Basic Terms and Concepts

There are a few (and only a few) things you need to understand in order to make setting up your accounting system easier. They're basic (trust me), and they will probably clear up any confusion you may have had in the past when talking with your CPA or other technical accounting types.

Debits and CreditsThese are the backbone of any accounting system. Understand how debits and credits work and you'll understand the whole system. Every accounting entry in the general ledger contains both a debit and a credit. Further, all debits must equal all credits. If they don't, the entry is out of balance. That's not good. Out-of-balance entries throw your balance sheet out of balance.

Therefore, the accounting system must have a mechanism to ensure that all entries balance. Indeed, most automated accounting systems won't let you enter an out-of-balance entry-they'll just beep at you until you fix your error.

Depending on what type of account you are dealing with, a debit or credit will either increase or decrease the account balance. (Here comes the hardest part of accounting for most beginners, so pay attention.) Figure 1 illustrates the entries that increase or decrease each type of account.

Figure 1Debits and Credits vs. Account Types

Account         Type Debit          CreditAssets             Increases          DecreasesLiabilities         Decreases          IncreasesIncome            Decreases          IncreasesExpenses         Increases          Decreases

Notice that for every increase in one account, there is an opposite (and equal) decrease in another. That's what keeps the entry in balance. Also notice that debits always go on the left and credits on the right.

Let's take a look at two sample entries and try out these debits and credits:

In the first stage of the example we'll record a credit sale:

Accounts Receivable          $1,000 Sales Income                     $1,000

If you looked at the general ledger right now, you would see that receivables had a balance of $1,000 and income also had a balance of $1,000.

Now we'll record the collection of the receivable:

Cash                                 $1,000 Accounts Receivable          $1,000

Notice how both parts of each entry balance? See how in the end, the receivables balance is back to zero? That's as it should be once the balance is paid. The net result is the same as if we conducted the whole transaction in cash:

Cash                     $1,000 Sales Income         $1,000

Of course, there would probably be a period of time between the recording of the receivable and its collection.

That's it. Accounting doesn't really get much harder. Everything else is just a variation on the same theme. Make sure you understand debits and credits and how they increase and decrease each type of account.

Assets and LiabilitiesBalance sheet accounts are the assets and liabilities. When we set up your chart of accounts, there will be separate sections and numbering schemes for the assets and liabilities that make up the balance sheet.

A quick reminder: Increase assets with a debit and decrease them with a credit. Increase liabilities with a credit and decrease them with a debit.

Identifying assetsSimply stated, assets are those things of value that your company owns. The cash in your bank account is an asset. So is the company car you drive. Assets are the objects, rights and claims owned by and having value for the firm.

Since your company has a right to the future collection of money, accounts receivable are an asset-probably a major asset, at that. The machinery on your production floor is also an asset. If your firm owns real estate or other tangible property, those are considered assets as well. If you were a bank, the loans you make would be considered assets since they represent a right of future collection.

There may also be intangible assets owned by your company. Patents, the exclusive right to use a trademark, and goodwill from the acquisition of another company are such intangible assets. Their value can be somewhat hazy.

Generally, the value of intangible assets is whatever both parties agree to when the assets are created. In the case of a patent, the value is often linked to its development costs. Goodwill is often the difference between the purchase price of a company and the value of the assets acquired (net of accumulated depreciation).

Identifying liabilitiesThink of liabilities as the opposite of assets. These are the obligations of one company to another. Accounts payable are liabilities, since they represent your company's future duty to pay a vendor. So is the loan you took from your bank. If you were a bank, your customer's deposits would be a liability, since they represent future claims against the bank.

We segregate liabilities into short-term and long-term categories on the balance sheet. This division is nothing more than separating those liabilities scheduled for payment within the next accounting period (usually the next twelve months) from those not to be paid until later. We often separate debt like this. It gives readers a clearer picture of how much the company owes and when.

Owners' equityAfter the liability section in both the chart of accounts and the balance sheet comes owners' equity. This is the difference between assets and liabilities. Hopefully, it's positive-assets exceed liabilities and we have a positive owners' equity. In this section we'll put in things like

Partners' capital accounts Stock Retained earnings

Another quick reminder: Owners' equity is increased and decreased just like a liability:

Debits decrease Credits increase

Most automated accounting systems require identification of the retained earnings account. Many of them will beep at you if you don't do so.

By the way, retained earnings are the accumulated profits from prior years. At the end of one accounting year, all the income and expense accounts are netted against one another, and a single number (profit or loss for the year) is moved into the retained earnings account. This is what belongs to the company's owners-that's why it's in the owners' equity section. The income and expense accounts go to zero. That's how we're able to begin the new year with a clean slate against which to track income and expense.

The balance sheet, on the other hand, does not get zeroed out at year-end. The balance in each asset, liability, and owners' equity account rolls into the next year. So the ending balance of one year becomes the beginning balance of the next.

Think of the balance sheet as today's snapshot of the assets and liabilities the company has acquired since the first day of business. The income statement, in contrast, is a summation of the income and expenses from the first day of this accounting period (probably from the beginning of this fiscal year).

Income and ExpensesFurther down in the chart of accounts (usually after the owners' equity section) come the income and expense accounts. Most companies want to keep track of just where they get income and where it goes, and these accounts tell you.

A final reminder: For income accounts, use credits to increase them and debits to decrease them. For expense accounts, use debits to increase them and credits to decrease them.

Income accountsIf you have several lines of business, you'll probably want to establish an income account for each. In that way, you can identify exactly where your income is coming from. Adding them together yields total revenue.

Typical income accounts would be

Sales revenue from product A Sales revenue from product B (and so on for each product you want to track) Interest income Income from sale of assets Consulting income

Most companies have only a few income accounts. That's really the way you want it. Too many accounts are a burden for the accounting department and probably don't tell management what it wants to know. Nevertheless, if there's a source of income you want to track, create an account for it in the chart of accounts and use it.

Expense accountsMost companies have a separate account for each type of expense they incur. Your company probably incurs pretty much the same expenses month after month, so once they are established, the expense accounts won't vary much from month to month. Typical expense accounts include

Salaries and wages Telephone Electric utilities Repairs Maintenance Depreciation Amortization Interest Rent

Income Statements

An income statement, otherwise known as a profit and loss statement, is a summary of a company’s profit or loss during any one given period of time, such as a month, three months, or one year. The income statement records all revenues for a business during this given period, as well as the operating expenses for the business.

What are income statements used for? You use an income statement to track revenues and expenses so that you can determine the operating performance of your business over a period of time. Small business owners use these statements to find out what areas of their business are over budget or under budget. Specific items that are causing unexpected expenditures can be pinpointed, such as phone, fax, mail, or supply expenses. Income statements can also track dramatic increases in product returns or cost of goods sold as a percentage of sales. They also can be used to determine income tax liability.

It is very important to format an income statement so that it is appropriate to the business being conducted.

Income statements, along with balance sheets, are the most basic elements required by potential lenders, such as banks, investors, and vendors. They will use the financial reporting contained therein to determine credit limits.

1. Sales The sales figure represents the amount of revenue generated by the business. The amount recorded here is the total sales, less any product returns or sales discounts.

2. Cost of goods sold This number represents the costs directly associated with making or acquiring your products. Costs include materials purchased from outside suppliers used in the manufacture of your product, as well as any internal expenses directly expended in the manufacturing process.

• Gross profit Gross profit is derived by subtracting the cost of goods sold from net sales. It does not include any operating expenses or income taxes.

3. Operating expenses These are the daily expenses incurred in the operation of your business. In this sample, they are divided into two categories: selling, and general and administrative expenses.

• Sales salaries These are the salaries plus bonuses and commissions paid to your sales staff.

• Collateral and promotions Collateral fees are expenses incurred in the creation or purchase of printed sales materials used by your sales staff in marketing and selling your product. Promotion fees include any product samples and giveaways used to promote or sell your product.

• Advertising These represent all costs involved in creating and placing print or multi-media advertising.

• Other sales costs These include any other costs associated with selling your product. They may include travel, client meals, sales meetings, equipment rental for presentations, copying, or miscellaneous printing costs.

• Office salaries These are the salaries of full- and part-time office personnel.

• Rent These are the fees incurred to rent or lease office or industrial space.

• Utilities These include costs for heating, air conditioning, electricity, phone equipment rental, and phone usage used in connection with your business.

