Basic Terms of Accounting

In this post, we will learn about the Basic Terms of Accounting.

Basic Terms of Accounting

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Business Entity

A business entity refers to a legally recognized organization created to conduct business activities, such as a corporation, partnership, or sole proprietorship. It is considered a separate and distinct entity from its owners or shareholders and has its own financial transactions, assets, and liabilities that are recorded and reported separately from those of its owners. By treating the business as a separate entity, it is possible to track and analyze its financial performance, make informed decisions, and comply with legal and tax requirements.

Transaction

A transaction refers to any business event that involves a financial change. It is a specific activity that is recorded in the accounting system and can be expressed in terms of money or another unit of measurement. Transactions are the basis of all accounting records and financial statements, and they can be categorized into different types depending on their nature.

Examples of transactions include the purchase or sale of goods or services, payment or receipt of cash, issuance or retirement of debt, acquisition or disposal of assets, accrual of revenue or expenses, and so on. Each transaction affects at least two accounts and must be recorded in a way that maintains the balance of the accounting equation (Assets = Liabilities + Equity). The recording process involves identifying the accounts involved, determining the amount and direction of the transaction, and entering the information in the appropriate journals and ledgers.

Expenses

Expenses refer to the costs incurred by a business to generate revenue or maintain its operations. Expenses can be classified as either direct or indirect expenses.

Direct expenses are those expenses that are directly related to the production or sale of goods or services. Examples of direct expenses include the cost of raw materials, wages and salaries of production workers, and freight charges.

Indirect expenses, on the other hand, are those expenses that are not directly related to the production or sale of goods or services. These expenses are also known as overheads. Examples of indirect expenses include rent, utilities, insurance, and office supplies.

Expenses are typically recorded in the accounting records as they are incurred. This is known as the accrual basis of accounting. Under this method, expenses are recorded when they are incurred, regardless of when the payment is actually made. This allows for a more accurate representation of the financial health of the business.

Assets

Assets are economic resources of an enterprise that can be usefully expressed in monetary terms. Assets are items of value used by the business in its operations.

There are two types of assets:

A. Tangible Asset
B. Intangible Asset

A. Tangible Asset: Tangible assets are physical assets that have a physical form and can be seen, touched, and felt. Examples of tangible assets include buildings, land, machinery, equipment, inventory, and cash. These assets can be owned, purchased, and sold by a business or an individual, and they are typically used to generate income or as a means of generating wealth. In accounting, tangible assets are recorded on the balance sheet at their historical cost less any accumulated depreciation.

There are two types of tangible assets:

1. Current Assets: These are assets that can be converted into cash or consumed within a year. Examples include cash, inventory, accounts receivable, and prepaid expenses.
2. Fixed Assets: These are assets that are expected to provide benefits over a longer period of time, usually several years. Examples include land, buildings, equipment, and vehicles.

B. Intangible Asset: Intangible assets refer to non-physical assets that lack a physical presence and cannot be touched. These assets are often identifiable and have long-term value to the business. Examples of intangible assets include patents, trademarks, copyrights, goodwill, brand recognition, and customer relationships. Unlike tangible assets, intangible assets do not have a fixed lifespan and can provide benefits to a business over a longer period of time. In accounting, intangible assets are typically recorded on the balance sheet and are subject to periodic impairment testing to ensure that their recorded value accurately reflects their actual value.

Liability

Liability refers to an obligation that a company or an individual owes to another party. It is an amount of money that the entity owes to others and has to be paid back in the future. Examples of liabilities include bank loans, accounts payable, and salaries payable.

Liabilities can be classified into two types: current liabilities and long-term liabilities. Current liabilities are short-term debts that are expected to be paid off within a year, such as accounts payable and short-term loans. Long-term liabilities, on the other hand, are debts that are not due for payment within a year, such as long-term loans and bonds payable.

Liabilities are important to track in accounting because they represent the company’s financial obligations and can affect its ability to secure financing and engage in business activities.

Equity

Equity refers to the residual interest in the assets of a business after deducting all its liabilities. It is the value that remains for the owners of the business, also known as shareholders or stockholders, after all debts and other obligations have been paid off.

Equity can be divided into two main categories: contributed capital and retained earnings. Contributed capital is the amount of money invested in the business by its owners, while retained earnings refer to the profits that the business has earned over time and has chosen to keep rather than distribute to its shareholders.

The equity section of a balance sheet shows the total amount of equity in a business and is an important indicator of its financial health. It is also used to calculate financial ratios such as return on equity, which measures the profitability of a business relative to the amount of equity invested in it.

