ACCOUNTING TERMS

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Accounting, financial analysis and financial modeling are integrated disciplines which a good financial analyst should be familiar with. In particular, it is important that a sound knowledge of fundamental accounting principles and accounting terms is had to ensure a common basis and language for understanding, intepretating and analyzing financial statements and financial model results.

We provide here a long list of the most common accounting terms that a financial analyst may come across:

• Absorption: the sharing out of the costs of a cost center amongst the products which use the cost center.

• Account: a record in a double entry system that is kept for each (or each class) of asset, liability, revenue and expense.

• Accounting equation: an expression of the equivalence, in total, of assets = liabilities + equity.

• Accounting period: that time period, typically one year, to which financial statements are related.

• Accounting policies: the specific accounting bases selected and followed by a business enterprise (e.g. straight line or reducing balance depreciation).

• Accounting rate of return: a ratio sometimes used in investment appraisal but based on profits not cash flows.

• Accounting standards: Prescribed methods of accounting by the accounting standards or financial reporting standards regulation body in your jurisdiction.

• Accruals: (that which has accrued, accumulated, grown) expenses which have been consumed or enjoyed but which have not been paid for at the accounting date.

• Accruals convention: the convention that revenues and costs are matched with one the other and dealt with in the Profit and Loss (P&L) Account of the period to which they relate irrespective of the period of receipt or payment.

• Accumulated depreciation: that part of the original cost of a fixed asset which has been regarded as a depreciation expense in successive Profit and Loss (P&L) Accounts: cost less accumulated depreciation = net book value.

• Acid test: The ratio of current assets (excluding stock) to current liabilities.

• Acquisitions: operations of a reporting entity that are acquired in a period. Separate disclosure of turnover, profits, etc must be made.

• Activity based costing: cost attribution to cost units on the basis of benefit received Irons indirect activities. The idea is that overhead costs are driven by activities (e.g. setting up a machine) not products.

• Allocation: the charging of discrete, identifiable costs to cost centers or cost units. A cost is allocated when it is unique to a particular cost center.

• Amortization: another word for depreciation: commonly used for depreciation of the capital cost of acquiring leasehold property.

• Apportionment: the division of costs among two or more cost centers in proportion to estimated benefit on some sensible basis. Apportionment is for shared costs.

• Assets: resources of value owned by a business entity.

• Assets utilization ratio: a ratio which purports to measure the intensity of use of business assets. Calculated as sales over net operating assets. Can be expressed as sales as a percentage of net operating assets.

• Asset value: a term which expresses the money amount of assets less liabilities of a company attributable to one ordinary share.

• Avoidable costs: the specific costs of an activity or sector of a business which would be avoided if that activity or sector did not exist.

• Auditing: the independent examination of, and expression of an opinion on, the financial statements of an enterprise by an appointed auditor in pursuance of that appointment and in compliance with any relevant statutory obligation.

• AVCO (average cost): a method of valuing fungible assets (notably stock) at average (simple or weighted) input prices.

• Bad debts: debts known to be irrecoverable and therefore treated as losses by inclusion in the Profit and Loss (P&L) Account as an expense.

• Balance Sheet: a financial statement showing the financial position of a business entity in terms of assets, liabilities and capital at a specified date.

• Bankruptcy: a legal status imposed by a court. Usually a trustee is appointed to receive and realize the assets of the bankrupt and to distribute the proceeds to his creditors according to the law.

• Benefits in kind: things or services supplied by a company to its directors and others in addition to cash remuneration. A good example is the provision of and free use of a motor car. The value of benefits in kind are taxable.

• Bond: a formal written document that provides evidence of a loan. Bond has mainly American usage. Its UK equivalent is debenture.

• Bonus issue: a free issue of new shares to existing shareholders. No payment is made for the shares. Its main effect is to divide the substance of the company (assets less liabilities) into a larger number of shares.

• Book value: the amount at which an asset is carried on the accounting records and Balance Sheet. The usual book value for fixed assets is cost less accumulated depreciation. Alternative words include written down value, net book value and carrying value. Book value rarely if ever corresponds to saleable value.