• Depreciation Depreciation is an annual expense that takes into account the loss in value of equipment used in your business. Examples of equipment that may be subject to depreciation includes copiers, computers, printers, and fax machines.

• Other overhead costs Expense items that do not fall into other categories or cannot be clearly associated with a particular product or function are considered to be other overhead costs. These types of expenses may include insurance, office supplies, or cleaning services.

4. Total expenses This is a tabulation of all expenses incurred in running your business, exclusive of taxes or interest expense on interest income, if any.

5. Net income before taxes This number represents the amount of income earned by a business prior to paying income taxes. This figure is arrived at by subtracting total operating expenses from gross profit.

6. Taxes This is the amount of income taxes you owe to the federal government and, if applicable, state and local government taxes.

7. Net income This is the amount of money the business has earned after paying income taxes.

Overview

The Profit and Loss (P&L) Statement is also known as the Income Statement. It shows how well a company buys and sells inventory (or services) to make a profit. A firm must create a profit in order to survive and remain solvent. Careful analysis of the components of a P&L is important in determining the cash flow available to repay existing debt, finance additional debt (for business expansion), or to reinvest in the company.

Just as the Balance Sheet (see Balance Sheet Fact Sheet, CDFS-1154) is a snapshot of the financial condition of a company at a certain point in time, the Profit and Loss statement shows the results of financial operations over a period of time. The amount of time could be a month, a quarter of a year, a half year, or a year.

Profit and Loss Statement Format

The categories of a profit and loss statement are arranged in a specific order regardless of the legal form of the business (i.e., sole proprietor, C corporation, etc.). Within each category, revenues and expenses may be listed separately or grouped. Financial reporting needs to remain consistent over a period of time. Listing the same type of expense under different headings year after year may raise a red flag.

Expense Categories

The following is a typical P&L statement. Each expense category is made up of either variable, fixed, or "discretionary" expenses.

The Cost of Goods Sold (COGS) is the general category for all production related expenses which is subtracted first from sales. COGS is defined as:

COGS = (Beginning Inventory) + (Purchases of Inventory) - (Ending Inventory)

For the manufacturing firm, the "Purchases of Inventory" would include the raw materials and direct labor used to produce a product.

Sales- Cost of Goods Sold (variable)

= Gross Profit- Selling & Gen. Admin. (fixed/period)

= Operating Profit- Officer Salaries (discretionary)- Interest (discretionary)- Depreciation (discretionary)- Rent (discretionary)+/- Other Income/Expenses

= Earnings Before Tax- Taxes

= Profit After Tax

Completing the computation results in the Gross Profit (Sales - COGS). At this point, all production related expenses are covered and the remaining overhead costs associated with business operations must be subtracted in order to determine the company's Earnings Before Tax (EBTx).

The Selling, General and Administrative (SG&A) category contains fixed, variable, and discretionary expenses and may include:

Salaried personnel Travel and entertainment Rent Utilities Postage Printing Insurance Interest Depreciation Dues/Subscriptions Advertising

It is a mixture of many different things and thus, difficult to analyze. Most often, the expenses listed under SG&A tend to remain fixed over a relevant range of time. However, watch for variability as production levels increase significantly or sales change.

Taking a Closer Look

Simply stated, profits are equal to the difference between revenues and expenses:

Profits = Revenues - Expenses

To understand how well a company buys and sells inventory or services to make a profit, one must look at the types of expenses being charged against revenues and ask whether or not these are being recorded accurately and consistently. For analysis purposes, expenses are classified as variable, fixed, and discretionary.

Variable Expenses

Variable expenses are directly affected by sales. They are the production-related expenses, such as raw materials, direct labor, commissions, and shipping. On the P&L, they are listed as the "Cost of Goods Sold" (COGS) and are typically the largest expense category.

Fixed Expenses

Fixed expenses are constant. They do not vary with sales or production. They are the basic overhead costs of the company, such as utilities, insurance, postage, etc., which are charged against revenues on a periodic basis (weekly, monthly, annually). On the P&L, fixed expenses

are listed under the heading, "Selling, General and Administrative" (SGA) and may contain several different categories.

Discretionary Expenses

The National Development Council, specialists in economic development finance and business credit analysis training, proposes a third type of expense classified as "discretionary." Discretionary expenses are those which the business owner may control in order to decrease the reported profits.

When looking at the P&L, the following expenses are separated from the SGA for further analysis:

Officers' Salaries Interest Expense Depreciation Rent

A closer look at these items provides one with the questions to ask the entrepreneur.

Officers' Salaries. As a specific line item in SG&A, has this amount increased or decreased over the years? It is usually a difficult question to pose in as much as, how much is too much for officers to be paid? Or, are they willing to decrease their salaries in order to free up additional dollars in the company?

A careful analysis of the financial statements may reveal additional forms of officer compensation including dividends, travel and entertainment expenses, rent expense (officers own the facility where the company is housed), interest on officers' loans to the company, pension fund investments, and others. When officer salaries are low, there are usually other forms of compensation.

Interest. Interest is a discretionary expense item only when the amount of debt a company carries increases, decreases, or is refinanced. If a company restructures existing financing or pays off a loan, the interest expense may be less. However, this may be offset by any additional debt the company incurs due to a business expansion project (which is primarily interest expense in the early stages of the loan). Interest expense should be looked at carefully because it is usually affected by new financing.

Depreciation. Depreciation is a non-cash expense which reflects the "wearing out" of assets over time. When assets are purchased (with the exception of land), they are useful to a company for a limited number of years. The cost of each asset is expensed over the period of time during which services are received from the asset. The purpose of depreciating an asset (even though no actual "cash" is paid) is because at the point in time when the asset wears out, a new cash payment must be made in order to replace the asset.

Different assets have different depreciation schedules (or "useful life" as defined by the Internal Revenue Service). If a company is profitable, it may accelerate depreciation in order to reduce reported profits. Because depreciation is a non-cash expense, a cash payment is not made by the company to "Depreciation," and more dollars are available to invest in new assets.

When analyzing depreciation, generally the total amount is not available for debt service. Some depreciation should be allocated for replacement purposes and short-term asset purchases.

Rent. Rent expense may be discretionary for several reasons. First, the company officers may own the building or facility and rent it to the business. Typically, the amount paid in rent is enough to cover the debt service on the building and other associated expenses, such as real estate taxes and insurance, which may or may not be included in the lease agreement.

If the amount charged to rent over a period of time (historical financials) has increased significantly, questions should be raised. Have the expenses actually increased or is the corporation attempting to decrease reported profits and thus, pay less in taxes? Furthermore, is there any debt on the building or do the officers own the building free and clear and simply rent it to the company? If this is the case, could they forego the rent payment, leaving more cash in the company?

Second, the company could eliminate rent payment by purchasing the building they are currently leasing. Cash which was used to make a monthly rent payment would be available to the company.

Discretionary Expenses are "Fudgeable"

Carefully examining the expense categories of rent, officers' compensation, interest, and depreciation may uncover "hidden" cash flow available to repay proposed new debt. These particular expenses, when compared to other less flexible categories grouped under Selling, General and Administrative, are fudgeable. In other words, they may be manipulated to either reduce or overstate the reported earnings before tax of a company.

A company may overstate expenses in order to reduce the amount of earning before tax and thus, lower the company's tax liability, or a company may want to understate officers' salaries and other expenses which would increase the earnings before tax (overstate profits), and thus, give the illusion of debt capacity. A careful look at the discretionary expenses and how they are controlled is critical to understanding the profit and loss statement.

Pro Forma Cash Flows

A pro forma cash flow is created to predict inflow and outflow of cash to your business. It is particularly valuable in predicting when your business may experience a cash shortage. This allows you to determine in advance whether or not you will need to cover your cash shortage by borrowing money, selling more stock in the business, or taking other steps, such as cutting expenses, to improve your cash position.

Starting cash To create a pro forma cash flow, you need to know your current cash position. To demonstrate the steps

of building a pro forma cash flow, let’s use a hypothetical company, West Coast Shoe Wholesaler’s, Inc. West Coast Shoe is beginning 2000 with $90,000 in its checking account.

Cash sources

• Receivables (sales) West Coast Shoe sells to retailers on a credit basis. Retailers pay their accounts to West Coast Shoe thirty days after they are shipped their shoe orders. This means that in January 2000, West Coast Shoe will not receive cash from sales made in January, but will be collecting on sales made in December 1999. Those sales totaled $30,000, so that amount is entered in the January sales column of the cash flow.

