How often do you leave a meeting with your accountant feeling more confused than before you started? This reminds me of the joke What is the definition of “accountant”? Someone who solves a problem you didn’t know you had in a way you don’t understand. In all seriousness, as a business owner it is helpful to know the basic accounting terminology to understand your annual financial statements. Below is a list of 10 important definitions.
- CPA: In Canada this stands for “Chartered Professional Accountant” and is a designation given by the Chartered Professional Accountants of Canada to individuals who pass an examination and meet both educational and experience requirements. CPAs are regulated provincially and subject to oversight by the provincial body to ensure the public interest is protected.
- Canadian GAAP: This is a bit of an older acronym in Canada and stands for “Canadian generally accepted accounting principles” as defined by the Accounting Standards Board of the Chartered Professional Accountants in the CPA Canada Handbook. This is a set of rules and guidelines developed by the accounting industry for companies to follow when reporting financial data. In Canada “GAAP” can refer to a number of different accounting standards such as those for private corporations (ASPE) or not-for-profit organizations (ASNPO), but generally refers to the accounting standards applied to the financial statements
- Financial Statements: These are reports prepared by an accountant to present the financial performance and position at a point in time. These generally include a balance sheet, income statement, statement of retained earnings and may also include a statement of cash flows. These statements are prepared to give users outside of the organization, like investors and creditors, more information about the organization’s financial goings-on.
- General Ledger: The general ledger provides a detailed recording of every transaction that takes place during a period. The transactions tell us what makes up the balance of an account and what gave rise to changes in balances. The general ledger contains all balance sheet and income statement accounts.
- Trial Balance: This is a report that provides a snapshot of all of the account balances in the general ledger at a particular point in time. In accounting we reference “debits” and “credits”, which can be thought of as positive and negative numbers. Every transaction has a self-balancing debit and credit side to the entry. For instance, if we deposit money to a bank account as payment on a receivable, we debit or increase the bank and credit or reduce the accounts receivable by the same amounts. The trial balance is so named because when all of the debit and credit accounts are added up, they should sum to zero.
- Retained Earnings: We use this term to reference an organization’s accumulated, after-tax earnings which have not been distributed to owners by way of dividends or salaries. So if a company earned $100,000 after tax in year 1 and $50,000 after tax in year 2 and paid out dividends of $25,000 in year 2, at the end of year 2 the retained earnings would equal (100,000+50,000-25,000=$125,000).
- Accrual Accounting: This is a concept that can really confuse a lot of non-accountant types. We often think of spending and earning in the context of cash, money in and money out. However, most accounting standards require the use of accrual accounting, which reflects expenses and revenue as they are incurred or earned and not as cash is received or paid. So, for instance, if a company received an invoice for $10,000 dated April 15th, but didn’t pay it until May 15th, cash-based accounting would reflect the expense on May 15th, whereas accrual-based accounting reflects the expense on April 15th, when the invoice is dated and would show an accounts payable for the unpaid invoice. Accrual accounting gives a better picture of activities as it captures all rights and obligations of an organization, regardless of whether they have yet been settled in cash.
- Dividends: Referring to the above point on retained earnings, a dividend is a distribution of retained earnings to shareholders. A dividend can only be paid when there is retained earnings (so we cannot pay dividends if there is an accumulated loss).
- Unqualified Opinion: This term is used to describe an auditor’s opinion on an audited financial statement. Specifically, an “unqualified” opinion means the auditor did not find any material errors to the financial statements and finds the statements to be correct within materiality.
- Materiality: Materiality is referenced in the context of audit and review engagements as a calculated amount which reflects what a reasonable user of the financial statements would quantify as an error which would affect their decision making on the statements. As an example, if an organization has $1million in sales and $100,000 in net income, an error of $500 in the financial statements would not likely have any impact on how a reader of the financial statements would view the organization. However, if an error of $20,000 existed, that could very well change the opinion of the reader, particularly if it impacted net income. Thus the $500 would be immaterial and the $20,000 material. Auditing requires statistical sampling and analysis which requires the use of materiality in its calculations and assessments.
Understanding your accounting records is important and at RHN we always strive to explain terms and concepts in a way that is approachable to non-accountants. We are always happy to help de-mystify financial reporting!
This post has been prepared for general information purposes. It is not advice. The information presented may not fit your unique situation, please consult one of our trusted business advisors at RHN CPA for further clarification and interpretation of your circumstances.