comply with GAAP, the trucks are valued at historical cost less accumulated depreciation.
OK, now assume that company A’s trucks are listed in the balance sheet at $100,000, while B’s trucks have a value of $200,000. What does this data tell you? On average, A’s trucks are worth less than B’s trucks, and that also means that A’s trucks are older and must be replaced sooner.
Company A will have to invest in new trucks before company B. If you were considering investing in either company, that difference would impact your investment decision. A is going to have to spend money on trucks sooner than B, and that leaves less money for other needs.
Deciding on accrual basis or cash basis
The cash basis of accounting recognizes revenue when cash is received and posts expenses when they are paid in cash. This method means that you post your accounting activity based on when cash moves in or out of your business. It’s accounting by “using your checkbook.”
Recognizing revenue or expenses refers to the timing of when you post the amounts to your accounting records.
Installing the cash basis
There’s a problem with the cash basis of accounting — it doesn’t follow the matching principle. This principle requires accountants post revenue when it’s earned and expenses when they are incurred.
The matching principle is a two-step process. Your first step is to determine when revenue is earned. You earn revenue when you deliver your product (as explained earlier), or complete a service you perform for a customer. You may receive payment in advance of the delivery, or a few weeks after the delivery. When you earn, the revenue may be different from when you receive the cash payment.
For a retailer, revenue is earned when the customer walks out of the store with, say, a new baseball glove. If you’re a tax preparer, you earn revenue when you deliver a completed tax return to your client.
After you determine when revenue is earned, you match the revenue to the expenses that are related to the product or service. The retailer would match the inventory cost of the glove with the baseball glove’s revenue. The tax preparer would match the labor cost paid to the staff with the revenue from the tax return.
Because the cash basis doesn’t follow the matching principle, the method is used only by very small businesses. Everyone else uses the accrual method of accounting.
Moving to the accrual method
The accrual method of accounting recognizes revenue when it’s earned and expenses when they are incurred. Accrual accounting is more complicated than the cash basis you just read about (but only a little bit). That’s because your cash may not move in the same period when revenue or expense is recognized.
Say you ship goods to your client in late January. The customer pays for the order in February. You completed everything that the customer required in January, so you should recognize revenue in January. But the cash moves (you get paid) in February.
Accrual accounting requires you to make an entry to accounts receivable and to sales revenue in January. The entry shows that you earned the revenue, even though you haven’t been paid yet. Accounts receivable means that you are owed money for a sale that was posted to revenue in January. When the cash is received in February, you reduce accounts receivable and increase cash.
Assume an employee works in your store during the last week of May. Your next payroll is paid in the first week of June. Your store has sales in May. You should include the salary expense for the employee’s work during May with the May revenue. That’s how the matching principle works. The process matches the effort (costs) with the reward (revenue). However, the cash doesn’t move until June.
Using accrual accounting, you make an entry to accounts payable and salary expense in May. Accounts payable represents an amount you owe as a business expense. So you post the salary expense in May. When you pay the employee in June, you reduce accounts payable and you reduce cash.
Finishing with conservatism
The principle of conservatism relates to decisions you make as an accountant (or as a business owner doing some accounting). By conservative, accountants mean the less-attractive decision. Your goal is to avoid creating accounting records that are overly optimistic.
Consider revenue. If you need to make a judgment on when to recognize revenue, choose to delay recognition. Delay posting the revenue until you’re sure the revenue has been earned. That decision is considered the conservative one, because it makes your financial statements less attractive to a reader.
Okay, now consider expenses. You should recognize expenses sooner than later. In the section “Previewing inventoriable costs,” marketing costs are recognized immediately. That’s because the accountant can’t justify delaying the expenses to a later period. Posting more expenses sooner makes your financial statements less attractive.
Chapter 3
Using Cost-Volume-Profit Analysis to Plan Your Business Results
IN THIS CHAPTER
Cost-volume-profit analysis (CVP) is a tool you can use to analyze your costs and plan for a reasonable profit. The CVP formula is simple, and using it is as easy as plugging in numbers as assumptions and seeing where your profit ends up.
Cost-volume-profit works for enterprises of all sizes. Take the neighborhood lemonade stand as an example. To set up a lemonade stand on the sidewalk, you’ll have costs. (“It takes money to make money.”) Those costs include lemons, sugar, water, stand construction, advertising, and so on.
Assume your lemonade stand startup costs total $30. You decide to sell each glass of lemonade for $1. How many glasses do you need to sell to recover all your costs? At what point would each lemonade sale create a profit? If your goal were to earn $20 in an afternoon, how many glasses would you need to sell? You can answer these questions using cost-volume-profit.
Understanding How Cost-Volume-Profit Analysis Works
A little comprehension goes a long way. I work with many small-business clients who use cost-volume-profit analysis, but they don’t know the terminology