• Total cash sources This is a totaling of all cash received from all sources. Receivables from sales to retailers constitute the only source of cash for West Coast Shoe. Your cash sources may be more involved.

Cash uses

• Cost of goods West Coast Shoe purchases the same dollar value of shoes from manufacturers each month—$15,000. And West Coast Shoe pays immediately for receipt of these purchases. $15,000 is entered as the cost of goods. Your company may try to balance its receipt of goods to match anticipated sales. This will result in a vacillating cost of goods figure each month. Most firms buy goods on credit and delay paying for those goods as long as they can to improve their cash flow. These factors need to be taken into consideration when creating a pro forma cash flow. Small or new firms, however, often have to prepay for goods until credit is established.

• Operating expenses The operating expenses for West Coast Shoe are $10,000 per month.

• Income taxes Income taxes for most businesses fluctuate from month to month because both state and federal taxes are paid as estimates on a quarterly, not monthly, basis. West Coast Shoe paid its estimated tax installments in December and doesn’t have any tax payments due in January.

• Total cash uses This is a totaling of all cash expenditures. In the case of West Coast Shoe, in the month of January, this amounts to $25,000 derived from cost of goods and operating expenses.

Net change in cash position This figure is derived by subtracting the estimated cash uses from the estimated cash sources. For West Coast Shoe there is a net change in cash position of +$5,000.

By adding the net change figure to the starting cash figure, you will have the starting cash figure for the next month or time period for which you are calculating a cash flow. In this case, West Coast Shoe will begin February with $95,000.

Balance Sheets

A balance sheet is a snapshot of a business’ financial condition at a specific moment in time, usually at the close of an accounting period. A balance sheet comprises assets, liabilities, and owners’ or

stockholders’ equity. Assets and liabilities are divided into short- and long-term obligations including cash accounts such as checking, money market, or government securities. At any given time, assets must equal liabilities plus owners’ equity. An asset is anything the business owns that has monetary value. Liabilities are the claims of creditors against the assets of the business.

What is a balance sheet used for? A balance sheet helps a small business owner quickly get a handle on the financial strength and capabilities of the business. Is the business in a position to expand? Can the business easily handle the normal financial ebbs and flows of revenues and expenses? Or should the business take immediate steps to bolster cash reserves?

Balance sheets can identify and analyze trends, particularly in the area of receivables and payables. Is the receivables cycle lengthening? Can receivables be collected more aggressively? Is some debt uncollectable? Has the business been slowing down payables to forestall an inevitable cash shortage?

Balance sheets, along with income statements, are the most basic elements in providing financial reporting to potential lenders such as banks, investors, and vendors who are considering how much credit to grant the firm.

1. Assets Assets are subdivided into current and long-term assets to reflect the ease of liquidating each asset. Cash, for obvious reasons, is considered the most liquid of all assets. Long-term assets, such as real estate or machinery, are less likely to sell overnight or have the capability of being quickly converted into a current asset such as cash.

2. Current assets Current assets are any assets that can be easily converted into cash within one calendar year. Examples of current assets would be checking or money market accounts, accounts receivable, and notes receivable that are due within one year’s time.

• Cash Money available immediately, such as in checking accounts, is the most liquid of all short-term assets.

• Accounts receivables This is money owed to the business for purchases made by customers, suppliers, and other vendors.

• Notes receivables Notes receivables that are due within one year are current assets. Notes that cannot be collected on within one year should be considered long-term assets.

3. Fixed assets Fixed assets include land, buildings, machinery, and vehicles that are used in connection with the business.

• Land Land is considered a fixed asset but, unlike other fixed assets, is not depreciated, because land is considered an asset that never wears out.

• Buildings Buildings are categorized as fixed assets and are depreciated over time.

• Office equipment This includes office equipment such as copiers, fax machines, printers, and computers used in your business.

• Machinery This figure represents machines and equipment used in your plant to produce your product. Examples of machinery might include lathes, conveyor belts, or a printing press.

• Vehicles This would include any vehicles used in your business.

• Total fixed assets This is the total dollar value of all fixed assets in your business, less any accumulated depreciation.

4. Total assets This figure represents the total dollar value of both the short-term and long-term assets of your business.

5. Liabilities and owners’ equity This includes all debts and obligations owed by the business to outside creditors, vendors, or banks that are payable within one year, plus the owners’ equity. Often, this side of the balance sheet is simply referred to as “Liabilities.”

• Accounts payable This is comprised of all short-term obligations owed by your business to creditors, suppliers, and other vendors. Accounts payable can include supplies and materials acquired on credit.

• Notes payable This represents money owed on a short-term collection cycle of one year or less. It may include bank notes, mortgage obligations, or vehicle payments.

• Accrued payroll and withholding This includes any earned wages or withholdings that are owed to or for employees but have not yet been paid.

• Total current liabilities This is the sum total of all current liabilities owed to creditors that must be paid within a one-year time frame.

• Long-term liabilities These are any debts or obligations owed by the business that are due more than one year out from the current date.

• Mortgage note payable This is the balance of a mortgage that extends out beyond the current year. For example, you may have paid off three years of a fifteen-year mortgage note, of which the remaining eleven years, not counting the current year, are considered long-term.

• Owners’ equity Sometimes this is referred to as stockholders’ equity. Owners’ equity is made up of the initial investment in the business as well as any retained earnings that are reinvested in the business.

• Common stock This is stock issued as part of the initial or later-stage investment in the business.

• Retained earnings These are earnings reinvested in the business after the deduction of any distributions to shareholders, such as dividend payments.

6. Total liabilities and owners’ equity This comprises all debts and monies that are owed to outside creditors, vendors, or banks and the remaining monies that are owed to shareholders, including retained earnings reinvested in the business.

Depreciation

The concept of depreciation is really pretty simple. For example, let’s say you purchase a truck for your business. The truck loses value the minute you drive it out of the dealership. The truck is considered an operational asset in running your business. Each year that you own the truck, it loses some value, until the truck finally stops running and has no value to the business. Measuring the loss in value of an asset is known as depreciation.

Depreciation is considered an expense and is listed in an income statement under expenses. In addition to vehicles that may be used in your business, you can depreciate office furniture, office equipment, any buildings you own, and machinery you use to manufacture products.

Land is not considered an expense, nor can it be depreciated. Land does not wear out like vehicles or equipment.

To find the annual depreciation cost for your assets, you need to know the initial cost of the assets. You also need to determine how many years you think the assets will retain some value for your business. In the case of the truck, it may only have a useful life of ten years before it wears out and loses all value.

Straight-line depreciation Straight-line depreciation is considered to be the most common method of depreciating assets. To compute the amount of annual depreciation expense using the straight-line method requires two numbers: the initial cost of the asset and its estimated useful life. For example, you purchase a truck for $20,000 and expect it to have use in your business for ten years. Using the straight-line method for determining depreciation, you would divide the initial cost of the truck by its useful life.

The $20,000 becomes a depreciation expense that is reported on your income statement under operation expenses at the end of each year.

For tax purposes, some accountants prefer to use other methods of accelerating depreciation in order to record larger amounts of depreciation in the early years of the asset to reduce tax bills as soon as possible.

You need, additionally, to check the regulations published by the federal Internal Revenue Service and various state revenue authorities for any specific rules regarding depreciation and methods of calculating depreciation for various types of assets.

Chapter 3 - Cash flow accounting

Chapter objectivesStructure of the chapterAim of a cash flow statementStatements of source and application of fundsFunds use and credit planningKey terms

It can be argued that 'profit' does not always give a useful or meaningful picture of a company's operations. Readers of a company's financial statements might even be misled by a reported profit figure.

Shareholders might believe that if a company makes a profit after tax of say $100,000, then this is the amount which it could afford to pay as a dividend. Unless the company has sufficient cash available to stay in business and also to pay a dividend, the shareholders' expectations would be wrong. Survival of a business depends not only on profits but perhaps more on its ability to pay its debts when they fall due. Such payments might include 'profit and loss' items such as material purchases, wages, interest and taxation etc, but also capital payments for new fixed assets and the repayment of loan capital when this falls due (e.g. on the redemption of debentures).

Chapter objectives

This chapter is intended to provide an explanation of:

The aim, use and construction of cash flow statements

The meaning and calculation of the source and application of funds statement and their importance to business

A discussion on credit and types of loans available to businesses

An explanation of the cost of funds and capital

The importance and calculation of ownership costs, including depreciation, interest, repair, taxes and insurance.