• Breakeven chart: a chart which illustrates costs, revenues, profit and loss at various levels of activity within a relevant range.

• Breakeven point: the level of activity (e.g. level of sales) at which the business makes neither a profit nor a loss i.e. where total revenues exactly equal total costs.

• Budget: a formal quantitative expression of management’s plans or expectations. Master budgets are the forecast or planned Profit and Loss Account and Balance Sheet. Subsidiary budgets include those for sales, output, purchases, labor, cash etc.

• Capital: an imprecise term meaning the whole quantity of assets less liabilities owned by a person or a business.

• Capital allowances: deductions from profit for fixed asset purchases. In effect capital allowances is a standard system of depreciation used instead of depreciation for tax purposes only.

• Capital budgeting: the process of planning or appraising possible fixed asset acquisitions.

• Capital employed: a term describing the total net assets employed in a business. Various definitions are used, so beware when talking at cross purposes.

• Capital expenditure: expenditure on fixed assets.

• Cash: strictly coins and notes but used also to mean all forms of ready money including bank balances.

• Cash discount: a reduction in the amount payable by a debtor to induce prompt payment (equivalent to settlement discount).

• Cash flow: a vague term (compare cash flow difficulties) used for the difference between total cash in and total cash out in a period.

• Cash flow forecast: a document detailing expected or planned cash receipts and outgoings for a future period.

• Cash flow statement: a formal financial statement showing a summary of cash inflows and outflows under certain required headings.

• Committed costs: those fixed costs which cannot be eliminated or even cut back without having a major effect on the enterprise’s activities (e.g. rent).

• Common stock: the U.S equivalent of ordinary shares.

• Conservatism: (also known as prudence) the convention whereby revenue and profits are not anticipated, but provision is made for all known liabilities (expenses and losses) whether the amount of these is known with certainty or is a best estimate. Essentially – future profit, wait until it happens – future loss, count it

• Consideration: the amount to be paid for anything sold including businesses. May be cash, shares or other securities.

• Consistency: convention that there is consistency of accounting treatment of like items within each year and from year to year.

• Consolidation: the aggregation of the financial statements of the separate companies of a group as if they were a single entity.

• Contribution: a term used in marginal costing – the difference between sale price and associated variable costs.

• Controllable costs (also known as managed costs): costs, chargeable to a budget or cost centre, which can be influenced by the actions of the persons in whom control is vested.

• Conversion cost: the cost of bringing a product or service into its present location or condition. May include a share of production overheads.

• Convertible loan stock: loans where, at the option of the lender, the loan can be converted into ordinary shares at specified times and specified rates of conversion.

• Cost behavior: the change in a cost when the level of output changes.

• Cost center: a location, function, or item of equipment in respect of which costs may be ascertained and related to cost units.

• Cost convention: the accounting convention whereby Balance Sheet assets are mostly valued at input cost or by reference to input cost.

• Cost-volume-profit (CVP) analysis: the study of the relationships between variable costs, total fixed costs, levels of output and price and mix of units sold and profit, often analyzed in a financial modeling exercise.

• Credit: commonly used to refer to a benefit or gain also the practice of selling goods and expecting payment at a later date.

• Credit control: those measures and procedures adopted by a firm to ensure that its credit customers pay their accounts.

• Creditors: those persons, firms or organizations to whom the enterprise owes money.

• Creditors payment or settlement period: a ratio (usually creditors/ inputs on credit in a year x 365) which measures how long it takes the firm to pay its creditors.

• Cumulative preference shares: preference shares where the rights to dividends omitted in a given year accumulate. These dividends must be paid before a dividend can be paid on the ordinary shares.

• Current assets: cash + those assets (stock, debtors, prepayments, bank accounts) which the management intend to convert into cash or consume in the normal course of business within one year or within the operating cycle.

• Current cost accounting (CCA): a system of accounting which recognizes the fluctuating value of money by measuring current value by applying specific indices and other devices to historical costs. A valid method which is complex and difficult to understand intuitively.

• Current liabilities: debts or obligations that will be paid within one year of the accounting date. Another term used to describe the same is Creditors: amount falling due within one year.

