Accounting (Subject) / Accounting Definitions (Lesson)

Accounting Definitions

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• Prepayments Amounts paid in advance for goods and services to be provided in the future. These amounts are recognized as prepayments at the statement of financial position date and as a deduction from current period expenses
• Accruals Expenses incurred during an accounting period but not paid for until after the accounting period end are still recognized as a liability in the statement of financial position and as an expense in the income statement.
• Depreciation The allocation of the cost of a non-current asset to the accounting periods benefiting from that non-current asset’s use within a business. Depreciation is not a way of reflecting the market value of assets in financial statements and it does not represent a loss in value.
• Net Book Value Cost or fair value – accumulated depreciation.
• Residual Value The amount which the original purchaser of a non-current asset thinks that the asset could be sold for when the time comes to dispose of it.
• Straight Line A method of allocating the cost of non-current assets to the accounting periods benefiting from their use. The straight-line method allocates the same charge for depreciation to each accounting period benefiting from a non-current asset’s use within a business.
• Reducing Balance A method of allocating depreciation on non-current assets to accounting periods benefiting from their use. This method uses a fixed percentage of cost in the first year of an asset’s life and which then applies the same percentage to the net book value of assets in accounting periods subsequent to year 1. The reducing balance method allocates a smaller charge for depreciation to each successive accounting period benefiting from a non-current asset’s use. Residual value is ignored when calculating reducing balance depreciation.
• Bad Debts: Trade receivables from which it is known that cash will not be collected. Bad debts are an expense in the income statement and are not a deduction from sales.
• Doubtful Debts Trade receivables from which cash might not be collected. Doubtful debts are not bad debts.
• Provision for Doubtful Debts The provision for doubtful debts is calculated as a percentage of trade receivables after deducting known bad debts.
• Prudence The process of exercising caution in the production of financial statements, being cautious and expecting less favourable outcomes.
• Realization: Profits should not be anticipated until they have been earned through a sale
• Going Concern A business that has sufficient demand for its products and sufficient sources of finance to enable it to continue operating for the foreseeable future.
• Cash Flow from Operating Activities One of the three sections in the statement of cash flows. This section represents the cash generated from sales less the cash spent in both generating those sales and in running the organization
• Cash Flow from Investing Activities One of the three sections in the statement of cash flows. This section represents the cash spent on buying new non-current assets and the cash received from selling surplus non-current assets.
• Cash Flow from Financing Activities: One of the three sections in the statement of cash flows. This section represents the cash raised from the issue of share capital and loans and the cash spent in repaying borrowings and interest paid and received.
• Statement of Cash Flows A summary of the cash inflows and outflows of an entity for a given period of time.
• Consistency The presentation or measurement of the same piece of accounting information on the same basis each year.
• Money Measurement The measurement of financial results in money terms.
• Periodicity: The preparation of financial statements for a set period of time, usually one year.
• Annual General Meeting (AGM): A meeting held every year by limited liability companies at which shareholders consider and vote on various significant resolutions affecting the company.
• Debenture & Bond A long-term loan to an organization with a fixed rate of interest and a fixed repayment date.
• Ordinary Share Capital The most common form of share capital issued by companies conferring on holders the right to receive all of a company’s profits as dividends and to vote at company meetings.
• Preference Share Capital Preference shares receive a fixed rate of dividend that is paid before the ordinary shareholders receive any dividend. Preference share capital is returned to preference shareholders before any amounts are returned to ordinary shareholders on the winding up of a company. However, preference shareholders have no right to vote in company general meetings.
• Ratio: The expression of the relationship between two different figures.
• Profitability An assessment of the profits made during an accounting period by comparing current period profits to those of previous periods.
• Gross Profit Margin (Ratio Gross Profit divided by Sales (revenue) x 100%. Concentrates on costs of making goods and services ready for sale. Small changes in this ratio can be highly significant and there tends to be a “normal” value for each industry.
