Common Financial Accounting Terms Explained – Part 2
Financial accounting terminology can sound like a foreign language sometimes. While much of this might appear very confusing on the face, as a business owner or manager, being able to decipher at least a little bit of accounting terminology is extremely important. Earlier this year we presented an article unpacking some common accounting terminology, but there was simply too much! So, here is our second installment.
Statement of Cash Flows
The traditional income statement (or “P&L”) included in financial statements prepared under the generally-accepted accounting principles (“GAAP”) basis of accounting reports the operations and performance of a company on an accrual basis. This means the net income reported does not equate solely to the cash receipts and disbursements of the company. That is where the statement of cash flows comes in. This financial statement takes the net income from the year and provides a reconciliation to the actual change in cash from the beginning to the end of the year with subtotals by main component – operating, investing, and financing activities. The company could have had sales growth but, due to timing of cash collections, also growth in the balance of their accounts receivable (resulting in a decrease in cash provided by operating activities). Or maybe the company had a huge year and then used that cash to acquire new equipment (resulting in an increase in cash used in investing activities).
While accounts payable represents liabilities that have been billed to the company by their vendors at a point in time, what about purchases from vendors that have not been billed or where bills have not yet received? Let us say, for instance, that a vendor provided goods and/or services to the company in the last week of December yet did not bill the company until January. The vendor has performed, and the company has received the benefit. Therefore, while billing has not taken place, the company has a commitment to the vendor in December and should record an accrued expense liability at that time.
The opposite of the accrued expense mentioned above is the prepaid expense. In cases where the company has paid a vendor for goods and/or services in advance of delivery or performance, the company need not record the full expense at that point in time. Instead, the company records a prepaid expense asset and then reverses it to zero as the vendor satisfies their obligation to the company and the company’s benefit is fulfilled. You might see this with insurance premiums – the company may prepay in two six-month installments as opposed to receiving a bill each month. At the end of the year there could be three months remaining on their previous payment – these three months relate to the upcoming year, are an asset to the company at the current year-end, and will not become an expense until the upcoming year.
Allowance for Doubtful Accounts
We discussed accounts receivable in our previous accounting terminology article. Another important aspect is the allowance for doubtful accounts. The company is required to perform an analysis and arrive at an assessment as to what portion of the accounts receivable balance will be uncollectible and then book a reserve (a credit balance or “contra account” that reduces accounts receivable on the balance sheet). Useful information in performing this analysis includes the aging of accounts receivable, history of customer payments, etc.
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