Accounting Chapter 8 PDF

CHAPTER 8 T he summer is moving right along. August is approaching, when your family takes its annual vacation. There’s only a week or two before the vacation, and after that school starts. Which means you only have a brief time left to operate your lemonade stand and learn more about accounting....

CHAPTER 8 T he summer is moving right along. August is approaching, when your family takes its annual vacation. There’s only a week or two before the vacation, and after that school starts. Which means you only have a brief time left to operate your lemonade stand and learn more about accounting. It’s Monday, and you’re about to start a new week: week five. What’s the first thing you do? Roll up the earnings from the last week. Go ahead and do that. 122 T H E AC C O U N T I N G GA M E $41.00 $23.00 $0.00 $ 1 6 .00 $23.00 $ 10 $ 10.00 $0 $ 5.00 $ 2.00 $12 $1 $ 1 1 .00 $80.00 Okay, with last week now officially behind us, it’s time to tackle a new week’s challenges. The first challenge isn’t long in coming. Business is slow and, at first, you can’t figure out why. The weather’s nice and warm. Certainly everyone seems to like your new stand. No one seems to have minded that your lemonade is no longer made from scratch. What gives? A friend rides by on her bike. You yell at her to stop for some lemonade. She yells back, “I can’t right now. My sister’s playing in the all-city softball tournament at the park. If I don’t get there early I won’t find a seat—because everyone’s going to be there!” Ah-ha! A lot of potential customers are gathered at the softball fields at the park. But your stand is nailed to the ground here! If only you could find a way to get your greattasting lemonade to this mass of customers…. Ah-ha! You should get a mobile lemonade stand! One you can take to where crowds are. Because if you can’t get your customers to come to where your business is located, then a smart businessperson goes to where the customers are! C H APTER 8 You look in the phone book and make a lot of calls. Finally, you find a company which sells mobile refreshment stands, but they’re thousands of dollars! Well, there’s no way you can afford one of those, so it’s time to get creative. Let’s see. You’re not old enough to have a driver’s license, so you don’t need anything with a motor. You don’t own a horse or mule, so you’ll likely have to pull this unit by yourself. It doesn’t have to be that big, you know—just big enough to carry your supplies. And it can’t cost too much. Hmmmm. Then it hits you like a bolt from the blue! A wagon! Like the one you saw in the hardware store when you were there buying paint. Yes! You get Dad to drive you to the hardware store. The lady who sells wagons is Monsieur Claude’s twin sister. She wears a red-checked flannel shirt, red suspenders, and tucks her wool pants into tall black boots. She has her long, gray hair in a ponytail tied with a red rubberband. Her name tag reads, “Wonderful Willa Wagner.” “I’m interested in buying a wagon,” you tell her. “How much are they?” “We happen to be running a special on our very best model,” she tells you. “It’s built of the highest grade steel. Its paint is rust-resistant. The tires are puncture-proof. A wonderful example of old-world craftsmanship. It has an estimated life of ten years, and the cost is a mere $20.” This woman obviously knows her wagons! You immediately decide you want it, you need it—you buy it! Let’s demonstrate the purchase on the Balance Sheet. Do we have enough Cash to pay for it? Yes. You take $20 from Cash to buy the mobile unit. Is the wagon another Asset? Yes. What kind of Asset? Fixed Asset. How much is it? $20.00. But do we want to simply throw the wagon in with our other fixed assets—the stand, lot, and sink? No. Why not? Well…because…ah…help me! 123 124 T H E AC C O U N T I N G GA M E Let’s look at our other Fixed Assets, starting with our lemonade stand. Is it attached to the land? Yes. It’s like a building, right? Right. What about this wagon? Is it attached to the land? No, it’s mobile. Is the wagon like a building or plant? No. A Fixed Asset that’s movable is called what? Equipment. A-ha! There are different types of Fixed Assets. Many companies separate equipment from buildings on the Balance Sheet. Now, because the wagon is equipment, is that the only reason it’s set up as a separate fixed asset on the Balance Sheet? No. Can you think of another reason