Read Understanding Business Accounting For Dummies, 2nd Edition Online
Authors: Colin Barrow,John A. Tracy
Tags: #Finance, #Business
Understanding Business Accounting For Dummies, 2nd Edition (36 page)
Appreciating the positive impact of depreciation on cash flow
Whereas making sales on credit does not generate immediate cash inflow and thus has a temporarily negative impact on your cash flow, depreciation is good news for cash flow. This concept gets a little complex, so stay with us here.
Fundamentally, a business sets its sales prices high enough to recover its expenses plus provide a profit. In a real sense, the business is passing on the cost of its fixed assets to its customers and recovering some of the cost of the fixed assets each year through sales revenue. A good example to illustrate this critical point is a taxicab driver who owns his cab. He sets his fares high enough to pay for his time; to pay for the insurance, licence, petrol and oil; and to recover the cost of the cab. Included in each fare is a tiny fraction of the cost of the cab, which over the course of the year adds up to the depreciation expense that he passed on to his passengers and collected in fares. At the end of the year, he has collected a certain amount of money that pays him back for part of the cost of the cab.
In short, fixed assets are gradually
liquidated
, or turned back into cash, each year. Part of sales revenue recovers a fraction of the cost of fixed assets, which is why the decrease in the fixed assets account to record depreciation expense has the effect of increasing cash (assuming your sales revenue was collected in cash during the year). What the company does with this cash recovery is another matter. Sooner or later, you need to replace the fixed assets to continue in business. In this chapter, we do not look beyond the cash recovery of part of the original cost invested in the fixed asset.
Here's what the financial effects of depreciation expense look like:
Cash + Non-cash = Operating + Retained Assets Liabilities Earnings
+60,000 +60,000
+25,000 Fixed assets-25,000
Compared with the cash flow effects of accounts receivable, depreciation is good news. Let us put it this way: If all sales revenue had been collected and all expenses except depreciation had been paid during the year, your cash would have increased by £85,000. The company would have realised £60,000 from your profit-making activities plus the £25,000 depreciation recovery during the year. The positive impact of depreciation on cash is just the prelude. Next in line are the favourable cash flow effects of unpaid expenses.
Unpaid expenses
A typical business pays many expenses after the period benefited by the expense. For example, suppose that your business hires a law firm that does a lot of legal work for the company during the year but you don't pay the bill until the following year. Your business may match retirement contributions made by employees but you may not pay your share until the following year. Or your business may have unpaid bills for telephone, gas, electricity, and water that it has used during the year.
Accountants use three different types of operating liability accounts to record a business's unpaid expenses:
Accounts payable, or creditors:
For items that the business buys on credit and for which it receives an invoice (a bill).
For unpaid costs that a business generally has to estimate because it doesn't receive an invoice for them. An example of accrued expenses is unused holiday that your employees carry over to the following year, which you will have to pay for in the coming year.
For income taxes, or corporation tax, that a business still owes to HM Revenue and Customs.
Your business has each of the three operating liabilities we just listed. Some of your total expenses for the year are unpaid at year-end - part in the accounts payable account, part in the accrued expenses payable account, and part in the income tax payable account. Here's what the financial effects of your unpaid expenses look like in the balance sheet equation:
Cash + Non-cash = Operating Liabilities + Retained Assets Earnings
+60,000 +60,000
+30,000 Accounts payable +30,000
+35,000 Accrued expenses payable +35,000
+5,000 Income tax payable +5,000
The total of these three unpaid operating liabilities is £70,000 (£30,000 accounts payable + £35,000 accrued expenses payable + £5,000 income tax payable). Your balance sheet would report these liabilities because they are claims against the business. You may think that liabilities are bad, but for cash flow, liabilities are good. Your business has not yet paid £70,000 of the expenses for the year, and your cash balance is higher by this amount - you get to hang on to the cash until you pay the liabilities. Of course, you have to pay these liabilities next year, but isn't it nice to have your balance sheet show a big, fat cash increase for this year even though you have to show the liabilities as well?
Prepaid expenses
are the opposite of unpaid expenses
.
For example, a business buys fire insurance and general liability insurance (in case a customer who slips on a wet floor sues the business). You pay insurance premiums ahead of time, before the period in which you're covered, but you charge that expense to the actual period benefited. At the end of the year, the business may be only halfway through the insurance coverage period, so it charges off only half the premium cost as an expense (for a six-month policy, you charge one-sixth of the premium cost to each of the six months covered). So at the time you pay the premium, you charge the entire amount to the prepaid expenses asset account, and for each month of coverage, you transfer the appropriate fraction of the cost to the insurance expense account.