Structure of the chapter

"Cash flow" is one of the most vital elements in the survival of a business. It can be positive, or negative, which is obviously a most undesirable situation. The chapter develops the concept of cash flow and then shows how the funds can be used in the business. Funds are not only generated internally; they may be externally generated, and so the chapter finishes with a discussion of externally generated funds.

Aim of a cash flow statement

The aim of a cash flow statement should be to assist users:

to assess the company's ability to generate positive cash flows in the future to assess its ability to meet its obligations to service loans, pay dividends etc to assess the reasons for differences between reported and related cash flows to assess the effect on its finances of major transactions in the year.

The statement therefore shows changes in cash and cash equivalents rather than working capital.

Indirect method cash flow statement

Figure 3.1 shows a pro forma cash flow statement.

Figure 3.1 Pro forma cash flow statement

Cash Flow Statement For The Year Ended 31 December 19X4

$ $

Net cash inflow from operating activities X

Returns on investments and servicing of finance

Interest received X

Interest paid (X)

Dividends paid (X)

Net cash inflow/ (outflow) from returns on investments and servicing of finance X

Taxation

Corporation tax paid (X)

Tax paid (X)

Investing activities

Payments to acquire intangible fixed assets (X)

Payments to acquire tangible fixed assets (X)

Receipts from sales of tangible fixed assets X

Net cash inflow/ (outflow) from investing activities X or (X)

Net cash inflow before financing X

Financing

Issue of ordinary capital X

Repurchase of debenture loan (X)

Expenses paid in connection with share issues (X)

Net cash inflow/ (outflow) from financing X or (X)

Increase/ (Decrease) in cash and cash equivalents X

NOTES ON THE CASH FLOW STATEMENT

1. Reconciliation of operating profit to net cash inflow from operating activities

$

Operating profit X

Depreciation charges X

Loss on sale of tangible fixed assets X

Increase/(decrease) in stocks (X)

Increase/(decrease) in debtors (X)

Increase/(decrease) in creditors X

Net cash inflow from operating activities X

2. Analysis of changes in cash and cash equivalents during the year

Balance at 1 January 19X4 X

Net cash inflow X

Balance at 31 December 19X4 X

3. Analysis of the balances of cash and cash equivalents as shown in the balance sheet

19X4 19X3 Change in year

$ $ $

Cash at bank and in hand X X (X)

Short term investments X X X

Bank overdrafts (X) (X) (X)

X X X

4. Analysis of changes in finance during the year

Share capital Debenture loan

$ $

Balance at 1 January 19X4 X X

Cash inflow/(outflow) from financing X (X)

Profit on repurchase of debenture loan for less than its book value - (X)

Balance at 31 December 19X4 X X

Note: Any transactions which do not result in a cash flow should not be reported in the statement. Movements within cash or cash equivalents should not be reported.

Explanations

It is often difficult to conceptualise just what is "cash" and what are "cash equivalents". Cash need not be physical money; it can take other forms:

a) Cash in hand and deposits repayable on demand with any bank or financial institution.

b) Cash equivalents: Short term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value.

c) Operating activities: Principal revenue-producing activities of the company and other activities that are not investing or financing activities. The reconciliation between the operating profit reported in the profit and loss account and the net cash flow from operating activities must show the movements in stocks, debtors and creditors related to operating activities.

d) Returns on investments and servicing of finance. Cash inflows from these sources includes:

i) interest received, also any related tax recovered, andii) dividends received.

Cash outflows from these sources includes:

i) interest paidii) dividends paidiii) interest element of finance lease payments.

e) Taxation: These cash flows will be those to and from the tax authorities in relation to the company's revenue and capital profits, i.e. corporation tax.

f) Investing activities: the acquisition and disposal of long term assets and other investments not included in cash equivalents.

Cash receipts include:

i) receipts from sales or disposals of fixed assets (or current asset investments)

ii) receipts from sales of investments in subsidiary undertakings net of any cash or cash equivalents transferred as part of the sale

iii) receipts from sales of investments in other entities

iv) receipts from repayment or sales of loans made to other entities.

Cash payments include;

i) payments to acquire fixed assets

ii) payments to acquire investments in subsidiary net of balances of cash and cash equivalents acquired

iii) payments to acquire investments in other entities

iv) loans made and payments to acquire debt of other entities.

g) Financing: activities that result in changes in the size and composition of the equity capital and borrowings of the enterprise.

Financing cash inflows include:

i) receipts from issuing shares or other equity instrumentsii) receipts from issuing debentures, loans, notes and bonds and so on.

Financing cash outflows include:

i) repayments of amounts borrowedii) the capital element of finance lease rental paymentsiii) payments to re-acquire or redeem the entity's shares.

Now attempt exercise 3.1.

Exercise 3.1 Cash flow statement

Set out below are the accounts for TPK Pvt Ltd as at 31 December 19X4 and 19X5.

PROFIT AND LOSS ACCOUNTS FOR THE YEARS TO 31 DECEMBER

19X4 19X5

Z$'000 Z$'000

Operating profit 9,400 20,640

Interest paid - (280)

Interest received 100 40

Profit before taxation 9,500 20,400

Taxation (3,200) (5,200)

Profit after taxation 6,300 15,200

Dividends

Preference (paid) (100) (100)

Ordinary: interim (paid) 1,000) (2,000)

final (proposed) (3,000) (6,000)

Retained profit for the year 2,200 7,100

BALANCE SHEETS AS AT 31 DECEMBER

Fixed Assets

Plant, machinery and equipment at cost 17,600 23,900

Less: accumulated depreciation 9,500 10,750

8,100 13,150

Current Assets

Stocks 5,000 15,000

Trade debtors 8,600 26,700

Prepayments 300 400

Cash at bank and in hand 600 -

14,500 42,100

Current liabilities

Bank overdraft - 16,200

Trade creditors 6,000 10,000

Accruals 800 1,000

Taxation 3,200 5,200

Dividends 3,200 6,000

3,000 38,400

9,600 16,850

Share capital

Ordinary shares of $1 each 5,000 5,000

10% preference shares of $1 each 1,000 1,000

Profit and loss account 3,000 10,100

9,000 16,100

Loans

15% debenture stock 600 750

9,600 16,850

Prepare a cash flow statement for the year to 31 December 19X5.

Statements of source and application of funds

Although cash flow statements have now superseded statements of source and application of funds, funds flow statements may not disappear entirely. Some businesses or industries will continue to find fund flow statements useful and informative. For this reason, it is necessary to examine funds flow statements.

Funds statement on a cash basis

Funds statements on a cash basis can be prepared by classifying and/or consolidating:

a) net balance sheet changes that occur between two points in time into changes that increase cash and changes that decrease cash

b) from the Income statement and the surplus (profit and loss) statement, the factors that increase cash and the factors that decrease cash and

c) this information in a sources and uses of funds statement form.

Step (a) involves comparing two relevant Balance sheets side by side and then computing the changes in the various accounts.

Sources of funds that increase cash

Sources of funds which increase cash are as follows:

a net decrease in any asset other than cash or fixed assets a gross decrease in fixed assets a net increase in any liability proceeds from the sale of preferred or common stock funds provided by operations (which usually are not expressed directly in the income statement).

To determine funds provided by operations, we have to add back depreciation to net income after taxes. In other words, suppose we have:

Net income after taxes of a company, being = $750,000

and depreciation (non-cash expense), being = $100,500

850,500

Then, the funds provided by operations of such a company will be obtained by adding the values of the two above items, i.e. $850,500. Thus, the net income of a company usually understates the value of funds provided by operations by the value of the depreciation - in this case by $100,500.

But then, depreciation is not a source of funds, since funds are generated only from operations. Thus, if a company sustains an operating loss before depreciation, funds are not provided regardless of the magnitude of the depreciation charges.

Application of funds of a company usually include:

a net increase in any asset other than cash or fixed assets a gross increase in fixed assets a net decrease in any liability a retirement or purchase of stock and the payment of cash dividends.

To avoid double counting, we usually compute gross changes in fixed assets by adding depreciation for the period to net fixed assets at the ending financial statement date and subtract from the resulting amount the net fixed assets at the beginning financial statement date. The residual represents the gross change in fixed assets for the period. If the residual is positive, it represents a use of funds; if it is negative, it represents a source of funds.

