Chapter OneElements of Business Accounting
In This Chapter
* Working with the accounting equation
* Understanding the differences between cash- and accrual-basis accounting
* Examining the three primary business financial statements
* Seeing the effects of crooked accounting on financial statements
The starting point in accounting is identifying the entity being accounted for. A business entity can be legally organized as a partnership, corporation, limited liability company, or other structures permitted by law. Alternatively, a business entity simply may consist of the business activities of an individual, in which case it's called a sole proprietorship. Regardless of how the business entity is legally established, it's treated as a separate entity or distinct person for accounting purposes.
Keeping the Accounting Equation in Balance
If you've ever studied accounting, you probably recall the accounting equation:
Assets = Liabilities + Owners' equity
The accounting equation says a lot in very few words. It's like the visible part of an iceberg - a lot of important points are hidden under the water. Notice the two sides to the equation: assets on one side and the claims against the assets on the other side. These claims arise from credit extended to the business (liabilities) and capital invested by owners in the business (owners' equity). (The claims of liabilities are significantly different than the claims of owners; liabilities have seniority and priority for payment over the claims of owners.)
Suppose a business has $10 million total assets. These assets didn't fall down like manna from heaven (as my old accounting professor was fond of saying). The money for the assets came from somewhere. The business's creditors (to whom it owes its liabilities) may have supplied, say, $4 million of its total assets. Therefore, the owners' equity sources provided the other $6 million.
Business accounting is based on the two-sided nature of the accounting equation. Both assets and sources of assets are accounted for, which leads, quite naturally, to double entry accounting. Double entry, in essence, means two-sided. It's based on the general economic exchange model. In economic transactions, something is given and something is received in exchange. For example, I recently bought an iPod from Apple Computer. Apple gave me the iPod and received my money. Another example involves a business that borrows money from its bank. The business gives the bank a legal instrument called a note promising to return the money at a future date and to pay interest over the time the money is borrowed. In exchange for the note, the business receives the money. (Chapter 3 explains how to implement double entry accounting.)
Q. Is each of the following equations correct? What key point does each equation raise?
a. $250,000 Assets = $100,000 Liabilities + $100,000 Owners' equity
b. $2,345,000 Assets = $46,900 Liabilities + $2,298,100 Owners' equity
c. $26,450 Assets = $675,000 Liabilities - $648,550 Owners' equity
d. $4,650,000 Assets = $4,250,000 Liabilities + $400,000 Owners' equity
A. Each accounting equation offers an important lesson.
a. Whoops! This accounting equation doesn't balance, so clearly something's wrong. Either liabilities, owner's equity, or some combination of both is $50,000 too low, or the two items on the right-hand side could be correct, in which case total assets are overstated $50,000. With an unbalanced equation such as this, the accountant definitely should find the error or errors and make appropriate correcting entries.
b. This accounting equation balances, but, wow! Look at the very small size of liabilities relative to assets. This kind of contrast isn't typical. The liabilities of a typical business usually account for a much larger percentage of its total assets.
c. This accounting equation balances, but the business has a large negative owners' equity. Such a large negative amount of owners' equity means the business has suffered major losses that have wiped out almost all its assets. You wouldn't want to be one of this business's creditors (or one of its owners either).
d. This accounting equation balances and is correct, but you should notice that the business is highly leveraged, which means the ratio of debt to equity (liabilities divided by owners' equity) is very high, more than 10 to 1. This ratio is quite unusual.
1. Which of the following is the normal way to present the accounting equation?
a. Liabilities = Assets - Owners' equity
b. Assets - Liabilities = Owners' equity
c. Assets = Liabilities + Owners' equity
d. Assets - Liabilities - Owners' equity = 0
2. A business has $485,000 total liabilities and $1,200,000 total owners' equity. What is the amount of its total assets?
3. A business has $250,000 total liabilities. At start-up, the owners invested $500,000 in the business. Unfortunately, the business has suffered a cumulative loss of $200,000 up to the present time. What is the amount of its total assets at the present time?
4. A business has $175,000 total liabilities. At start-up, the owners invested $250,000 capital. The business has earned $190,000 cumulative profit since its creation, all of which has been retained in the business. What is the total amount of its assets?
Distinguishing Between Cash- and Accrual-Basis Accounting
Cash-basis accounting refers to keeping a record of cash inflows and cash outflows. An individual uses cash-basis accounting in keeping his checkbook because he needs to know his day-to-day cash balance and he needs a journal of his cash receipts and cash expenditures during the year for filing his annual income tax return. Individuals have assets other than cash (such as cars, computers, and homes), and they have liabilities (such as credit card balances and home mortgages). Hardly anyone I know keeps accounting records of their noncash assets and their liabilities (aside from putting bills to pay and receipts for major purchases in folders). Most people keep a checkbook, and that's about it when it comes to their personal accounting.
Although it's perfect for individuals, cash-basis accounting just doesn't cut it for the large majority of businesses. Cash-basis accounting doesn't provide the information that managers need to run a business or the information needed to prepare company tax returns and financial reports. Some small personal service businesses (such as barber shops, lawyers, and real estate brokers) can get by using cash-basis accounting because they have virtually no assets other than cash and they pay their bills right away.
The large majority of businesses use accrual-basis accounting. They keep track of their cash inflows and outflows, of course, but accrual-basis accounting allows them to record all the assets and liabilities of the business. Also, accrual-basis accounting keeps track of the money invested in the business by its owners and the accumulated profit retained in the business. In short, accrual-basis accounting has a much broader scope than cash-basis accounting.
A big difference between cash- and accrual-basis accounting concerns how they measure annual profit of a business. With cash-basis accounting, profit simply equals the total of cash inflows from sales minus the total of cash outflows for expenses of making sales and running the business, or, in other words, the net increase in cash from sales and expenses. With the accrual-basis accounting method, profit is measured differently because the two components of profit - sales revenue and expenses - are recorded differently.