• Current ratio: the ratio of current assets to current liabilities.

• Cut-off: the difficulties encountered by accountants in ensuring all items of income and expense are correctly ascribed to the right annual profit statement.

• Debenture: a document which creates or acknowledges a debt. Commonly used for the debt itself.

• Debt: a sum due by a debtor to his creditor. Commonly used also as a generic term for borrowings.

• Debtors: those who owe money.

• Debtors payment (settlement) period: a calculation of the average time taken by credit customers to pay for their goods. Calculated by Debtors/credit sales in a year x 365.

• Depletion method: a method of depreciation applicable to wasting assets such as mines and quarries. The amount of depreciation in a year is a function of the quantity extracted in the year compared to the total resource.

• Depreciation: a measure of the wearing out, consumption or other loss of value whether arising from use, passage of time or obsolescence through technology and market changes. Depreciation should be allocated to accounting period so as charge a fair proportion to each accounting period during the expected useful life of the asset.

• Direct costs: those costs comprising direct materials, direct labor and direct expenses which can be traced directly to specific jobs, products or services.

• Discontinued operations: operations of the reporting entity that are sold or terminated in a period. Turnover and results must be separately disclosed.

• Discount: a monetary deduction or reduction. Settlement discount (also known as cash discount) is given for early settlement of debts. Debentures can be redeemed at a discount. Trade discount is a simple reduction in price given to favored customers for reasons such as status or bulk purchase.

• Discounted cash flow: an evaluation of the future cash flows generated by a capital investment project, by discounting them to their present value.

• Dividend: a distribution of earnings to its shareholders by a company.

• Dividend cover: a measure of the extent to which the dividend paid by a company covered by its earnings (profits).

• Dividend yield: a measure of the revenue earning capacity of an ordinary share to its holder. It is calculated by dividend per share as a percentage of the quoted share price.

• Drawings: cash or goods withdrawn from the business by a proprietor for his private use.

• Earnings: another word for profits, particularly for company profits.

• Earnings per share: an investor ratio, calculated as after tax profits from ordinary activities / number of shares.

• Economic Order Quantity (EOQ): that purchasing order size which takes into account the optimum combination of stockholding costs and ordering costs.

• Equity convention: the convention that a business can be viewed as a unit that is a separate entity and apart from its owners and from other firms.

• Equity: the ordinary shares or risk capital of an enterprise.

• Exceptional items: material items which derive from events or transactions that fall within the ordinary activities of the reporting entity and which need to be disclosed by virtue of their size or incidence if the financial statements are to give a true and fair view. Examples are profits or losses on termination of an operation, costs of a fundamental reorganization and profits and losses on disposal of fixed assets.

• Expense: a cost which will be in the Profit and Loss (P&L) Account of a year.

• Exposure draft: a document issue on a specific accounting topic for discussion.

• Extraordinary items: material items possessing a high degree of abnormality which arise from events or transactions that fall outside the ordinary activities of the reporting entity and which are not expected to recur. They should be disclosed but are very rare indeed.

• Factoring: the sale of debtors to a factoring company to improve cash flow. Factoring is a method of obtaining finance tailored to the amount of business done but factoring companies also offer services such as credit worthiness checks, sales and debtor recording, and debt collection.

• FIFO: first in first out – a method of recording and valuation of fungible assets, especially stocks, which values items on the assumption that the oldest stock is used first. FIFO stocks are valued at most recent input prices.

• Finance lease: a leasing contract which transfers substantially all the risks and rewards of ownership of an asset to the lessee. In effect the lessee is really buying the assets with the aid of a loan and the lease installments are really payments of interest and repayments of capital. They are accounted for as such in accordance with the accounting convention of substance over form.

• Financial statements: Balance Sheets, Profit and Loss Account, Income and Expenditure Accounts, Cash Flow Statements and other documents which formally convey information of a financial nature to interested parties concerning an enterprise. In companies, the financial statements are subject to audit opinion.

• Fixed assets: business assets which have a useful life extending over more than one year. Examples are land and buildings, plant and machinery, vehicles.