Once all sources and applications of funds are computed, they may be arranged in statement form so that we can analyse them better.

Now attempt exercises 3.2 and 3.3

Exercise 3.2 Source and application of funds I

Given below are some different sources and applications of funds finance items purposely scattered for an Agribusiness Company K for the year ended 31 December 19X8.

1) Identify them as sources and applications of funds, and arrange them in a proper manner with the Sources of funds on the left and the Applications on the right of a tabulated statement for the said period.

2) Comment briefly on some of the uses of the tabulated statement.

$

Increase in cash position = 12,000

Decrease in debtors = 8,000

Increase in long term debt = 2,500

Increase in stocks = 26,500

Increase in tax prepayments = 2,000

Net profit = 35,000

Increase in other accruals = 3,000

Additions to fixed assets = 4,500

Cash dividends = 15,000

Increase in bank loans = 20,000

Increase in prepaid expenses = 2,500

Increase in investments = 9,000

Increase in creditors = 5,000

Decrease in accrued taxes = 8,000

Depreciation = 6,000

Note: The above figures are based on the balance sheet and income statement of Company K, which are not shown in this exercise.

Exercise 3.3 Sources and applications of funds II

Using the data and information in the annual reports (especially the balance sheet and income statements) of Cerial Marketing Board provided for 1993 and 1992:

a) compute and identify the sources and applications of funds of the parastatal for the years 1992 and 1993 and

b) arrange them into a sources and applications of funds statement for 1993.

Funds use and credit planning

Funds (or capital) is a collective term applied to the assortment of productive inputs that have been produced. Funds may be broadly categorised into operating (or working) capital (difference between current assets and current liabilities), and ownership (or investment) capital.

Operating capital in a company or firm usually refers to production inputs that are normally used up within a production year. On the other hand, investment capital (or funds) refers to durable resources like machines and buildings in which money invested is tied up for several years. Funds are generally quantified in monetary value terms.

Funds use, especially borrowed capital, is usually influenced by many factors, namely: the alternative demands for it; the availability of credit as and when needed; the time and interest rate payable on it; the types of loans that might be needed to generate it; and the cost of funds and business ownership cost. Thus, careful credit planning is essential in the successful operations of any company.

In general, this requires the application of what, in strategic company management, has come to be known as the strategic four-factor model called "SORS". The letters that make up SORS stand for:-

Strategic planning (S) Organisational planning (O) Resource requirements (R) Strategic control (S).

Figure 3.2 summarises the simplified matrix of interacting factors and component parts that make up 'SORS'. In general terms, SORS is influenced or determined by four major factors: the external environment, the internal environment, organisational culture and resource (especially funds) availability. These four factors interact to create four inter-related components which normally determine the success or failure of any given company. These are:

a) competitive environmentb) strategic thrustc) product/market dynamicsd) competitive cost position and restructuring.

A proper and pragmatic manipulation of these four component parts requires:

assessing the external environment understanding the internal environment adopting a leadership strategy strategically planning the finances of the company.

The purpose of this text is not to cover all the components summarised in figure 3.1. Instead, the major concern is to have a proper understanding of financial analysis for strategic planning. This, in strategic management, requires a sound financial analysis backed by strategic funds programming, baseline projections (or budgeting), what-if (decision tree) analysis, and risk analysis. This book attempts to cover all these areas.

Alternative uses of funds

Dealing with alternatives is what management is all about. Some of the tools for evaluating alternatives (e.g. partial budgets, cash flow budgets and financial statements), are covered in this text.

It is assumed that most people are already familiar with the analysis that usually leads to major capital use decisions in various companies. However, highlighted are some of these points throughout the book, since company backgrounds differ and what is considered "major capital use decisions" varies with the size of businesses. For instance, a $50,000 expenditure may be major to one company and of little significance to another.

Figure 3.2 The strategic four-factor model

Almost everyone is familiar with the substantial capital or funds demand in all forms of business. Obviously, this does not all have to be owned capital. Evaluation of successful businesses has found that many of them operate with 50 percent or more rented or borrowed capital. The pressure on businesses to grow is likely to continue, and these businesses are likely to grow faster than will be permitted by each reinvesting its own annual savings from net income alone. Thus, because demand for credit will continue to expand, careful credit planning and credit use decisions are of paramount importance to marketing companies in any country.

Credit and types of loans

Credit is the capacity to borrow. It is the right to incur debt for goods and/or services and repay the debt over some specified future time period. Credit provision to a company means that the business is allowed the use of a productive good while it is being paid for.

Other than the fact that funds generated within a business are usually inadequate to meet expanding production and other activities, credit is often used in order to:

increase the returns on equity capital allow more efficient labour utilisation increase income.

The process of using borrowed, leased or "joint venture" resources from someone else is called leverage. Using the leverage provided by someone else's capital helps the user business go farther than it otherwise would. For instance, a company that puts up $1,000 and borrows an additional $4,000 is using 80% leverage. The objective is to increase total net income and the return on a company's own equity capital.

Borrowed funds are generally referred to as loans. There are various ways of classifying loans, namely:

in payment terms, e.g. instalment versus single payment in period-of-payment terms, e.g. short-term versus intermediate-term or long-term in the manner of its security terms, e.g. secured versus unsecured in interest payment terms, e.g. simple interest versus add-on, versus discount, versus balloon.

On the basis of the above classification, there are twelve common types of loans, namely: short-term loans, intermediate-term loans, long-term loans, unsecured loans, secured loans, instalment loans, single payment loans, simple-interest loans, add-on interest loans, discount or front-end loans, balloon loans and amortised loans.

Short-term loans are credit that is usually paid back in one year or less. Short term loans are usually used in financing the purchase of operating inputs, wages for hired labour, machinery and equipment, and/or family living expenses. Usually lenders expect short-term loans to be repaid after their purposes have been served, e.g. after the expected production output has been sold.

Loans for operating production inputs e.g. cotton for the Cotton Company of Zimbabwe (COTCO) and beef for the Cold Storage Company of Zimbabwe (CSC), are assumed to be self-liquidating. In other words, although the inputs are used up in the production, the added returns from their use will repay the money borrowed to purchase the inputs, plus interest. Astute managers are also expected to have figured in a risk premium and a return to labour management. On the other hand, loans for investment capital items like machinery are not likely to be self-liquidating in the short term. Loans for family living expenses are not at all self-liquidating and must come out of net cash income after all cash obligations are paid.

Intermediate-term (IT) loans are credit extended for several years, usually one to five years. This type of credit is normally used for purchases of buildings, equipment and other production inputs that require longer than one year to generate sufficient returns to repay the loan.

Long-term loans are those loans for which repayment exceeds five to seven years and may extend to 40 years. This type of credit is usually extended on assets (such as land) which have a long productive life in the business. Some land improvement programmes like land levelling, reforestation, land clearing and drainage-way construction are usually financed with long-term credit.

Unsecured loans are credit given out by lenders on no other basis than a promise by the borrower to repay. The borrower does not have to put up collateral and the lender relies on credit reputation. Unsecured loans usually carry a higher interest rate than secured loans and may be difficult or impossible to arrange for businesses with a poor credit record.

Secured loans are those loans that involve a pledge of some or all of a business's assets. The lender requires security as protection for its depositors against the risks involved in the use planned for the borrowed funds. The borrower may be able to bargain for better terms by putting up collateral, which is a way of backing one's promise to repay.

Instalment loans are those loans in which the borrower or credit customer repays a set amount each period (week, month, year) until the borrowed amount is cleared. Instalment credit is similar to charge account credit, but usually involves a formal legal contract for a predetermined period with specific payments. With this plan, the borrower usually knows precisely how much will be paid and when.

Single payment loans are those loans in which the borrower pays no principal until the amount is due. Because the company must eventually pay the debt in full, it is important to have the self-discipline and professional integrity to set aside money to be able to do so. This type of loan is sometimes called the "lump sum" loan, and is generally repaid in less than a year.

Simple interest loans are those loans in which interest is paid on the unpaid loan balance. Thus, the borrower is required to pay interest only on the actual amount of money outstanding and only for the actual time the money is used (e.g. 30 days, 90 days, 4 months and 2 days, 12 years and one month).