When using accrual-basis accounting, a business records sales revenue when a sale is made and the products and/or services are delivered to the customer, whether the customer pays cash on the spot or receives credit and doesn't pay the business until sometime later. Sales revenue is recorded before cash is actually received. The business doesn't record the cost of the products sold as an expense until sales revenue is recorded, even though the business paid out cash for the products weeks or months earlier. Furthermore, with accrual-basis accounting, a business records operating expenses as soon as they're incurred (as soon as the business has a liability for the expense), even though the expenses aren't paid until sometime later.
Cash-basis accounting doesn't reflect economic reality for businesses that sell and buy on credit, carry inventories of products for sale, invest in long-lived operating assets, and make long-term commitments for such things as employee pensions and retirement benefits. When you look beyond small cash-based business, you quickly realize that businesses need the comprehensive recordkeeping system called accrual-basis accounting. I like to call it "economic reality accounting."
The following example question focuses on certain fundamental differences between cash-basis and accrual-basis accounting regarding the recording of sales revenue and expenses for the purpose of measuring profit.
Q. You started a new business one year ago. You've been very busy dealing with so many problems that you haven't had time to sit down and look at whether you made a profit or not. You haven't run out of cash (which for a start-up venture is quite an accomplishment), but you understand that the sustainability of the business depends on making a profit. The following two summaries present cash flow information for the year and information about two assets and a liability at year-end:
Revenue and Expense Cash Flows For First Year
$558,000 cash receipts from sales
$375,000 cash payments for purchases of products
$340,000 cash payments for other expenses
Two Assets and a Liability at Year-End
$52,000 receivables from customers for sales made to them during the year
$85,000 cost of products in ending inventory that haven't yet been sold
$25,000 liability for unpaid expenses
Compare the profit or loss of your business for its first year according to the cash- and accrual-basis accounting methods.
A. Profit according to cash-basis accounting equals the cash inflow from sales minus the total of cash outflows for expenses (and the total of cash outflows for expenses equals the purchases of products plus other expenses). Thus, under cash-basis accounting, your business has a $157,000 loss for the year ($558,000 sales revenue - $715,000 expenses = $157,000 loss).
Under accrual-basis accounting, you record different amounts for sales revenue and the two expenses, which are calculated as follows:
$558,000 cash receipts from sales + $52,000 year-end receivables from customers = $610,000 sales revenue
$375,000 cash payments for purchases of products - $85,000 year-end inventory of unsold products = $290,000 cost of products sold expense
$340,000 cash payments for other expenses + $25,000 year-end liability for unpaid expenses = $365,000 other expenses
Deducting cost of products sold and other expenses from sales revenue gives a net loss of $45,000 ($610,000 sales revenue - $290,000 cost of products sold - $365,000 other expenses = $45,000 net loss for year).
To answer Questions 5 through 8, please refer to the summary of revenue and expense cash flows and the summary of two assets and a liability at year-end presented in the preceding example question.
5. What would be the amount of accrual-basis sales revenue for the year if the business's year-end receivables had been $92,000?
6. What would be the amount of accrual-basis cost of products sold expense for the year if the business's cost of products held in inventory at year-end had been $95,000?
Solve It 7. What would be the amount of accrual-basis other expenses for the year if the business's liability for unpaid expenses at yearend had been $30,000?
8. Based on the changes for the example given in Questions 5, 6, and 7, determine the profit or loss of the business for its first year.
Summarizing Profit Activities in the Income (Profit & Loss) Statement
As crass as it sounds, business managers get paid to make profit happen. Management literature usually stresses the visionary, leadership, and innovative characteristics of business managers, but these traits aren't worth much if the business suffers losses year after year or fails to establish sustainable profit performance. After all, businesses are profit-motivated, aren't they?
It's not surprising that the income statement takes center stage in business financial reports. The income statement summarizes a company's revenue and other income, expenses, losses, and bottom-line profit or loss for a period. The income statement gets top billing over the other two primary financial statements (the balance sheet and the statement of cash flows), which I discuss later in this chapter. The income statement is referred to informally as the Profit & Loss or P&L statement, although these titles are seldom used in external financial reports. (Alternatively, it may be titled Earnings Statement or Statement of Operations.)
Financial reporting standards demand that an income statement be presented in quarterly and annual financial reports to owners. But financial reporting rules are fairly permissive regarding exactly what information should be reported and how it's presented (see Chapter 5 for the full scoop on income statement disclosure).
Q. Take a look at this extremely abbreviated and condensed income statement for a business's most recent year. (Note: A formal income statement in a financial report must disclose more information than this.)
Income Statement for Year
Sales revenue $26,000,000 Expenses 24,310,000 Net income $1,690,000
This business sells products, which are also called goods or merchandise. The cost of products sold to customers during the year was $14,300,000. Expand the condensed income statement to reflect this additional information.
A. Income statement reporting requires a company to show the cost of goods (products) sold as a separate expense and deduct it immediately below sales revenue. The difference must be reported as gross margin (or gross profit). Therefore, the condensed income statement should be expanded as follows:
Income Statement for Year
Sales revenue $26,000,000 Cost of goods sold 14,300,000 Gross margin $11,700,000 Other expenses 10,010,000 Net income $1,690,000
9. One rule of income statement reporting is that interest expense and income tax expense be reported separately. The $10,010,000 "Other expenses" in the income statement for the answer to the example question includes $350,000 interest expense and $910,000 income tax. Rebuild the income statement given the information for these additional two expenses. Hint: Profit before interest expense is usually labeled "operating earnings," and profit after interest and before income tax expense is usually labeled "earnings before income tax."