Accounting Terms Explained

accountancy terms explained

The accounting industry has a long-standing reputation for using technical words and confusing jargon, often resulting in misunderstanding and frustration for their clients.

We believe that every client is a specialist in their own field, so they shouldn’t also have to be accounting-jargon experts.  After all, it’s our job to offer them the accounting support they need to be able to focus on growing their businesses. We speak to our clients in a way that they understand the information provided and can use it to their benefit. 

There are however, some accounting terms which our clients come across more regularly and which require more detailed explanation.  In this week’s blog, we explore some of these in more detail.

1. Cash Accounting vs Accrual Accounting

There are two main accounting methods: cash accounting and accrual accounting.

Cash accounting

Cash accounting is a method that records income when it is received and expenses when they are paid.  For example, when buying tea and coffee for the office, a company will usually pay cash for them.  Under this accounting method, the company has a business expense, and their cash (bank) balance reduces when the expense is paid.  Similarly, when invoicing a client for work done, the income will only be recorded when the client pays and their cash (bank) balance increases.

This is a simple accounting method which is geared toward small businesses, as business owners record each transaction as money changes hands. Despite the name, cash basis accounting also has nothing to do with the form of payment received – it applies whether the payment is electronic or in actual cash.

While cash accounting is simple and shows business owners how much money they have on hand each day, it is not accurate as it does not show the income that’s been invoiced for and not received, or the bills that are still payable by the business.

Accrual accounting

Accrual accounting is a method that records income and expenses when they are earned/incurred, regardless of when cash comes into or goes out of the business.  For example, when buying merchandise, a business will usually have an account and payment terms with their supplier.  This means that they may receive stock in the middle of the month, but they will only pay for it at the beginning of the following month.

This is the accounting method which most businesses use. Whilst it is more complicated and time-consuming than the cash accounting method, it provides a more accurate picture of business performance and finances, and it enables business owners to make decisions with more confidence.

2. Double-Entry Bookkeeping

This is a type of bookkeeping system that keeps the accounting equation (Assets = Liabilities + Equity) in balance and every transaction is recorded in two places within the accounts – once as a debit and once as a credit.

The double-entry system can make it easier to prepare accurate financial statements and identify errors.

3. ROI

ROI stands for ‘Return on Investment’ and it is the financial reward a business generates from things it invests in.  For example, a business can invest in a marketing campaign, new equipment or a new website.

When a business puts money into an investment, ROI helps the business owner understand how much profit or loss the investment has earned.

To calculate ROI, business owners subtract the cost of the investment from the current value of the investment to calculate the net profit. They then divide the net profit by the cost of the investment and multiply that by 100 (to represent the result as a percentage). 

For example: If you invest £5,000 in a marketing campaign and the campaign generates £7,000 of sales, the ROI will be calculated as follows:

Value of investment       :             £7,000

Less cost of investment  :             £5,000

Net profit                        :             £2,000

ROI = (£2 000 / £5 000) x 100, which equates to 40%.

4. Input VAT vs Output VAT

You’ve heard of and probably have a basic understanding of Value Added Tax (VAT), and you likely pay VAT on many of the items that you buy, but do you understand the difference between input VAT and output VAT?

Input and output VAT applies to businesses that are required to be registered for VAT.  A business must register for VAT if their VAT taxable turnover is more than £85,000 per year.  VAT taxable turnover is the total of everything sold that is not VAT exempt.  A business can also voluntarily register for VAT if it chooses to do so.

Input VAT refers to the VAT added to the cost of certain good and services when they’re bought.  The amount of input VAT that’s added varies depending on whether the goods or services are taxed at the standard, reduced or zero rate of VAT.

Output VAT is the amount of VAT that a business charges on sales of goods and services.  Businesses that are registered for VAT must add this charge to each vatable sale.

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