Add-on interest loans are credit in which the borrower pays interest on the full amount of the loan for the entire loan period. Interest is charged on the face amount of the loan at the time it is made and then "added on". The resulting sum of the principal and interest is then divided equally by the number of payments to be made. The company is thus paying interest on the face value of the note although it has use of only a part of the initial balance once principal payments begin. This type of loan is sometimes called the "flat rate" loan and usually results in an interest rate higher than the one specified.

Discount or front-end loans are loans in which the interest is calculated and then subtracted from the principal first. For example, a $5,000 discount loan at 10% for one year would result in the borrower only receiving $4,500 to start with, and the $5,000 debt would be paid back, as specified, by the end of a year.

On a discount loan, the lender discounts or deducts the interest in advance. Thus, the effective interest rates on discount loans are usually much higher than (in fact, more than double) the specified interest rates.

Balloon loans are loans that normally require only interest payments each period, until the final payment, when all principal is due at once. They are sometimes referred to as the "last payment due", and have a concept that is the same as the single payment loan, but the due date for repaying principal may be five years or more in the future rather than the customary 90 days or 6 months for the single payment loan.

In some cases a principal payment is made each time interest is paid, but because the principal payments do not amortise (pay off) the loan, a large sum is due at the loan maturity date.

Amortised loans are a partial payment plan where part of the loan principal and interest on the unpaid principal are repaid each year. The standard plan of amortisation, used in many intermediate and long-term loans, calls for equal payments each period, with a larger proportion of each succeeding payment representing principal and a small amount representing interest.

The repayment schedule for a 10 year standard amortised loan of $10,000 at 7% is presented in table 3.1.

The constant annual payment feature of the amortised loan is similar to the "add on" loan described above, but involves less interest because it is paid only on the outstanding loan balance, as with simple interest. Amortisation tables are used to determine the regular payment for an amortised loan. The $1,424.00 annual payment for the 10 year loan was determined by using the amortisation factor (AF) of 0.1424 and multiplying that by $10,000, the face value of the loan. The proper procedure for deriving a schedule as in table 3.1 is to:

a) first read off the amortisation factor from an amortisation table for a given interest rate against the given year the loan is expected to last

b) calculate the total payment at the end of each year

c) then, on a year-by-year basis, calculate the annual interest payable on the balance of the principal

d) obtain the annual principal payment by subtracting the calculated annual interest from the total end-of-year payment.

Repeat the procedure for each of the years involved. Now attempt exercise 3.4.

Table 3.2 Amortisation of a $10,000 loan in 10 years by equal annual instalments @ 7% interest

Year Unpaid principal at beginning of year ($) Payment at the end of the year

Interest ($) Principal ($) Total ($)

1 10,000.00 700.00 724.00 1,424.00

2 9,276.00 649.30 774.70 1,424.00

3 8,501.30 595.10 828.90 1,424.00

4 7,672.40 537.10 886.90 1,424.00

5 6,785.50 475.00 949.00 1,424.00

6 5,836.50 408.60 1,015.40 1,424.00

7 4,821.10 337.50 1,086.50 1,424.00

8 3,734.60 261.40 1,162.60 1,424.00

9 2,572.00 180.00 1,244.00 1,424.00

10 1,328.00 93.00 1,331.00 1,424.00

Total 4,240.00 10,000.00 14,240.00

Exercise 3.4 Amortised loan

Suppose a new machine is being financed by the Dairiboard of Zimbabwe Ltd with an 18 year $25,000 loan at a 9% interest rate. Obtain an amortisation schedule to show how the Dairiboard of Zimbabwe Ltd will pay off the resulting amortised loan. (Hint: the AF is 0.1142).

Cost of funds

The cost of funds (capital) is crucial to investment analysis. Usually, the present value measures of an investment's economic worth depend on the use of an appropriate discount rate (or rate of return). The most appropriate rate is the firm's cost of capital. This rate, when determined, provides a yardstick for testing the acceptability of any investment; those that have a high probability of achieving a rate of return in excess of the firm's cost of capital are acceptable.

A firm's cost of capital may be estimated through:

a) the use of the interest rate attainable by "investing" in lending institutions (deposits or securities) before taxes as an estimate of opportunity cost of capital and

b) the determination of the weighted average after-tax cost of capital, which reflects the cost of all forms of capital the firm uses. The two basic sources of capital are borrowed funds from lending institutions and ownership or internal capital representing profits reinvested in the business.

To estimate the weighted average cost of capital, one needs to determine:

a) the present cost of borrowed or leased funds from each source

b) an average cost of internal capital as reflected by the percentage of equity in business and risks being taken and

c) an adjustment for income tax effect.

Cost of borrowed capital

Lenders' interest rates vary by type of lender. And since many of these lenders' rates are keyed to money market conditions, predicting costs of borrowed capital through time is imprecise. Less difficulty exists when borrowers have considerable long-term borrowings at fixed rates. Normally, a rough idea of the average cost of borrowed capital for a firm is obtained by dividing the total interest paid by the company by the capital borrowed by the same company.

Cost of ownership (Equity) capital

Cost of ownership capital is more difficult to determine than that of borrowed capital. Theoretically, one knows that the cost of ownership capital is the opportunity cost of placing the owner's funds elsewhere in comparable risk situations. Generally, the guide for selecting an appropriate ownership cost of capital is to use the condition that the cost of equity or ownership capital should be equal to or greater than the cost of borrowed capital.

Average cost of capital

Using a balance sheet or other information, one can estimate the percentage of the sources of capital in a business. Assuming that a company has a 50% equity (or will average about half borrowed and half owned capital over the investment period) the average cost of capital is estimated as follows:

Table 3.2 Average cost of capital

Sources of capital (1) % of Capital (2) % of cost Weighted cost (1) x (2)

Equity capital borrowed 50 0.10 5.00

Bank 40 0.09 3.60

Insurance company 10 0.08 0.80

TOTAL 9.40

Business ownership costs

There are five ownership costs that every company incurs, namely: depreciation costs, interest costs, repair costs taxes, and insurance costs. They are commonly referred to as the "DIRTI 5".

a) Depreciation

This is a procedure for allocating the used up value of durable assets over the period they are owned by the business or until they are salvaged. By depreciating an asset, an allowance is made for the deterioration in the asset's value as a result of use (wear and tear), age and obsolescence. Generally, property is depreciable if it is used in business or to earn income;, wears out, decays, gets used up or becomes obsolete, and has a determinable useful life of more than one year. The proportion of the original cost to be depreciated in any one year is largely a matter of judgement and financial management. Normally, the depreciation allowance taken in any given year should reflect the actual decline in value of the asset - whether it is designed to influence income taxes or the undepreciated value of an asset reflecting the resale value of the asset.

There are four main and acceptable methods of calculating depreciation, namely:

the accelerated cost recovery system (ACRS) method the straight line method the declining balance method the sum of the years-digits method.

The accelerated cost recovery system method is a relatively new method of calculating depreciation for tangible property. It came into use effectively in 1981. As a method ACRS generally gives much faster write off than other methods because it has tax savings as its

primary objective. It usually gives little consideration to actual year-to-year change in value. Thus, for accounting purposes, other methods are more appropriate.

For tax purposes, property is classified as follows:-

i) 3 year property - automobiles and light-duty trucks used for business purposes and certain special tools, and depreciable property with a midpoint life of 4 years or less.

ii) 5 year property - most farm equipment, grain bins, single purpose structures and fences, breeding beef and dairy cattle, office equipment and office furniture.

iii) 10 year property- includes depreciable property with an expected life between 10 and 12.4 years.

iv) 15 year property - buildings.

The straight line method computes depreciation, Ds, as follows:

where:

OC = Original cost or basisSV = Salvage valueL = expected useful life of the asset in the business.

Declining balance method calculates depreciation as:-

Dd = RV x R

where:

RV = undepreciated value of the asset at the start of the accounting period such that, in year 1, RV = OC, and in succeeding years,

RVi = [RVi-1 - Dd,i-1] x R (with salvage value not being deducted from original value before computing depreciation),

R = the depreciation rate, which may be up to twice the rate of decline, 1/L, allowed under straight line method.

