaction, (b) Credit transaction, (c) Goods, (d) Loss, (e) Assets, (f) Liability, (g) Contingent Liability,(h) Cash Discount, (i) Intangible Assets

Conclusion:- After completing basic accounting terms and definitions you are now able to identify financial accounting terminology on financial accounting.