• Fixed cost: a cost which in the short term, remains the same at different levels of activity. An example is rent.

• Flexible budget: a budget which is flexed to recognize the difference in behavior of fixed and variable costs in relation to levels of output. Total budgeted costs changed to accord with changed levels of activity.

• Floating charge: an arrangement whereby a lender to a company has a floating charge over the assets generally of the company gives the lender priority of repayment from the proceeds of sale of the assets in the event of insolvency. Banks frequently take a floating charge when lending.

• Format: a specific layout for a financial statement. Several alternatives are often prescribed by the prevailing governing authority or law of the country in which the enterprise operates or reports its financial performance.

• Funds flow statement: a financial statement which links Balance Sheets at the beginning and end of a period with the Profit and Loss (P&L) Account for that period. Now replaced by the cash flow statement.

• Fungible assets: assets which are substantially indistinguishable from each other. Used for stocks which can then be valued on FIFO or AVCO principles. LIFO is also possible but often not usually for tax reasons.

• Gearing: also known as leverage, the relationship between debt and equity in the financing structure of a company.

• Gilt-edged securities: securities and investments which offer a negligible risk of default. Principally government securities.

• Goal congruence: the situation in which each individual, in satisfying his or her own interests, is also making the best possible contribution to the objectives of the enterprise.

• Going concern: the accounting convention which assumes that the enterprise will continue in operational existence for the foreseeable future. This means in particular that the Profit and Loss (P&L) Account and Balance Sheet (BS) assume no intention or necessity to liquidate or curtail significantly the scale of operation.

• Goodwill: an intangible asset which appears on the Balance Sheet of some businesses. It is valued at (or below) the difference between the price paid for a whole business and the fair value of the net assets acquired.

• Gross: usually means before or without deductions. For example Gross Salary or Gross Profit.

• Gross profit: sales revenue less cost of sales but before deduction of overhead expenses. In a manufacturing company it is sales revenue less cost of sales but before deduction of non-manufacturing overheads.

• Gross margin: (or gross profit ratio), gross profit expressed as a percentage of sales.

• Group: a set of interrelated companies usually consisting of a holding company and its subsidiary and sub-subsidiary companies.

• Group accounts: the financial statements of a group wherein the separate financial statements of the member companies of a group are combined into consolidated financial statements.

• HIFO: highest in highest out, a pricing policy where costs are collected for a job on the basis that the cost of materials and components is the highest recent input price.

• Historical cost: the accounting convention whereby goods, resources and services are recorded at cost. Cost is defined as the exchange or transaction price. Under this Convention, realizable values are generally ignored. Inflation is also ignored. The almost universal adoption of this convention makes accounting harder to understand and lessens the credibility of financial statements.

• Hurdle: a criteria that a proposed capital investment must pass before it is accepted. It may be a certain interest rate, a positive NPV or a maximum payback period.

• Income and expenditure account: the equivalent to Profit and Loss (P&L) Accounts in nonprofit organizations such as clubs, societies and charities.

• Indirect costs: costs which cannot be traced to particular products. An example is rent or management salaries. They are usually shared by more than one product and are called overheads.

• Insolvency: the state of being unable to pay debts as they fall due. Also used to describe the activities of practitioners in the fields of bankruptcy, receivership and liquidations.

• Intangible assets: assets which have long term value but no physical identity. Examples are goodwill, patents, trade marks and brands.

• Interim dividend: a dividend paid during a financial year, generally after the issue of un-audited profit figures half way through the year.

• Internal rate of return: the rate of discount which will just discount the future cash flows of a proposed capital investment back to the initial outlay.

• Inventory: a detailed list of things. Used by accountants as another word for stock.

• Investment appraisal: the use of accounting and mathematical methods to determine the likely returns for a proposed investment or capital project.

• Key factor: a factor of production which is in limited supply and therefore constrains production.

• Labor hour rate: a method of absorption where the costs of a cost centre are shared out amongst products on the basis of the number of hours of direct labor used on each product.

• Leverage: another word for gearing.

• LIFO: Last in first out – a valuation method for fungible items where the newest items are assumed to be used first. Means stocks will be valued at old prices. Not used in certain jurisdictions such as the U.K for tax reasons.