Sum of the year-digits method estimates the depreciation of an asset as follows:-

where:

RY = estimated years of useful life remaining

S = sum of the numbers representing years of useful life (i.e. for an asset with 5 years useful life, S would be 1+2+3+4+5 = 15).

b) Interest costs (rates) are incurred by a company when owned or borrowed funds are invested in durable assets, because such money is tied up and cannot be used for other purposes. On borrowed money, there will be a regular interest payment, a standing obligation which must be met regardless of the level of use of the asset purchased with the borrowed money. Also, an interest charge should be calculated on equity capital. In this case, the charge would be an opportunity interest cost. An annual charge should be made because the money invested has alternative productive uses, which may range from earning interest on a savings account to increasing production.

c) Repairs costs are principally variable costs incurred on assets because of the level of use of the assets through wear and tear. Some durable assets, however, deteriorate with time even though they are not used. Fences, buildings and some moving parts on machinery and equipment are prime examples, although they deteriorate even more rapidly with use.

d) Taxes are fixed costs that are usually incurred on machinery, buildings and some other durable assets. Taxes are usually not related to the level of use or productive services provided. Thus, any investment analysis that ignores the annual tax obligation associated with the proposed investment will be incomplete.

e) Insurance costs are also fixed costs that are incurred when a financed asset is purchased and has to be protected against fire, weather, theft, etc. Usually, lenders require that a financed asset be insured as a meant of security for the loan. Some operators, particularly those with low equity, also insure some of their more valuable assets because of the strain the loss of those assets would place on the financial condition of the business. In this country, the major insurance companies are Old Mutual Insurance and General Accident Insurance, Minet Insurance, Prudential Insurance, etc. Now attempt exercise 3.5.

Exercise 3.5 Computation of depreciation

Using the straight line, declining balance, and sum of the year-digits methods, compute and tabulate the depreciation of a $1,000 asset with an estimated 10 years' life and projected salvage value of 10% of the original cost. (Assume for the declining balance method a depreciation rate calculated as 20% of the value at the beginning of the year. Usually the rate may not be greater than twice the rate which would be used under the straight line method).

Key terms

Average cost of capitalBusiness ownership costsCashCash equivalentsCash flow statementCash paymentsCost of borrowed capital

Cost of equity capitalDepreciationDIRTI 5FinancingFunds useInsurance costsInterest ratesInvesting activitiesOperating activitiesPro forma cash flow statementRepair costsReturns on investment and servicing of financeSORSSource and application of fundsStrategic four-factor modelTaxationTaxes

Introduction to Balance SheetWe also have Quizzes, Crosswords, and Q&A for the topic Balance Sheet.

The accounting balance sheet is one of the major financial statements used by accountants and business owners. (The other major financial statements are the income statement, statement of cash flows, and statement of stockholders' equity) The balance sheet is also referred to as the statement of financial position.

The balance sheet presents a company's financial position at the end of a specified date. Some describe the balance sheet as a "snapshot" of the company's financial position at a point (a moment or an instant) in time. For example, the amounts reported on a balance sheet dated December 31, 2010 reflect that instant when all the transactions through December 31 have been recorded.

Because the balance sheet informs the reader of a company's financial position as of one moment in time, it allows someone—like a creditor—to see what a company owns as well as what it owes to other parties as of the date indicated in the heading. This is valuable information to the banker who wants to determine whether or not a company qualifies for additional credit or loans. Others who would be interested in the balance sheet include current investors, potential investors, company management, suppliers, some customers, competitors, government agencies, and labor unions.

In Part 1 we will explain the components of the balance sheet and in Part 2 we will present a sample balance sheet. If you are interested in balance sheet analysis, that is included in the Explanation of Financial Ratios.

We will begin our explanation of the accounting balance sheet with its major components, elements, or major categories:

Assets Liabilities Owner's (Stockholders') Equity

AssetsAssets are things that the company owns. They are the resources of the company that have been acquired through transactions, and have future economic value that can be measured and expressed in dollars. Assets also include costs paid in advance that have not yet expired, such as prepaid advertising, prepaid insurance, prepaid legal fees, and prepaid rent. (For a discussion of prepaid expenses go to Explanation of Adjusting Entries.)

Examples of asset accounts that are reported on a company's balance sheet include:

Cash Petty Cash Temporary Investments Accounts Receivable Inventory Supplies Prepaid Insurance Land Land Improvements Buildings Equipment Goodwill Bond Issue Costs

Etc.

Usually these asset accounts will have debit balances.

Contra assets are asset accounts with credit balances. (A credit balance in an asset account is contrary—or contra—to an asset account's usual debit balance.) Examples of contra asset accounts include:

Allowance for Doubtful Accounts Accumulated Depreciation-Land Improvements Accumulated Depreciation-Buildings Accumulated Depreciation-Equipment Accumulated Depletion

Etc.

Classifications Of Assets On The Balance SheetAccountants usually prepare classified balance sheets. "Classified" means that the balance sheet accounts are presented in distinct groupings, categories, or classifications. The asset classifications and their order of appearance on the balance sheet are:

Current Assets Investments Property, Plant, and Equipment Intangible Assets Other Assets

An outline of a balance sheet using the balance sheet classifications is shown here:

Example CompanyBalance Sheet

December 31, 2010

ASSETS LIABILITIES & OWNER'S EQUITY

Current Assets Current Liabilities

Investments Long-term liabilities

Property, Plant, and Equipment Total Liabilities

Intangible Assets

Other Assets Owner's Equity

Total Assets Total Liabilities & Owner's Equity

To see how various asset accounts are placed within these classifications, view the sample balance sheet in Part 4.

Effect of Cost Principle and Monetary Unit AssumptionThe amounts reported in the asset accounts and on the balance sheet reflect actual costs recorded at the time of a transaction. For example, let's say a company acquires 40 acres of land in the year 1950 at a cost of $20,000. Then, in 1990, it pays $400,000 for an adjacent 40-acre parcel. The company's Land account will show a balance of $420,000 ($20,000 for the first parcel plus $400,000 for the second parcel.). This account balance of $420,000 will appear on today's balance sheet even though these parcels of land have appreciated to a current market value of $3,000,000.

There are two guidelines that oblige the accountant to report $420,000 on the balance sheet rather than the current market value of $3,000,000: (1) the cost principle directs the accountant to report the company's assets at their original historical cost, and (2) the monetary unit assumption directs the accountant to presume the U.S. dollar is stable over time—it is not affected by inflation or deflation. In effect, the accountant is assuming that a 1950 dollar, a 1990 dollar, and a 2011 dollar all have the same purchasing power.

The cost principle and monetary unit assumption may also mean that some very valuable resources will not be reported on the balance sheet. A company's team of brilliant scientists will not be listed as an asset on the company's balance sheet, because (a) the company did not purchase the team in a transaction (cost principle) and (b) it's impossible for accountants to know how to put a dollar value on the team (monetary unit assumption).

Coca-Cola's logo, Nike's logo, and the trade names for most consumer products companies are likely to be their most valuable assets. If those names and logos were developed internally, it is reasonable that they will not appear on the company balance sheet. If, however, a company should purchase a product name and logo from another company, that cost will appear as an asset on the balance sheet of the acquiring company.

Remember, accounting principles and guidelines place some limitations on what is reported as an asset on the company's balance sheet.

Effect of ConservatismWhile the cost principle and monetary unit assumption generally prevent assets from being reported on the balance sheet at an amount greater than cost, conservatism will result in some assets being reported at less than cost. For example, assume the cost of a company's inventory was $30,000, but now the current cost of the same items in inventory has dropped to $27,000. The conservatism guideline instructs the company to report Inventory on its balance sheet at $27,000. The $3,000 difference is reported immediately as a loss on the company's income statement.

Effect of Matching PrincipleThe matching principle will also cause certain assets to be reported on the accounting balance sheet at less than cost. For example, if a company has Accounts Receivable of $50,000 but anticipates that it will collect only $48,500 due to some customers' financial problems, the company will report a credit balance of $1,500 in the contra asset account Allowance for Doubtful Accounts. The combination of the asset Accounts Receivable with a debit balance of $50,000 and the contra asset Allowance for Doubtful Accounts with a credit balance will mean that the balance sheet will report the net amount of $48,500. The income statement will report the $1,500 adjustment as Bad Debts Expense.

The matching principle also requires that the cost of buildings and equipment be depreciated over their useful lives. This means that over time the cost of these assets will be moved from the balance sheet to Depreciation Expense on the income statement. As time goes on, the amounts reported on the balance sheet for these long-term assets will be reduced.