why? __________________________________________________________________________ __________________________________________________________________________ Well, another reason is, since it’s a different type of Fixed Asset, we can depreciate it differently. Let’s do the next Balance Sheet, reflecting the wagon purchase. $23.00 $ 0.00 $ 1 6.00 $23.00 $ 10 $ 1 0 .00 $ 0 $ 2.00 $ 5.00 $52.00 $12 $1 $ 1 1 .00 $ 0.00 $57.00 $80.00 d b C H APTER 8 It’s very late on Saturday afternoon when you start for the softball tournament. Not to worry—it’s an evening tournament and the first game gets underway in fifteen minutes. You head out across the neighborhood to the game, feeling on top of the world. After all, you’ve just bought that shining red wagon and you’re going to the game to cash in on another great entrepreneurial idea. On the way, you go by Pappy’s grocery store to buy more Truman’s Own. But the store is closed! You don’t know what’s going on—then you remember Mr. Parker said he was closing early today so he could go to the game. You’re a little worried about Pappy’s store being closed because you need more inventory. You decide to push on. Hey, there’s bound to be a store near the ball park. Sure enough, a mere block from the field you see that you’re in luck! There is a store and it’s open. But, once inside, you realize it’s one of the warehouse type stores that sells only in bulk. You look at the price and you really feel sick. Because the price here is $30—ten dollars more than what you paid at Pappy’s for the same quantity. Thirty dollars! Your heart sinks. What are you going to do? Because you only have $21 in the cigar box you brought along (Note cash on your last balance sheet.) Looks like we have a major, MAJOR problem. What are we going to do? What would you do? __________________________________________________________________________ __________________________________________________________________________ __________________________________________________________________________ What can we do? Go to Mom and Dad! Isn’t that what parents are for? It’s a good idea, but then you remember that Mom’s at her weekly aerobics class and Dad took the afternoon to hit some golf balls at the driving range. No way can you reach them! Now what? Go to the bank and borrow some money. Is the bank open Saturday afternoons? No, It closes at noon on Saturday. Maybe you could float a check! OHHH! Would our banker like that? No, and neither would the police! You’re desperate. This is the worst business situation since Coke tried to pull its old formula with a “new, improved” Coke! Since Ford rolled out the Edsel! Dang! You have this shiny, new mobile unit—but no lemonade to sell! What should you do?! Sell the mobile unit! 125 126 T H E AC C O U N T I N G GA M E The game’s getting going any minute now. Are you going to have the time to sell the mobile unit and run to some other store for pre-made lemonade? No. Besides, you need a place to put your lemonade. What else might you do? Put the squeeze on your friends who still owe you money! The Accounts Receivable. Maybe. But none of them are at the game. Can you return the wagon and get your money back? No Willa Wagner is at the tournament, like everyone else. You could always buy less lemonade, right? Sure, if you had all night to find a store that was opened and sold the brand you wanted. Okay, you decide, I’ll go to the insurance agent and get back your money on the policy. But his office is closed, too. Desperate people try desperate measures. It’s not a proud moment…it’s not something you’ll tell your grandkids sixty years from now. You decide to use the old inventory. But, for how long has it been hanging around? Weeks and weeks by now. So, can we use it? Only if we want a visit from the health inspector and a possible lawsuit on our hands. Okay, what do a lot of start-up businesses do? Sell stock and go public. At a softball tournament? These ideas have gone from bad to worse! Is there nothing we can try? Finally, you ask some friends for advice. One of them says, “You’ve been bragging about all those retained earnings you’ve been rolling up all summer. Why don’t you just spend some of those?” Ah, a true friend! Let’s try this one, you decide. You rush back to the store and say to the first clerk you see, “I want to buy some Truman’s Own, pre-made lemonade.” “Yes, we carry it,” the clerk says. You are so happy and relieved that they have it