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The 5 most confusing accounting words

4 April 2016 | Published by AME

Accounting is a language and not a science.  If you don’t speak the language, you can feel left out and stupid. On top of that, there are certain common accounting words or terms that can have multiple or ambigous meanings, leading to further confusion and misunderstanding.  Below we take a look at the 5 most confusing accounting words or terms…

Debt

The words ‘debt’ and ‘liabilities’ are often used interchangeably.  In accounting, ‘liabilities’ is a technical term and refers to what you (or your business) owe other parties. Liabilities includes both short- and long-term debts and these debts could be interest-bearing or not.

On the other hand, the word ‘debt’ could be used to mean a number of different things. It could indeed refer to all liabilities, as just described.  Other times, the word ‘debt’ is used to refer to interest-bearing borrowings only, such as a loan from the bank.  This is the case when ‘debt’ is included in the formula of certain financial ratios.

It is definitely worth clariyfing how the term debt is being used and if calculating financial ratios, be sure to be consistent in your approach.

Expenditure

When one hears the word ‘expenditure’, most people think of spending money.   However, this is not the accounting definition of expenditure.  This is because accounting uses the accrual basis and not the cash basis to record transactions . This means that we record transactions when they have occurred in substance rather than when the cash flows in or out.

Looking at an example, we would record the cost of telephone calls made in October as an expense in October, regardless of whether we have paid the bill or not in that month.  This is because we have used the telephone in October. The related expense for accounting purposes therefore belongs in that month.

In summary, ‘expenditure’ for accounting is not the same thing as cash out.

Debits & Credits

When you look at your personal bank statement , an increase in your bank balance is traditionally described as a credit.  When you learn the basics of accounting, the opposite it true – an increase in the bank account is described as a debit.

At first, this seems very confusing. But remember that the bank statement is drawn up from the bank’s perspective.  So from the bank’s perspective, your positive bank balance represents a liability to the bank, i.e. a credit account.

Many people get confused by the idea of a positive bank balance being a debit, as for years, they have thought of being ‘in credit’ with the bank as a good thing.

Capital

This is possibly one of the most confusing terms of all.  In accounting, ‘capital’ can refer to longer term (‘non-current’) Assets, such as property, machinery and equipment.  However, ‘capital’  can also refer to money that the owners or shareholders have put into the business, i.e. share capital.  Share capital falls under ‘Equity’ on the Balance Sheet.

In addition, many people use the word ‘capital’ to loosely mean money.  For example, “the business doesn’t have enough capital to grow”.  Technically, this is incorrect, as money in the bank (Asset) is not the same thing as owners’ capital (Equity).

Profits

The term ‘profit’ gets casually thrown around in boardrooms and workplaces on a regular basis.  But does everyone using the word have the same understanding?   Looking at the Income Statement, it is apparent that profit could be referring to a number of different line items.  In summary, there is:

  • Gross Profit (Sales less Cost of Sales)
  • Operating Profit (otherwise referred to Earnings before Interest & Tax)
  • Profit before Tax
  • Profit after Tax.

The difference between Gross Profit and Profit after Tax can clearly be vast.

As you can see, the language of accounting is not always straight-forward.  There is no shame in asking exactly what a person means when they use the above terms.  You might even find that they themselves are not totally clear! And when you are using the language of accounting, try to be as simple and clear as possible to avoid misunderstanding.