Understanding Business Accounting For Dummies, 2nd Edition (37 page)

Here's what the financial effects of your prepaid expenses look like in the balance sheet equation:

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

+60,000 +60,000

-15,000 Prepaid expenses +15,000

The build-up of prepaid expenses has a negative impact on the business's cash. In other words you had to write cheques for the prepaid expenses so your cash balance is smaller. The prepayment of these expenses lays the groundwork for continuing your operations seamlessly into next year. What it comes down to is that certain costs of your profit-making operations must be paid in advance - you don't have a choice. Remember that although your business is £15,000 cash poorer, profit remains the same (£60,000) as it was in all the previous scenarios.

Stock (or Inventory) and cost of goods sold expense

Cost of goods sold
is one of the primary expenses of businesses that sell products. It's just what its name implies: the cost that a business paid for the products it sells to customers. A business makes profit by setting its sales prices high enough to cover the actual costs of products sold, the costs of operating the business, interest on borrowed money, and income taxes (assuming that the business pays income tax), with something left over for profit.

When the business acquires a product, the cost of the product goes into a
stock asset account
(and, of course, the cost is either deducted from the cash account or added to the accounts payable liability account, depending on whether the business paid with cash or bought on credit). When a customer buys that product, the business transfers the cost of the product from the stock asset account to the cost-of-goods-sold expense account because the product is no longer in the business's stock; the product has been delivered to the customer.

The first step in determining profit for the period is deducting the cost-of-goods-sold expense from the sales revenue for the goods sold. Most profit and loss accounts report the cost of goods sold as a separate expense (refer to ‘Reporting Profit to Managers and Investors: The Profit and Loss Account,' later in this chapter).

So assume that your business did, in fact, start the year with a sizable stock of products whose cost is recorded in the stock asset account. As your business sold the products early in the year, the cost of the goods sold was removed from the stock account, and that cost was charged to expense.

Your business sells products so you need to have a stock of products on hand to sell to your customers. This stockpile of goods on the shelves waiting to be sold (or in storage space in the back room) is called
stock.
When you drive by a car dealer and see all the cars waiting to be sold, remember that these products are called stock. The cost of unsold products (goods held in stock) is not charged to expense until the products are actually sold. In this way, the cost-of-goods-sold expense is correctly matched against the sales revenue from the goods sold.

During the year you increased the number of products offered for sale. Therefore, your total purchases of products during the year was £55,000 more than your total cost of goods sold. In other words, you increased the size of your stock by £55,000 cost. The financial effects of your ending stock increase in the balance sheet equation are as follows:

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

+60,000 +60,000

-55,000 Stock+55,000

You not only replaced the products sold to customers during the year, but you also bought additional products that cost £55,000. This stock build-up requires cash - notice the £55,000 drain on cash. Your increase in stock may be a smart move but it did use £55,000 in cash.

An increase in the accounts payable liability account may provide part of the stock increase because businesses that have established good credit histories can buy their stock on credit. However, we didn't want to add another change in the accounts payable account and in most situations, a good part of the stock increase would have to be paid for by the end of the year.

So Where's Your Hard-Earned Profit?

As a business manager, not only should you make profit, but you should also understand and manage the financial effects of profit. In particular, understand that profit does not simply mean an increase in cash. Sales revenue and expenses, the two factors of profit, affect many assets and operating liabilities - making sales on credit impacts accounts receivable, expenses paid in advance impact prepaid assets, unpaid expenses impact operating liabilities and so on. You simply can't have expenses without a smorgasbord of changes in assets and operating liabilities.

Knowing how much profit your business made isn't enough. You need to take another step and ask, ‘Did the profit generate an increase in cash equal to the profit?' and, because it hardly ever does, ‘Where is the rest of the profit?'

So far, we've looked at each step along the reality road separately, as if it were the only change from the simple cash-basis example. Now we assemble all the steps together that we've analysed since starting with the simple all-cash example. In reading the following summary remember that increases in assets hurt your cash balance but that increases in operating liabilities help your cash balance:

Summary of Changes During Year in Non-cash Assets and Operating Liabilities

Changes in Non-cash Assets:

Accounts receivable +80,000

Stock +55,000

Prepaid expenses +15,000

Fixed assets
-25,000

Net increase £125,000in non-cash assets

Changes in Operating Liabilities:

Creditors (Accounts payable) +30,000

Accrued expenses payable +35,000

Income tax payable
+5,000

Increase of operating liabilities
£70,000

Net decrease in cash balance during year £55,000

Our purpose right now is simply to explain that £55,000 of your profit for the year is not found in an increase in cash but rather consists of the changes in non-cash assets and operating liabilities. Profit is a mixture, or you could say a smorgasbord, of changes in the assets and operating liabilities that are an integral part of the profit-making process.

If it isn't in cash, where is it? The following schedule summarises the changes in your non-cash assets and operating liabilities caused by the profit-making steps we showed you earlier in this chapter:

Changes in Non-cash Assets

Accounts receivable +80,000

Stock +55,000