Understanding Business Accounting For Dummies, 2nd Edition (35 page)

An example: During a period, a business records the full cost of all wages and benefits that its employees earn. The full cost is the correct amount of expense to record in the period to measure profit for the period. But at the end of the period, some part of this total cost has not been paid. The unpaid balance of the total cost is recorded in an operating liability account.

Preparing the balance sheet equation

Each asset of a business is different from the others, but cash is in a class by itself. Furthermore, the cash flow aspects of profit are receiving a great deal of attention these days - almost to the level of being an equal concern with profit itself. So separating assets into cash and non-cash assets is useful. Moreover, separating liabilities into operating liabilities and borrowed money (generally referred to as
debt
) is useful, and separating owners' equity into invested capital and retained earnings is useful. This six-fold subdivision of the balance sheet equation looks like this:

Cash + non-cash assets = operating liabilities + debt + invested capital + retained earnings

On the one hand, this expansion of the balance sheet equation helps clarify the different types of assets, liabilities, and owners' equity. On the other hand, for exploring the profit-making process, debt and invested capital are not needed because revenue and expenses do not involve these two types of accounts. Debt and invested capital are excess baggage for the following journey through the profit-making process of a business. So to simplify the equation assume that the business has no debt and no invested capital (not realistic, but very convenient here). Thus the balance sheet equation that we use in the following sections is as follows:

Cash + Non-cash Assets = Operating Liabilities + Retained Earnings

A simple, all-cash example to start things off: Suppose your business collected all sales revenue for the year immediately in cash and paid all expenses for the year immediately in cash. Your profit for the year was £60,000. Here's how that profit affects the financial condition of your business (to simplify, pound signs are not used):

Cash + Non-cash = Operating + Retained Assets Liabilities Earnings

+60,000 +60,000

The cash asset account increases by £60,000, which is the net difference between sales revenue and expenses - your business bank account balance is £60,000 higher at the end of the year than at the beginning of the year. (If you had distributed some of the profit, the balance of the retained earnings account would be the amount you distributed subtracted from £60,000, and your cash would be lower by the same amount.)

Exploring the Profit-Making Process One Step at a Time

We don't mean to scare you off but the profit picture gets more complex than the simple all-cash example just discussed. Many businesses sell their products on credit rather than cash, for example, and usually don't collect all their sales revenue by the end of the year. In other words some of the expenses for the year aren't paid by the end of the year. Each of the following steps adds a layer of reality, one at a time, to make the profit picture more realistic. The following sections start with the all-cash scenario as the point of departure and then make one change at a time to show you how the additional factor affects the balance sheet equation.

Making sales on credit

If your business allows customers to buy its products or services on credit, you need to add an asset account called debtors or
accounts receivable
(also terms we will use interchangeably) which records the total amount owed to the business by its customers who made purchases unofficially and haven't paid up yet. You probably wouldn't have collected all your receivables by the end of the year, especially for credit sales that occurred in the last weeks of the year. However, you still record the sales revenue and the cost-of-goods-sold expense for these sales in the year in which the sales occurred. The initial scenario in which all sales were collected in cash and all expenses were paid in cash is used as the point of reference in the following steps.

Your business had sales revenue of £1 million and total expenses of £940,000, all of which were paid by year-end, making for a bottom-line profit of £60,000. Now assume that £80,000 of the sales revenue came from credit sales that haven't yet been collected at the end of the year. Here's what the financial effects look like (for convenience, pound signs in the balance sheet equation are not used):

Cash + Non-cash = Operating + Retained Assets Liabilities Earnings

+60,000 +60,000

Accounts receivable

-80,000 +80,000

Note that the first line in the balance sheet equation (which is underlined) is from the initial all-cash scenario and serves as the point of reference. Everything in the new scenario is the same as in the all-cash scenario except for the changes shown below the line. Also note that the name of the specific non-cash asset - in this case, accounts receivable - is entered in the balance sheet equation column. When a change in a non-cash asset is entered in the balance sheet equation, the corresponding effect on cash is shown in the cash column.

The £80,000 of uncollected sales revenue at year-end has the effect of decreasing the cash you have by £80,000. Accounts receivable represents cash waiting in the wings to be collected in the near future (assuming that all your customers will pay their accounts receivable to you on time). But until the money is actually received, your business is without the £80,000 cash inflow. This situation may appear to be pretty serious. But hang on; there are several more steps to go.

Whether collected entirely in cash or not, the entire £1 million in sales revenue for the year is recorded and used to calculate profit. So bottom-line profit is £60,000 - the same as in the all-cash scenario. But the cash effects between the two scenarios are quite different. When making sales on credit, you count the sales in calculating your profit, even though the cash is not collected from customers until sometime later. This is one feature of the
accrual basis of accounting,
which is explained in Chapter 3. The accrual basis of accounting records revenue when sales are made and records expenses when these costs are incurred. When sales are made on credit, the accounts receivable asset account is increased; later, when cash is received from the customer, cash is increased and the accounts receivable account is decreased.

Depreciation expense

Depreciation expense accounting
is the method of spreading out the cost of a fixed asset instead of charging the entire cost to the year of purchase. That way, each year of use bears a share of the total cost.
Fixed assets
are long-lived operating assets - buildings, machinery, office equipment, vehicles, computers and data-processing equipment, shelving and cabinets, and so on.

For example, cars and light trucks may be depreciated over five years. (Businesses apply the five-year rule to other kinds of assets as well.) The basic idea of depreciation is to charge a fraction of the total cost to depreciation expense for each of the five years. (The actual fraction each year depends on which method of depreciation you choose, which is explained in Chapter 13.)

Suppose your £940,000 total of expenses for the year includes £25,000 depreciation for fixed assets. (You bought these assets for £125,000 and are charging one-fifth of the cost each year for five years.) But you didn't actually pay anything for the fixed assets this year - you bought the assets in previous years. Depreciation is a real expense, but not a
cash outlay
expense after the fixed assets are already bought and paid for. (See the ‘Appreciating the positive impact of depreciation on cash flow' sidebar if you're confused about this point.)