that you feel like standing on your tiptoes and hugging the clerk. “How much is it?” you ask, hoping you misread the high price. C H APTER 8 “Thirty dollars,” the clerk says. “We only sell it by the shrink-wrapped case.” “Cool. I’ll take it,” you say. “How will you pay?” the clerk then asks. “Well, I would like to give you $21 in cash and $9 of my retained earnings.” “Sorry,” the clerk says. “Cash only.” You lay out the $21 dollars. “That’s not enough,” the clerk says. “Where’s the rest?” “I have $9 in retained earnings. My earnings are as good as cash!” you insist. “What we take here is green—the real stuff,” the clerk says. “I see $21 in green. Are your earnings green?” “Well, not exactly. They’re black—as in ‘in the black!’” you admit. “But won’t you take my retained earnings? Please. PLEASE! Please, please, please, with whipped cream and a cherry on top! People have always told me I could spend my earnings. The only difference is my cash is green and my earnings are black.” “Sorry, no,” the clerk says. With that, he smiles, shrugs, and walks away. So, can you spend earnings? No. You cannot spend earnings. You can only spend what? Cash. You’re more than a little bewildered by this experience. Well, you think, if I can’t spend my earnings, what good are they? And, by the way, if they aren’t cash, where are they? You resolve to figure that out later. Meanwhile, you’re desperate! You’re only a few dollars short and no one will help you! Maybe you should steal the lemonade. Wow, steal it? Do we want to do that? I don’t think so. Hey, Pappy Parker let you open an account. Maybe this nice looking clerk at the warehouse-type store will let you charge the lemonade. You chase after him. You find him dusting shrink-wrapped cartons of toothpicks. “Okay,” you say, with as much confidence as you can muster. “I’d like to give you $21 cash and charge the balance. Will you do it?” “I don’t know you, kid,” the clerk replies. “How do I know you will pay it back?” “How about calling my personal grocer, Pappy Parker, across town? I’ve got credit with him and I’ve paid all my bills.” Then you remember, again, that Pappy’s at the tournament, like everyone else. You beg with the clerk; you plead. You offer to leave your valuable polished rock that you always carry in your pocket for luck. 127 128 T H E AC C O U N T I N G GA M E Finally, the clerk agrees to talk to the manager on your behalf. And, miracle of miracles, the manager agrees to let you open an account. He said something about knowing Pappy and that anyone who could get credit from Pappy is probably okay. We give the clerk how much cash? $21.00 The clerk gives us how much lemonade? $30.00 Go ahead and demonstrate the transaction. $ 0.00 $ 1 6.00 $ 10 $ 2.00 $ 5.00 $52.00 $12 $1 $ 1 1 .00 $ 0.00 $20.00 $57.00 How do we balance it? Add $9.00 to Accounts Payable. Are we in balance? Yes. Let’s take a moment to look at our Balance Sheet. If someone showed you this Balance Sheet, what would you say about this business? Are we profitable? Do we have lots of assets? Pretty good for four weeks in the business. Is there a problem? You bet there is! What about our cash position? Don’t ask! Come on, what is the problem? No cash! C H APTER 8 If we have rain and everybody goes home and doesn’t buy any lemonade, what’s going to happen? No cash coming from sales. We have lots of assets. We just don’t have lots of what? Cash. To be blunt, we have zero cash. Zip! Zilch! A big fat goose egg! But our Balance Sheet says we have plenty of Retained Earnings. Aren’t they cash? Don’t we have them in the bank? We’ve been rolling up those earnings? Aren’t they in an account? That question is worth the whole summer’s business. You’ve probably heard people say, “I’m going to go spend my earnings.” But what did we just discover? Merchants will not take earnings. You can only spend cash. If earnings are not cash, where are your retained earnings? Certainly not available as cash. So, right now, those earnings are tied up where? In assets, inventory, equipment. Now, don’t forget because this is worth the whole summer: Earnings Are Not Cash! Remember, the left side of our scorecard is a reflection of what’s out at our stand. What we have in Cash, Inventory, etc. Look at the line items on the Balance Sheet. Find the line which represents our stand and sink. Our wagon. Our rotten lemons. Our insurance policy. The Receivables from friends. And, the right side is a record on