• Net Profit Margin (Ratio) or Operating Profit on Sales Operating profit divided by sales x 100%. Net Profit after tax may also be used instead of Operating profit (before interest and tax), however, the second version is more appropriate as it excludes the effects of financing decisions and taxation (which is uncontrollable). Measures net profit made as a percentage of sales.
• Return on Capital Employed Operating profit (before interest and tax) divided by total assets less current liabilities x 100%. This ratio relates to all sources of long term finance and assesses the management efficiency and the performance of a company as a whole.
• Efficiency Ratios Assesses the extent to which assets and liabilities are well-utilised and well-managed.
• Stock Holding (Turnover) Period Average Inventories (stock) held divided by cost of sales x 365 days. May use closing stock figure if opening stock figure is unavailable. Measures the average period for which stocks are being held.
• Customers (Trade Debtors) Collection Period: Closing Trade Receivables (Trade debtors) divided by Credit Sales (revenue) x 365 days. May use average trade receivables ((opening + closing)/2). However, use closing trade receivables figure if opening trade receivable figure is unavailable. Measures how long, on average, credit customers take to pay their debts.
• Suppliers’ (Trade Creditors’) Payment Period Trade Payables (Trade Creditors) divided by Credit purchases x 365 days. May use Average Trade Creditors ((opening + closing) / 2), however, use closing trade creditors figure if opening trade receivable figure is unavailable. May use Cost of Sales instead of credit purchases as the former data is often unavailable. Measures how long, on average, the business takes to pay its trade creditors.
• Total Asset Usage Sales divided by total assets x 100%. Indicates how well a company has used its fixed and current assets to generate sales.
• Liquidity: The ability of entities to meet payments to their creditors as they become due (short term).
• Current Ratio : Current assets divided by current liabilities. Assesses the ability to settle short-term liabilities with short-term assets; if less than 1:1, look closely at cash flow. Ability to generate daily cash might make this ratio adequate, e.g. a retailer selling to the public. Must look at norm for the industry, usually between 1.5:1 and 2:1 for manufacturing industry.
• Acid Test Current assets less inventory divided by current liabilities. Places emphasis on the most liquid assets and also varies from industry to industry.
• Solvency Ratios: Assess the relationship between debt financing and equity financing, and the extent of a business’ solvency (long term).
• Gearing Long-term loans (+bank overdraft?) divided by Ordinary share capital + reserves x 100%. Most often quoted in the financial press. A high figure indicates reliance on sources of long-term loan finance. Interest payments must always be met, so the company has exposure to interest rate movements.
• Interest Cover Operating profit (before interest and tax) divided by interest. Measures the amount of profit available to cover interest payments.
• Performance/ Investor Ratio Ratios of particular interest to an entity’s shareholders as they measure the returns to the owners of the business.
• Earnings per Share The profit after tax for ordinary shareholders divided by the number of ordinary shares in issue. Most often quoted measure of company performance and progress. Measure percentage increase from year to year.
• Price/ Earnings Ratio The current market price of a share divided by the latest earnings per share figure. It compares the amount invested by the shareholder in the company with the earnings per share. Number of years current profit represented by share price. Thus it reflects market’s confidence in future prospects of the company. Compare with average P/E for the industry, given daily in the Financial Times. Commonly uses as a basis for investment decisions.
• Dividend per Share The total dividend payable to ordinary shareholders is divided by the number of ordinary shares in issue to give a figure of dividends per share in pence. Since dividend is the most immediate reward for share ownership, this is of immediate interest to many investors. Most companies attempt to maintain a consistently increasing trend and a reduction in dividend per share is often only proposed by management as a last resort.
• Dividend Cover Earnings per share divided by dividend per share. Measures the ability of the business to pay dividends out of its current profit.
• Dividend Yield The dividend per share divided by share price x 100%. It allows investors to assess the income return (i.e. dividends) on their equity investment in the business.
• Stock A different term for inventory.
• Working Capital Current assets less current liabilities.
• Business entity Any organization involved in business. Businesses may be sole traders, companies with limited liability or partnerships
• Inventory Turnover: Inventory days.

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