Understanding Business Accounting For Dummies, 2nd Edition (132 page)

chart of accounts:
The official, designated set of accounts used by a business that constitute its
general ledger
, in which the transactions of the business are recorded.

Companies Acts:
A series of UK laws governing the establishment and conduct of incorporated businesses, consolidated into the Companies Act 2006.

compound interest:
‘Compound' is a code word for reinvested. Interest income
compounds
when you don't remove it from your investment, but instead leave it in and add it to your investment or savings account. Thus, you have a bigger balance on which to earn interest the following period.

comprehensive income:
Includes net income which is reported in the
profit and loss account
plus certain technical gains and losses in assets and liabilities that are recorded but don't necessarily have to be included in the profit and loss account. Most companies report their comprehensive gains and losses (if they have any) in their
statement of changes in owners' equity
.

conservatism:
If there is choice as to the amount of certain figures, when preparing accounts the lower figure for assets and the higher for liabilities should be used.

contribution margin:
Equals sales revenue minus cost of goods sold expense and minus all
variable expenses
(in other words, contribution margin is profit before
fixed expenses
are deducted). On a per unit basis, contribution margin equals sales price less
product cost
per unit and less variable expenses per unit.

cooking the books:
Refers to any one of several fraudulent (deliberately deceitful with intent to mislead) accounting schemes used to overstate profit and to make the financial condition look better than it really is. Cooking the books is different from
profit smoothing
and
window dressing
, which are tolerated - though not encouraged - in financial statement accounting. Cooking the books for income tax is just the reverse: It means overstating, or exaggerating, deductible expenses or understating revenue to minimize taxable income.

corporate venturing:
Refers to large companies taking a share of small entrepreneurial ventures in order to have access to a new technology. If this approach works, they often buy out the whole business.

corporation tax:
Tax paid by UK companies (with some exceptions) on ‘chargeable profits'. Rates are fixed each year by the government. Reduced rates apply for small businesses.

cost-benefit analysis:
Analysis of the costs and benefits of a particular investment or action, conducted to establish if that action is worthwhile from a purely accounting perspective.

cost of capital:
For a business, this refers to joint total of the interest paid on debt capital and the minimum net income it should earn to justify the owner's equity capital that it uses. Interest is a contractually set amount of interest; no legally set amount of net income is promised to owners. A business's
return on assets (ROA)
rate should ideally be higher than its weighted-average cost of capital rate (based on the mix of its debt and equity capital sources).

creative accounting:
The use of dubious accounting techniques and deceptions designed to make profit performance or financial condition appear better than things really are. See
profit smoothing
and
cooking the books
.

creditors:
One main type of the short-term liabilities of a business, representing the amounts owed to vendors or suppliers for the purchase of products, various supplies, parts, and services that were bought on credit; these do not bear interest (unless the business takes too long to pay). In the US,
creditors
or
trade creditors
are usually called accounts payable.

current assets:
Includes cash plus
debtors,
stock,
and
prepaid expenses
(and marketable securities if the business owns any). These assets are cash or assets that will be converted into cash during one
operating cycle.
Total current assets are divided by total current liabilities to calculate the
current ratio
, which is a test of short-term solvency.

current
liabilities:
Short-term liabilities, principally
creditors,
accrued expenses payable
,
corporation tax payable, overdrafts, and the portion of long-term debt that falls due within the coming year. This group includes both non-interest bearing and interest-bearing liabilities that must be paid in the short-term, usually defined to be one year. Total current liabilities are divided into total
current assets
to calculate the
current ratio
.

current ratio:
A test of a business's short-term solvency (debt-paying capability). Find the current ratio by dividing the total of its
current assets
by its total
current liabilities.

debits and credits:
These two terms are accounting jargon for decreases and increases that are recorded in assets, liabilities, owners' equity, revenue, and expenses. When recording a transaction, the total of the debits must equal the total of the credits.

debtors:
The short-term assets representing the amounts owed to the business from sales of products and services on credit to its customers. In the US these are known as
accounts receivable
.

deferred income:
Income received in advance of being earned and recognised.

depreciation expense:
Allocating (or spreading out) a fixed asset's cost over the estimated useful life of the resource. Each year of the asset's life is charged with part of its total cost as the asset gradually wears out and loses its economic value to the business. Either
reducing balance
or
straight-line depreciation
is used; both are acceptable under
generally accepted accounting principles (GAAP).

diluted earnings per share (EPS):
Diluted earnings per share equals net income divided by the sum of the actual number of shares outstanding plus any additional shares that will be issued under terms of share options awarded to managers and for the conversion of senior securities into common stock (if the company has issued convertible debt or
preference
shares). In short, this measure of profit per share is based on a larger number of shares than basic EPS (earnings per share). The larger number causes a dilution in the amount of net income per share. Although hard to prove for certain, market prices of shares are driven by diluted EPS more than basic EPS.

dividend yield:
Measures the cash income component of return on investment in shares of a corporation. The dividend yield equals the most recent 12 months of cash dividends paid on a share, divided by the share's current market price. If a share is selling for £100 and over the last 12 months has paid £3 cash dividends, its dividend yield equals 3 per cent.

double-entry accounting:
Symbolised in the
accounting equation,
which means both the assets of a business as well as the sources of money for the assets (which are also claims on the assets).

earnings before interest and taxes (EBIT):
Sales revenue less cost of goods sold and all operating expenses - but before deducting interest on debt and tax expenses. This measure of profit also is called
operating earnings, operating profit,
or something similar; terminology is not uniform.

earnings management:
See
profit smoothing
.

earnings per share:
See
basic earnings per share
and
diluted earnings per share
.

earn-out:
When a business is sold, buyers often make part of their offer conditional on the future profits being as forecasted. This, in effect, makes the seller earn out that portion.

effective interest rate:
The rate actually applied to your loan or savings account balance to determine the amount of interest for that period. See also
annualised rate of interest and rate of return
.

equity capital:
See
owners' equity.

external financial statements:
The financial statements included in financial reports that are distributed outside a business to its shareholders and debt-holders.

extraordinary gains and losses:
These are unusual, non-recurring gains and losses that happen infrequently and that are aside from the normal, ordinary sales and expenses of a business.

Financial Accounting Standards Board (FASB):
The highest authoritative, private-sector, standard-setting body of the accounting profession in the US.

financial leverage:
The term
is used generally to mean using debt capital on top of equity capital in any type of investment. For a business it means using debt in addition to equity capital to provide the total capital needed to invest in its
net operating assets.
The strategy is to earn a rate of
return on assets (ROA)
higher than the interest rate on borrowed money. A favourable spread between the two rates generates a financial leverage gain to the benefit of
owners' equity
.

financial reports:
The periodic financially-oriented communications from a business (and other types of organisations) to those entitled to know about the financial performance and position of the entity. Financial reports of businesses include three primary financial statements (
balance sheet
,
profit and loss account
, and
statement of cash flows
), as well as footnotes and other information relevant to the owners of the business.