There are a lot of basic terms in accounting related to balance sheet and income statement. Some terms may be general but they have specific meanings in accounting. We will discuss the basic accounting terms that are more frequently used in accounting.
Basic Terms in Accounting
Account is one of the most used terms in financial accounting. Accounts are the basic storage units for accounting data. We use them to accumulate amounts from similar transactions.
In simple words, “An account is a heading name given to any asset or liability or income or expense in the ledger that we use to accumulate amounts from similar transactions.”
An accounting system has a separate account for each asset, each liability, and each component of the owner’s equity, including revenues and expenses.
Under the modern classification of accounts, All the accounts are categorized into five;
In manual accounting, An account is created in the general ledger in a T shape which has a left‐hand side, called the debit side, and a right‐hand side called the credit side.
An account is debited when an amount is entered on the left‐hand side and credited when an amount is entered on the right‐hand side.
You go to a gift shop and buy some gifts for your brother and make a cash payment of Rs. 1500. Purchase of the gifts for cash is an example of a transaction, which involves a reciprocal exchange of two things:
- payment of cash,
- delivery of the gifts
Hence, the transaction involves this aspect, i.e. Give and Take. Payment of cash involves give aspect and delivery of gifts is a take aspect.
Thus, business transactions are exchanges of economic considerations between parties. The transaction could be a cash transaction or a credit transaction.
When the parties settle the transaction immediately by making payment in cash or by cheque, it is called a cash transaction.
In credit transactions, the payment is settled at a future date as per agreement between the parties.
The book in which the transaction is recorded for the first time is called Journal in accounting. A journal is also referred to as the Book of Prime Entry or the book of original entry.
In paper-based accounting, Journal is divided into two types –
(i) General Journal and
(ii) Special Journal.
General Journal: This book records those transactions which occur so infrequently that they do not require the setting up of special journals. Examples of such entries:
(i) opening entries
(ii) closing entries
(iii) rectification of errors
Special Journal: Special journals refer to the journals meant for specific transactions of similar nature. Special journals are also known as subsidiary books or day books.
The number of special journals varies according to the requirement of each enterprise. In any large business, the following special journals are generally used:
- Purchases (journal) book
- Sales (journal) book
- Purchase Returns (journal) book
- Sale Returns (journal) book
- Bills Receivable (journal) book
- Bills Payable (journal) book
The process of recording transactions in a journal is called as ‘Journalising’. The entry made in this book is called a ‘journal entry’.
There are two main types of journal entry: simple and compound.
Simple Journal Entry: When only two accounts are involved to record a transaction, it is called a simple journal entry.
Compound Journal Entry: When more than two accounts are involved to record a transaction is called compound journal entry.
The ledger is the principal book of the accounting system. A ledger is the collection of all the accounts, debited or credited, in the journal proper and various special journals.
After recording the transactions in the journals or subsidiary books then the same transactions are posted to individual accounts in the general ledger.
The purpose of a general ledger account is to determine a balance for each account in the records. An account is opened for every item, whether it is an asset, liability, income or expense, and the balance is determined for every account.
A balance is determined by calculating the difference between the debit side and the credit side of each account. The left-hand side of an account represents the debit side, and the right-hand side, the credit side.
Trial balance is a summary of all the debit and credit balances in the general ledger. It includes income, expense, and income and expense accounts.
The balance sheet is one of the basic financial statements. It is more formally referred to as the statement of financial position.
The balance sheet reports the financial position of an entity at a specific point in time.
The financial position is reflected by the assets of the entity, its liabilities or debts, and the equity of the owner.
A balance sheet has two sides:
- Liabilities & Owners’ Equity
Note that the two sides of the balance sheet are always equal.
The income statement is referred to by various names, such as the statement of profit and loss, the statement of income, statement of operations, statement of earnings, or others.
Whatever name is used, its purpose is the same:
To provide users of the financial statements with a measurement of a reporting entity’s results of operations over a period of time.
The reporting period covered by the income statement can be a month, quarter, half-year or year.
But generally, the reporting period of the income statement is of one year.
Proft for the period is the excess of income over expenses for that time. If expenses for the period exceed income, a loss is incurred.
Assets are the economic resources that a company owns. Assets are used by the company in its operations to generate sales and profits. There are two main categories of assets:
- Current Asset
- Non-Current Asset
examples of assets;
- Cash at bank
- land & buildings
Current assets are cash and other types of assets that:
- are held primarily for the purpose of sale or trading, or
- are reasonably expected to be converted to cash, sold or consumed by a business within its next operating cycle, or
- are expected to be realized within 12 months after the end of the entity’s reporting period
Hence the following assets are the current assets:
- Account receivable
- Stock in hand
- Prepaid Expense
An account receivable is an example of an asset. Accounts receivable are amounts owed to an entity by customers to whom the entity has provided goods or services on credit.
The Accounts Receivable is often called the Trade Debtors or simply Debtors.
Liabilities are obligations or debts that an enterprise has to pay at some time in the future. There are two main categories of liabilities:
- Current Liability
- Non-Current Liability
examples of liability;
- Account receivable
- Interest Payable
- Income Taxes Payable
- Advances from Customers
an account payable is an example of a liability. An account payable is an obligation to pay an amount to an outside party (a creditor) for the purchase of goods, supplies or services on credit.
The account payable is also commonly called Trade Creditors or simply Creditors.
any contribution made by the owner in the business is known as capital.
It may be brought in the form of cash or assets by the owner for the business entity.
Capital is an obligation and a claim on the assets of the business because the owner of the business is considered a separate entity for accounting purposes.
It is, therefore, shown as capital on the liabilities side of the balance sheet.
Prepaid expenses are the advance payment of future expenses in the current accounting period and are recorded as assets when cash is paid.
Prepaid expenses become expenses in the next accounting period.
- Prepaid Insurance
- Prepaid advertising
Outstanding expenses are unrecorded expenses that have been incurred in the current accounting period and for which cash has yet to be paid.
Wages owed to employees at the end of the accounting period but not yet paid are an outstanding expense.
Unearned revenues are the advance receipt of future revenues and are recorded as liabilities when cash is received. Unearned revenues become earned revenues over time or during normal operations.
Accounting period refers to the span of time at the end of which the financial statements of an enterprise are prepared, to know whether it has earned profits or incurred losses during that period and what exactly is the position of its assets and liabilities at the end of that period.
Trade discounts are a form of a special discount. They may be given for placing a large order, for example, or for being a loyal customer. Trade discounts are deducted from the normal purchase or selling price. They are not recorded in the books of account and they will not appear on any invoice.