Liabilities

Liabilities are obligations of the company; they are amounts owed to creditors for a past transaction and they usually have the word "payable" in their account title. Along with owner's equity, liabilities can be thought of as a source of the company's assets. They can also be thought of as a claim against a company's assets. For example, a company's balance sheet reports assets of $100,000 and Accounts Payable of $40,000 and owner's equity of $60,000. The source of the company's assets are creditors/suppliers for $40,000 and the owners for $60,000. The creditors/suppliers have a claim against the company's assets and the owner can claim what remains after the Accounts Payable have been paid.

Liabilities also include amounts received in advance for future services. Since the amount received (recorded as the asset Cash) has not yet been earned, the company defers the reporting of revenues and instead reports a liability such as Unearned Revenues or Customer Deposits. (For a further discussion on deferred revenues/prepayments see the Explanation of Adjusting Entries.)

Examples of liability accounts reported on a company's balance sheet include:

Notes Payable Accounts Payable Salaries Payable Wages Payable Interest Payable

Other Accrued Expenses Payable Income Taxes Payable Customer Deposits Warranty Liability Lawsuits Payable Unearned Revenues Bonds Payable Etc.

These liability accounts will normally have credit balances.

Contra liabilities are liability accounts with debit balances. (A debit balance in a liability account is contrary—or contra—to a liability account's usual credit balance.) Examples of contra liability accounts include:

Discount on Notes Payable Discount on Bonds Payable Etc.

Classifications Of Liabilities On The Balance SheetLiability and contra liability accounts are usually classified (put into distinct groupings, categories, or classifications) on the balance sheet. The liability classifications and their order of appearance on the balance sheet are:

Current Liabilities Long Term Liabilities Etc.

To see how various liability accounts are placed within these classifications, click here to view the sample balance sheet in Part 4.

CommitmentsA company's commitments (such as signing a contract to obtain future services or to purchase goods) may be legally binding, but they are not considered a liability on the balance sheet until some services or goods have been received. Commitments (if significant in amount) should be disclosed in the notes to the balance sheet.

Form vs. SubstanceThe leasing of a certain asset may—on the surface—appear to be a rental of the asset, but in substance it may involve a binding agreement to purchase the asset and to finance it through monthly payments. Accountants must look past the form and focus on the substance of the transaction. If, in substance, a lease is an agreement to purchase an asset and to create a note payable, the accounting rules require that the asset and the liability be reported in the accounts and on the balance sheet.

Contingent LiabilitiesThree examples of contingent liabilities include warranty of a company's products, the guarantee of

another party's loan, and lawsuits filed against a company. Contingent liabilities are potential liabilities. Because they are dependent upon some future event occurring or not occurring, they may or may not become actual liabilities.

To illustrate this, let's assume that a company is sued for $100,000 by a former employee who claims he was wrongfully terminated. Does the company have a liability of $100,000? It depends. If the company was justified in the termination of the employee and has documentation and witnesses to support its action, this might be considered a frivolous lawsuit and there may be no liability. On the other hand, if the company was not justified in the termination and it is clear that the company acted improperly, the company will likely have an income statement loss and a balance sheet liability.

The accounting rules for these contingencies are as follows: If the contingent loss is probable and the amount of the loss can be estimated, the company needs to record a liability on its balance sheet and a loss on its income statement. If the contingent loss is remote, no liability or loss is recorded and there is no need to include this in the notes to the financial statements. If the contingent loss lies somewhere in between, it should be disclosed in the notes to the financial statements.

Current vs. Long-term LiabilitiesIf a company has a loan payable that requires it to make monthly payments for several years, only the principal due in the next twelve months should be reported on the balance sheet as a current liability. The remaining principal amount should be reported as a long-term liability. The interest on the loan that pertains to the future is not recorded on the balance sheet; only unpaid interest up to the date of the balance sheet is reported as a liability.

Notes to the Financial StatementsAs the above discussion indicates, the notes to the financial statements can reveal important information that should not be overlooked when reading a company's balance sheet.

Owner's (Stockholders') Equity

Owner's Equity—along with liabilities—can be thought of as a source of the company's assets. Owner's equity is sometimes referred to as the book value of the company, because owner's equity is equal to the reported asset amounts minus the reported liability amounts.

Owner's equity may also be referred to as the residual of assets minus liabilities. These references make sense if you think of the basic accounting equation:

Assets   =   Liabilities   +   Owner's Equity

and just rearrange the terms:

Owner's Equity   =   Assets   –   Liabilities

"Owner's Equity" are the words used on the balance sheet when the company is a sole proprietorship. If the company is a corporation, the words Stockholders' Equity are used instead of Owner's Equity. An

example of an owner's equity account is Mary Smith, Capital (where Mary Smith is the owner of the sole proprietorship). Examples of stockholders' equity accounts include:

Common Stock Preferred Stock Paid-in Capital in Excess of Par Value Paid-in Capital from Treasury Stock Retained Earnings Etc.

Both owner's equity and stockholders' equity accounts will normally have credit balances.

Contra owner's equity accounts are a category of owner equity accounts with debit balances. (A debit balance in an owner's equity account is contrary—or contra—to an owner's equity account's usual credit balance.) An example of a contra owner's equity account is Mary Smith, Drawing (where Mary Smith is the owner of the sole proprietorship). An example of a contra stockholders' equity account is Treasury Stock.

Classifications of Owner's Equity On The Balance SheetOwner's equity is generally represented on the balance sheet with two or three accounts (e.g., Mary Smith, Capital; Mary Smith, Drawing; and perhaps Current Year's Net Income). See the sample balance sheet in Part 4.

The stockholders' equity section of a corporation's balance sheet is:

Paid-in Capital Retained Earnings Treasury Stock

The stockholders' equity section of a corporation's balance sheet is:

STOCKHOLDERS' EQUITY

Paid-in Capital

Preferred Stock

Common Stock

Paid-in Capital in Excess of Par Value - Preferred Stock

Paid-in Capital in Excess of Par Value - Common Stock

Paid-in Capital from Treasury Stock

Retained Earnings

Less: Treasury Stock

     TOTAL STOCKHOLDERS' EQUITY

Owner's Equity vs. Company's Market ValueSince the asset amounts report the cost of the assets at the time of the transaction—or less—they do not reflect current fair market values. (For example, computers which had a cost of $100,000 two years ago may now have a book value of $60,000. However, the current value of the computers might be just $35,000. An office building purchased by the company 15 years ago at a cost of $400,000 may now have a book value of $200,000. However, the current value of the building might be $900,000.) Since the assets are not reported on the balance sheet at their current fair market value, owner's equity appearing on the balance sheet is not an indication of the fair market value of the company.

Owner's Equity and Temporary AccountsRevenues, gains, expenses, and losses are income statement accounts. Revenues and gains cause owner's equity to increase. Expenses and losses cause owner's equity to decrease. If a company performs a service and increases its assets, owner's equity will increase when the Service Revenues account is closed to owner's equity at the end of the accounting year.

Sample Balance SheetMost accounting balance sheets classify a company's assets and liabilities into distinctive groupings such as Current Assets; Property, Plant, and Equipment; Current Liabilities; etc. These classifications make the balance sheet more useful. The following balance sheet example is a classified balance sheet.

Sample Balance Sheet:

Example CompanyBalance Sheet

December 31, 2010

ASSETS LIABILITIESCurrent Assets Current LiabilitiesCash $   2,100 Notes Payable $   5,000Petty Cash 100 Accounts Payable 35,900Temporary Investments 10,000 Wages Payable 8,500Accounts Receivable - net 40,500 Interest Payable 2,900Inventory 31,000 Taxes Payable 6,100Supplies 3,800 Warranty Liability 1,100Prepaid Insurance         1,500 Unearned Revenues         1,500 Total Current Assets       89,000 Total Current Liabilities       61,000

-Investments       36,000 Long-term Liabilities

Notes Payable 20,000Property, Plant & Equipment Bonds Payable     400,000 Land 5,500 Total Long-term Liabilities     420,000 Land Improvements 6,500Buildings 180,000Equipment 201,000 Total Liabilities     481,000 Less: Accum Depreciation       (56,000) Prop, Plant & Equip - net     337,000

-Intangible Assets STOCKHOLDERS' EQUITYGoodwill 105,000 Common Stock 110,000Trade Names     200,000 Retained Earnings 229,000Total Intangible Assets     305,000 Less: Treasury Stock       (50,000)

Total Stockholders' Equity     289,000 Other Assets         3,000

-Total Assets $770,000 Total Liab. & Stockholders' Equity $770,000

 The notes to the sample balance sheet have been omitted.