The Accounting Game: Basic Accounting Fresh from the Lemonade Stand
by Darrell Mullis and Judith Orloff
Balance sheet
Assets = Liabilities + Equity
Income statement
The movie that connects a period’s beginning and ending balance sheets which are snapshots.
Sales
-COGS
-Labor
________________
Gross Profit
-Expenses
________________
Net profit
Examples of expenses
bad debt, interest, insurance
An expense like insurance can be prepaid (ie a 10 year policy). So while you may pay cash for it upfront reducing your cash assets, you will expense only 1 year worth of its benefit while booking the remaining value as a “prepaid asset” on the balance sheet
For service businesses:
Sales
-Cost of services
_________________
Gross profits
-Expenses
_________________
Net profit
Cost of services are direct cost of providing service hours. Expenses include items like admin, sales & marketing including commission for leads, and R&D to develop materials, salaries including to owners.
- Income taxes are deducted on the income statement to compute a net income after taxes.
- If you sell an asset at a value higher/lower than book value you will register a gain/loss on the income statement
Inventory
- The inventory from a beginning balance sheet will be part of the COGS in an income statement.
- Inventory on balance sheet can be divided into raw materials and finished good. It takes cash (for example to pay labor) to turn a raw material to a finished good so there can be cash “locked” up in the balance sheet in the finished goods that can only be realized by making sales.
Valuing inventory
- In an inflationary business where the cost of materials rises over time, LIFO accounting will value the inventory and COGS higher, in turn, reducing paper profits and taxes.
- Most businesses start using FIFO which is operationally easier but switch to LIFO for tax reasons. In fact, LIFO records are expensive to maintain and usually only done by companies with large inventories.
- The IRS must grant permission for your business to switch methods a second time and require any back taxes be paid.
- Where it was possible to report cash balance sheets to the IRS and accrual ones for investors it is required to be consistent with method used to value inventory (LIFO or FIFO). So accounting statements will usually footnote whether the assets are being under or overstated based on the method used.
- If it is easy to value the inventory individually (ie each item has a serial number) then some businesses will average the value of the inventory.
Accrual vs Cash Accounting
- Accrual accounting is more accurate but leads to higher profits than cash accounting so it leads to higher taxes. Companies prefer cash method for IRS but accrual method for investors.
- Service companies have the advantage of being able to use cash accounting but companies who have inventories as a significant portion of business are required to use the accrual method. Otherwise, they could easily shield profits by spending cash on hand to buy inventory and reduce reported earnings.
By allocating items, we can allocate items in a way that lends economic insight into the business and price services correctly.
Capitalizing an asset vs expensing it
Plants and buildings are fixed assets although costs to maintain them would be recorded on the income statement as expenses.
- Equipment is also a fixed asset but usually separated from plants and buildings which are stationary.
- Whether a purchase is treated as an asset or expense really depends on:
- duration of its use. If it is many years then capitalize it as an asset. If it’s treated as an expense it will reduce earnings in the current period.
- Its cost. You can set a dollar limit, and any item which exceeds it will be capitalized.
Cash Statement
Keeps track of cash flow which is necessary when doing accrual accounting. For example, if you made a sale on credit in a previous accounting period and the cash for that sale comes in we do not adjust the income statement since we already accounted for the sale. However we will update the cash statement.
Depreciation
Shows up as an expense on the income statement reducing earnings. The balance sheet will be kept in balance by reducing the value of the fixed assets by the same amount as the expense.
- It is a rare Non-Cash Expense allowing us to reduce earnings without losing cash!
- Buildings must use “straight line” depreciation while equipment can use “straight line” or “accelerated”. There are a few types of “accelerated” schedules and the IRS intermittently changes them. “Accelerated” depreciation uses the updated “base” (ie the asset’s value after the last depreciation period) to calculate the new depreciation amount. The resulting curve will allow you to save taxes near term by taking steeper depreciation expense.
Categorization of Assets
“Current Assets”: assets such as cash, receivables, inventory and prepaid expenses which are probably convertible to cash within 1 year.
“Net Fixed Assets” or “net book value of assets”: gross fixed assets (using purchase price) + accumulated depreciation
- By breaking net fixed assets into gross + depreciation we can estimate how old the assets are.
- Assets are typically listed on a balance sheet in descending order of liquidity (ie cash is first).
Understanding the difference between earnings and cash
When you are investing in a business you may find that it has little cash and even if the business is very profitable it is very possible to have high retained earnings but no cash. Retained earnings are not cash! It is not a sum just sitting in a bank. It reflects that the business has been profitable, and also your ownership but it is not spendable like cash. It can be tied up in assets.
- On a daily basis, cash runs the business!