By now, we probably all appreciate the importance of knowing and understanding accounting terminology. As a business owner, CEO, CFO, or any leader with some input on the direction of the company, it’s imperative to comprehend the financials in order to determine where the company is today and where it can be tomorrow. Financial statements provide these insights, and, as they say, “the numbers don’t lie.”
Accounting Terminology that Doesn’t Add Up
Since the time of business owners writing down revenue and expenses on sheets of paper, accounting terms have largely remained the same. However, there are various instances where these terms are used inaccurately, and interpreted just as incorrectly. This misuse appears to be increasing in our virtual world, with more information available, and potentially unreliable, resources at our fingertips, causing confusion to the less seasoned financial mind (and sometimes, even to the most seasoned ones).
In some situations, terms are used interchangeably when they shouldn’t. In others, they are used in the incorrect context. And still in others, they are replaced by more commonly used terms. While this occurs in all walks of life (think back to when a copy became known as a Xerox), it can easily cause confusion. And confusion is something that does not belong anywhere near accounting.
It’s time to clear up any misconceptions and balance out the top three misused accounting terms with their actual meanings:
- Cash Basis Accounting vs. Accrual Basis Accounting. We understand this is more than one term, but together, their use could have a real impact on your business. This came up somewhat recently with regard to the Paycheck Protection Program (PPP). It became an issue because in order to qualify for the second round of funding, you had to show a loss of over 25%. As such, the method of accounting used impacted a company’s qualification. For example, if you ran the report on the accrual method and had invoiced clients, but not yet collected the payments, those payments would be deemed paid, hurting your chances of eligibility. However, had the same report been run on a cash basis, it would have reflected only the actual amounts collected, regardless of outstanding invoices, increasing your chances of eligibility.
Setting the Record Straight
The main difference between cash basis accounting and accrual basis accounting has to do with timing, and in particular, when revenue and expenses are recognized. The cash method more immediately recognizes revenue and expenses, such as in a cash sale, while the accrual method focuses on anticipated revenue and expenses in the future.
- Profit and Loss (P&L) Statement. This is an instance most equivalent to the Xerox example above. Did you know the term “Profit and Loss Statement” or P&L is a creation of QuickBooks? The P&L is actually our good old “Income Statement.” Far too many people get stuck when asked for an Income Statement because they have become so accustomed to saying “Profit and Loss Statement” or P&L.
Don’t get too caught up on what a document or report is called. Rather, look at its essential function. The Profit and Loss Statement, P&L, and Income Statement are all the same important financial statement. It allows you to see whether your business is profitable by focusing on your income and expenses for the current month or a certain period of time (quarter or year).
- Net Worth of a Company. If you’re like most people, you’ve heard of, and maybe even provided, the net worth of an individual—maybe even your own. That makes perfect sense. Yet what happens when you are asked for the net worth of a company on a loan application or other document? You likely start to wonder if you’re misreading or just don’t understand.
What it Means & its Relation to the Balance Sheet
The net worth of a company is determined just like the net worth of an individual—total assets minus total liabilities = net worth. In a corporate sense, this is more often known as “shareholders’ equity.” It is a crucial metric to measure a company’s health, providing a useful snapshot of its current financial position. And whenever we speak about a company’s health, we should automatically think about its balance sheet.
As a reminder, the balance sheet provides a view of the business’s assets, liabilities, and equity. It is used to evaluate the overall health of the business, as well as its liquidity. In contrast to the P&L statement, which shows performance, the balance sheet shows the health of the company by showing what it owns and owes at a specific moment in time.
At Agile Planners, our goal is always to provide you with the knowledge you need to help make your business a financial success. And a clear understanding of the accounting terms we use, as well as those you’ll encounter elsewhere, is key to that knowledge and success. As always, our mission is to give you the best tools to empower your decision-making, increase productivity, and deliver predictable outcomes for your business today. In order to better understand what impacts your business, it’s important to review your profit and loss statement and balance sheet at the end of every month. Be sure to download our Month-End Review Best Practices for additional information and learn how our CFO services can help your company achieve its goals faster.