paper of who owns or who provided this stuff. The truth is, everything on the right side is just on paper. The Liabilities show us how much we owe other people and the Equity (including the Retained Earnings) simply shows us what portion of the assets are ours free and clear. Was it a smart strategy to take out that much cash to buy the wagon? No. Can a business that’s profitable get itself in trouble? Absolutely. Because what runs the business on a daily basis? Do profits? No, cash runs the business on a daily basis! If you remember nothing else from this book, always remember this! 129 130 T H E AC C O U N T I N G GA M E ON A DAILY BASIS, CASH RUNS THE BUSINESS, NOT PROFITS. Are profits and cash the same thing? No. What’s the thing, the driving force, the blood of the business? Cash. Again, what runs the business? Cash. In truth, the profit just tells you how much you earned. It lets you know that your sales have exceeded your costs. And, when you combine the profits with your original investment it just tells you what portion of your total assets belongs to you. Can you run a business for a while without profits? Yes. How long can you run a business without cash? Not one day! So, if you were to look at a financial statement and it was typed out with dollar amounts and you saw $52 in retained earnings, you might conclude, “Gee, I must have $52 in a bank account somewhere.” Do we have any money in the bank? No. That is a really, really important distinction. Our stand has been successful and profitable. We have received a lot of Cash when we made those profits. But we have spent that Cash on Inventory, a building, an insurance policy, a wagon, etc. The Receivables tell us that some of those profits have not yet been turned into Cash because our customers still owe us. Making a profit is very important, but having profits do not mean you have Cash. And, as fate would have it, it doesn’t rain. Everybody crowds around our mobile unit for some lemonade and guess what? Sales are good! You sell all the pre-made lemonade for $50 cash. Your other Inventory remains the same. You breathe a sigh of relief. Let’s review what just happened. What goes out? Inventory for $30.00. What comes in? Cash. How much? $50.00. What are our earnings on that? $20.00. And on the Cash Statement, that’s what? Collections. Please complete your next Balance Sheet. 131 C H APTER 8 $32.00 $$0.00 .00 $ 1 6.00 $32.00 $ 10 $ 2.00 $ 5.00 $52.00 $12 $1 $ 1 1 .00 $20.00 Given that good weather, luck, and a little business savvy saved the day, you decide to pay yourself $4 salary in cash. Finally! It’s your fifth week in business and, after what you’ve been through, you think you deserve it. What comes out? $4.00 Cash. Salary to the owner is an expense. Which will reduce earnings by how much? $4.00. Complete another Balance Sheet, recording this transaction. 132 T H E AC C O U N T I N G GA M E $32.00 $ 0.00 $ 1 6.00 $32.00 $ 10 $1 0.00 $ 0 $ 2.00 $ 5.00 $52.00 $12 $1 $ 1 1 .00 $20.00 Now that you’re back on your feet, you can look down the road a little bit. As part of your financial planning, you realize that you have to depreciate the mobile unit—after all, you own it. What method did we use when we depreciated the building? Straight line depreciation. This is the only method you can use with a building. With equipment, though, you have a choice. You can use straight line or accelerated depreciation. For those of you who have done any depreciation of assets over the past few years, you probably recognize that the government often changes the formulas that you use to do depreciation. One formula is called 2x (2 “times”—or multiplied by 2) the straight line base (also called double declining balance). There’s another one called one and one-half times the declining balance. There was a method called ACRS (Accelerated Cost Recovery System). Then there was MACRS (Modified Accelerated Cost Recovery System). The government frequently changes the period of time you can depreciate an asset and the rate at which you can depreciate it. We’ve elected to use 2x the straight line base as the method we’re going to use for accelerated depreciation. 