• Limiting or key factor: a factor of production which is in limited supply and therefore constrains output.

• Liquidation: the procedure whereby a company is wound up, its assets realized and the proceeds divided up amongst the creditors and shareholders.

• Liquidity: the ease with which funds can be raised by the sale of assets.

• Liquidity ratios: ratios which purport to indicate the liquidity of a business. They include the current ratio and the acid test ratio.

• Listed companies: companies whose shares are traded on the stock exchange.

• Machine hour rate: a method of absorption of the costs of a cost center where the costs are shared out among the products which use the centre in proportion to the use of machine hours by the relevant products.

• Management accounting: the provision and interpretation of information which assists management in planning, controlling, decision making, and appraising performance.

• Management by exception: control and management of costs and revenues by concentrating on those instances where significant variances by actual from budgets have occurred.

• Manufacturing accounts: financial statements which measure and demonstrate the total costs of manufacturing in a period. They are followed by Trading and Profit and Loss (P&L) Accounts.

• Marginal costing: a system of cost analysis which distinguishes fixed costs from variable costs.

• Marginal cost: the additional cost incurred by the production of one extra unit.

• Margin of safety: the excess of budgeted activity over breakeven activity. Usually expressed as a percentage of budgeted activity.

• Mark-up: gross profit expressed as a percentage of cost of goods sold.

• Matching convention: the idea that revenues and costs are accrued, matched with one another as far as possible so far as their relationship can be established or justifiably assumed, and dealt with in the Profit and Loss (P&L) Account of the period in which they relate. An example is the matching of sales of a product with the development costs of that product. The appropriate periods would be when the sales occur.

• Master budgets: the overall budgets of an enterprise comprising cash budget, forecast Profit and Loss (P&L) Account and forecast Balance Sheet (BS). They are made up from subsidiary budgets.

• Materiality: the accounting convention that recognizes that accounting is a summarizing process. Some items and transactions are large (i.e. material) enough to merit separate disclosure rather than inclusion with others in a lump sum. Examples are an exceptionally large bad debt or an exceptionally large loss on sale of a fixed asset.

• Minority interest: the interests in the assets of a Group relating to shares in group companies not held by the holding company or other members of the group.

• Modified accounts: financial statements which are shortened versions of full accounts. Small and medium sized companies can file these with the Registrar of Companies instead of full accounts.

• Money measurement: the convention that requires that all assets, liabilities, revenues and expenses shall be expressed in money terms.

• Net: usually means after deductions. For example net current assets current assets less current liabilities and net cash flow means cash inflows less cash outflows. Contrast gross.

• Net book value: the valuation on the Balance Sheet of an asset. Also known as the carrying value or written down value.

• Net present value: the value obtained by discounting all cash inflows and outflows attributable to a proposed capital investment project by a selected discount rate.

• Net realizable value: the actual or estimated selling price of an asset less all further costs to completion (e.g. Cost of a repair if it needs to be repaired before sale) and all costs to be incurred before and on sale (e.g. commission).

• NIFO: Next in first out – a pricing policy where costs are collected on the basis that the cost of materials and components is the next input price.

• Nominal value: the face value of a share or debenture as stated in the official documents. Will not usually be the same as the issue price which may be at a premium and which will almost never correspond to actual value.

• Objectivity: the convention of using reliable and verifiable facts (e.g. the input cost of an asset) rather than estimates of ‘value’ even if the latter is more realistic.

• Operating cycle: the period of time it takes a firm to buy inputs, make or market a product and sell to and collect the cash from a customer.

• Opportunity cost: the value of a benefit sacrificed in favor of an alternative course of action.

• Ordinary shares: the equity capital of a company.

• Outsourcing: the use of services (such as administration or computing) from separate outside firms instead of using the enterprise’s own employees.

• Overheads: Indirect cost.

• Overtrading: a paradoxical situation when a company does so much business that stocks and debtors rise leading to working capital and liquidity difficulties.

• Par value: the nominal sum imprinted on a share certificate and which spears on the Balance Sheet (BS) of a company as share capital. It has no significance as a value.

