Understanding Business Accounting For Dummies, 2nd Edition (34 page)

Sales revenue
is the total amount of money or other assets received from sales of the company's products for the entire year. The number used in the profit equation represents all sales - you can't tell how many different sales were made, how many different customers the company sold products to, or how the sales were distributed over the 12 months of the year.

Sales revenue is strictly what belongs to the business and doesn't include money that anyone else can claim (for example, VAT that the business collects from customers and then remits to the government).

Note:
A business may have other sources of income in addition to the sales revenue from its products. One common alternative source of income is interest or other return earned on investments the company makes. In the profit report, investment income goes on a separate line and is not included with sales revenue - to make clear that this source of income is secondary to the mainstream sales revenue of the business.

Expenses
consist of a wide variety of costs of operating the business and making sales, starting with the cost of the goods (products) sold to the customers and including many other costs of operating the business:

• Payroll costs (wages, salaries, and benefits paid to employees)

• Insurance costs

• Property taxes on buildings and land

• Cost of gas and electric utilities

• Telephone and Internet charges

• Depreciation of operating assets that last more than one year (such as buildings, cars and trucks, computers, office furniture, tools and machinery, and shelving)

• Advertising and sales promotion costs

• Office supplies

• Legal and audit costs

• Interest paid on loans

• Income taxes

As is the case with sales revenue, you can't tell from the amount reported as an expense how much was spent on each component making up the total. For example, the total depreciation expense amount doesn't tell you how much was for buildings and how much was for vehicles.

By the way, notice that only one total is shown for all the business's expenses - to keep the profit equation as short as possible. However, when preparing a formal profit report - which is called a
profit and loss account
- expenses are broken down into several basic categories. (See ‘Reporting Profit to Managers and Investors: The Profit and Loss Account' at the end of the chapter.)

Measuring the Financial Effects of Profit-Making Activities

In the basic profit equation example introduced earlier in this chapter, a business earned £60,000 net income for the year. That means it's £60,000 richer now, right? Well, that could happen in a make-believe world, and we start this section with a hypothetical profit example in which the business checking account
does
increase by £60,000 - but this example is extremely oversimplified. In the real world, nothing is that simple.

The financial effects of making profit go far beyond a fatter bank account. To get a clear picture, a balance sheet equation is handy to sort out the various effects. The general format of the balance sheet equation (also called the
accounting equation
) is as follows:

Assets = liabilities + owners' equity


See Chapter 2 for more information about this equation.

Making a profit increases the assets of a business. Assets also increase when the owners invest money in the business and when the business borrows money. These two types of increases in assets are not profit. Profit is the net increase of assets from sales revenue less expenses, not from borrowing and not from its owners investing capital in the business.

Most businesses do not distribute all of their annual profit to their owners; they could, but they don't. Instead, the increase in assets from making profit is used to expand the resource base of the business. Profit not distributed is called reserves or
retained earnings.
The nature of retained earnings is shown in the following rearrangement of the balance sheet equation:

Assets - liabilities - invested capital = retained earnings


The key idea here is that if you start with total assets and then take away how much of the assets came from liabilities and how much was invested by the owners, the remainder must have come from retained earnings. For example, if a business has £6 million in assets, £2 million in liabilities, and £3 million in invested capital, the remaining £1 million must be due to retained earnings.

The retained earnings account is
not
- we repeat,
not
- an asset, even though its name may suggest otherwise. It is a
source
-of-assets account, not an asset account. See the ‘So why is it called retained earnings?' sidebar for more information about the retained earnings account.

The profit-making activities of a business affect several assets and also some
liabilities - not the kind recorded when borrowing money (interest-bearing debt), but the kind recorded for expenses that have not been paid immediately. The accounts used to record unpaid expenses are referred to as
operating liabilities.
Interest is paid on debt (borrowed money), but not on operating liabilities. The term
operating
simply refers to the sales and expense operations of a business that are necessary for making profit.