Capital

Capital refers to the amount of money or assets that a business or individual has available for investments or other financial activities. It can be in the form of cash, equipment, property, or any other valuable resource that can generate revenue. Capital can be used to start a business, expand an existing one, or invest in other ventures. It is considered a long-term source of funding for a business and is reflected on the balance sheet as an asset. In a sole proprietorship, the owner’s capital is the initial investment made in the business, and any additional investments made by the owner thereafter. In a partnership, each partner’s capital is their initial investment in the business, while in a corporation, capital can be raised through the sale of stocks to investors.

Insolvency

Insolvency refers to the inability of an individual or organization to pay off its debts as they become due. In other words, insolvency occurs when liabilities exceed assets and the organization or individual is unable to generate enough cash flow to meet its obligations. Insolvency can lead to bankruptcy, which involves a legal process that enables the discharge of debts or the liquidation of assets to pay off creditors. Insolvency can occur due to a range of reasons such as poor financial management, economic downturns, or unexpected events like natural disasters.

Voucher

A voucher is a document that serves as evidence of a business transaction. It contains information about the transaction such as the date, the parties involved, the amount of money exchanged, and the purpose of the transaction. Vouchers are typically used in accounting to record transactions and are usually numbered and filed for future reference. They serve as a record of a business’s financial activities and help ensure that transactions are properly authorized and recorded.

Drawings

Drawings refer to the amounts withdrawn by the owner or partners of a business for personal use. It is a reduction in the capital of the business and is recorded in the drawings account. Drawings can be taken in the form of cash, goods, or services, and are usually recorded on a periodic basis, such as weekly or monthly. Drawings are considered to be a personal expense of the owner and are not tax deductible as a business expense.

Stock

Stock (inventory) is a measure of something on hand-goods, spares and other items in a business. It is called Stock in hand. In a trading concern, the stock on hand is the amount of goods which are lying unsold as at the end of an accounting period is called closing stock (ending inventory). In a manufacturing company, closing stock comprises raw materials, semi-finished goods and finished goods on hand on the closing date. Similarly, opening stock (beginning inventory) is the amount of stock at the beginning of the accounting period.

Debit

A debit is an entry made on the left side of an account. It either increases an asset or expense account or decreases equity, liability, or revenue accounts. For example, you would debit the purchase of a new computer by entering the asset gained on the left side of your asset account.

Credit

A credit is an entry made on the right side of an account. It either increases equity, liability, or revenue accounts or decreases an asset or expense account. Record the corresponding credit for the purchase of a new computer by crediting your expense account.

Creditors & Debtors

Creditors: Creditors are the people or entities that a business owes money to. In other words, they are the ones who have extended credit to the business in the form of goods or services on the promise of receiving payment at a later date. This could include suppliers, lenders, employees, or any other party that the business owes money to. Keeping track of the amounts owed to creditors is an important part of managing a business’s finances and cash flow.

Debtors: Debtors refer to individuals or entities who owe money to a business for goods or services that have been sold or provided on credit. They are also known as accounts receivable. When a business sells goods or services on credit, it issues an invoice to the customer with a due date for payment. The customer becomes a debtor until they pay off the amount owed. The amount of money owed by debtors is recorded as an asset on the balance sheet of the business. The business will need to follow up with debtors to collect the amount owed within the specified time frame.

Sundry Creditors

Sundry creditors refer to a group of creditors who are not assigned individual ledger accounts in the books of accounts of a business. These creditors typically include suppliers, vendors, and other service providers who have provided goods or services to the business on credit, but whose outstanding balances are not significant enough to warrant individual ledger accounts. Sundry creditors are usually recorded in a single account in the balance sheet called “sundry creditors” or “accounts payable,” which represents the total amount owed to these creditors at a given point in time.

Sundry Debtors

Sundry debtors are parties or individuals who owe business money for goods or services that they have received on credit. These debtors are referred to as “sundry” because they are not a part of the regular customer base and may have different payment terms or credit limits than other customers. The term “sundry” is often used in accounting to refer to items that cannot be easily categorized or have a specific classification. Sundry debtors are recorded in a company’s accounts receivable ledger and are typically monitored to ensure that payments are received on time.

Bonds and Coupons

A bond is a form of debt investment and is considered a fixed income security. An investor, whether an individual, company, municipality or government, loans money to an entity with the promise of receiving their money back plus interest. The “coupon” is the annual interest rate paid on a bond.

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