• Payback: the number of years which will elapse before the total incoming cash receipts of a proposed project are forecast to exceed the initial outlays.

• Periodicity: the convention that financial statements are produced at regular intervals usually at least annually.

• Preference shares: shares in which holders are entitled to a fixed rate of dividend (if one is declared) in priority to the ordinary shareholders in a winding up situation.

• Planning variance: a variance arising because the budgeted cost is now seen as out of date. Examples are wage or price rises.

• Prepayments: expenditure already made on goods or services but where the benefit will be felt after the Balance Sheet (BS) date. Examples are rent or rates or insurances paid in advance.

• Price earnings ratio: an investor ratio calculated as – share / earnings per share.

• Prime cost: the direct costs of production.

• Private company: any company that is not a public company.

• Profitability index: in investment appraisal, the net present value of cash inflows / the initial out lays.

• Profit and Loss (P&L) Account: a financial statement which measures and reports the profit earned over a period of time.

• Pro Rata: in proportion to.

• Prospectus: an official document being in advertisement offering shares for sale to the public.

• Provision: a charge in the Profit and Loss (P&L) Account of a business for an expense which arose in the past but which will only give rise to a payment in the future. To be a provision the amount payable must be uncertain as to amount or as to payability or both. An example is possible damages awardable by a court in a future action over a past incident (e.g. a libel).

• Prudence (or conservatism): the convention whereby revenue and profits are not anticipated, but provision is made for all known liabilities (expenses and losses) whether the amount of these is known with certainty or is a best estimate. Essentially future profit, wait until it happens – future loss, count it now.

• Quick ratio: also known as acid test ratio, current assets (except stock) / current liabilities.

• Quoted company: also known as a listed company, a company whose shares are traded on the stock exchange.

• Realizable value: the amount that an asset can be sold for.

• Realization: to sell an asset and hence turn it into cash.

• Realization convention: the concept that a profit is accounted (or when a good is sold and not when the cash is received.

• Receiver: an insolvency practitioner who is appointed by a debenture holder with a fixed or floating charge when a company defaults.

• Redemption: repayment of shares, debentures or loans.

• Redemption yield: the yield given by an investment expressed as a percentage and taking into account both income and capital gain or loss.

• Reducing balance: a method of depreciation whereby the asset is expensed to the Profit and Loss (P&L) Account over its useful life by applying a fixed percentage to the written down value.

• Relevant costs: costs that will only be incurred if a proposed course of action is actually taken. The only ones relevant to an actual decision.

• Relevant range: the range of activity which is likely. Within it variable costs are expected to be linearly variable with output and fixed costs are expected to be unchanged.

• Reporting: the process whereby a company or other institution seeks to inform shareholders and other interested parties of the results and position of the entity by means of financial statements.

• Reserves: a technical term indicating that a company has total assets which exceed in amount the sum of liabilities and share capital. This excess arises from retained profits or from revaluations of assets.

• Resource accounting and budgeting: the use of normal accruals accounting and Balance Sheets in federal / government departments and agencies.

• Retained profits: also known as retentions, the excess of profits over dividends.

• Return on capital employed: a profitability ratio being income expressed as a percentage of the capital which produced the income.

• Return on sales: the ratio of profit to sales expressed as a percentage.

• Returns: the income flowing from the ownership of assets. May include capital gains.

• Revenue: amounts charged to customers for goods or services rendered.

• Revenue expenditure: expenditure that benefits only the current period and which will therefore be charged in the Profit and Loss (P&L) Account.

• Rights issue: an invitation to existing shareholders to subscribe cash for new shares in the company in proportion to their holdings.

• Salvage value: also known as residual value, the amount estimated to be recoverable from the sale of a fixed asset at the end of its useful life.

• Secured liabilities: liabilities secured by a fixed or floating charge or by other operation of law such as hire purchase commitments.

• Securities: financial assets such as shares, debentures and loan stocks.

• Segmental reporting: the practice of breaking down turnover, profits and capital employed into sections to show the separate contributions of each to the overall picture. Segments can be distinct products, geographical areas, or classes of customers, etc.