133 C H APTER 8 What did we say the life of our wagon will be? Ten years. What was the cost of the wagon? $20.00. If we’re going to depreciate using straight line, what happens? It is how much per year? $2.00. Straight line equals $2 per year. We’re not using straight line, we’re using 2x straight line. What would our depreciation amount be in the first year? $4.00. If we took $4 off our mobile unit, how do we show that on a Balance Sheet? Reduce the value of the Fixed Asset. Show this transaction. $46.00 $32.00 $0.00 $ .00 $ 1 6.00 $32.00 $ 10 $ 0 $1 0.00 $ 2.00 $ 5.00 $52.00 $12 $1 $ 1 1 .00 $20 Okay, so our mobile unit is now valued at what? $16.00. We know now that depreciation is what? An expense. What do expenses do to earnings? Reduce them. In the case of depreciating the wagon, what will it do to our earnings? Reduce them by $4.00. Taking them down to what? $12.00. Will it show up on the cash statement? No. Remember, depreciation is a non-cash expense. 134 T H E AC C O U N T I N G GA M E How about the income statement? Yes. as an expense. So, the first year, instead of taking $2 we’re going to take $4. The key word in the depreciation formula is the word “base.” What was the cost of the wagon—or its original base? $20.00. Now, we subtract $4 in year one, what’s the new base? $16.00. It’s still a ten-year property. What would be the straight line depreciation on a ten-year property with a $16 base? $1.60. That amount, times 2 = 3.20. So, your second year depreciation is 3.20. What’s the new base for year 3? $12.80 (subtract 3.20 from 16). The straight line depreciation for year three equals? $1.28. That amount, times 2 is $2.56. You see how it works. The next year is $2.04, etc. If we do a graph, it looks like this…$4, 3.20, 2.56, 2.04…you see it’s a curved line. You’re taking a greater amount of the depreciation in the earlier years and taking less depreciation in the later years. Is that good? Yes. Another way to say that is you are saving current tax dollars versus future tax dollars. Why? Because saving current dollars is better than saving future dollars because of inflation. The government often lets you take accelerated depreciation for things that will need to be replaced early on due to wear and tear. It’s the government’s way to support businesses in buying and selling assets which stimulates the economy. Those are only some of the reasons for accelerated depreciation. Now we’re going to introduce one final concept that affects all companies—TAXES. For now, let’s just focus on this week’s profit. You now owe taxes to the government. Our profits this week are $12. The tax rate is 25 percent. With $12 in earnings taxed at 25 percent, what are the taxes? $3.00. Which reduces earnings to what? $9.00. Remember that we said that we owe the taxes, not that we paid them. 135 C H APTER 8 Now, create a Balance Sheet, Income Statement, and Cash Statement for this week and include the tax liability. We have printed the Balance Sheet to more closely resemble an actual company balance sheet. See if you can complete it. Cash Accounts Receivable $ ______ $ ______ Inventory Prepaid Expenses Total Current Assets $ ______ $ ______ $ ______ Gross Fixed Assets $ ______ Accumulated Depreciation $ ______ Net Fixed Assets $ ______ Total Assets $ ______ Accounts Payable Notes Payable Tax Liability TOTAL LIABILITIES OWNER’S EQUITY Original Investment Retained Earnings Earnings Week to Date TOTAL EQUITY Total Liabilities and Owner’s Equity $ $ $ $ _____ _____ _____ _____ $ $ $ $ _____ _____ _____ _____ $ _____ The Cash, Accounts Receivable, Inventory, and Prepaid Expenses are what are called “Current Assets.” Current Assets are those assets that will likely be converted to cash within one year. The total Current Assets are $74. When you don’t have the use of color to show Fixed Assets and depreciation, there are often three entries for Fixed Assets. “Gross Fixed Assets” is the total purchase price of all the fixed assets. “Accumulated Depreciation” represents the total depreciation taken to date on the assets. And the “Net Fixed Assets,” of course, is the difference—or what’s called the Net Book Value of the assets. One advantage of having all three numbers is the ease by which to compare the accumulated depreciation amount to the Gross Fixed Assets amount. This comparison lets us know that our company’s fixed assets are relatively new. The Net Fixed Assets amount was for how much $27.00. And the total assets are? $101.00. The total liabilities, including $3 in Tax Liability is how much? $35.00. Total equity equals…? $66.00. Are we in balance? Yes. 136 T H E AC C O U N T I N G GA M E Before we do the week’s Income Statement and Cash Statement, let’s review the transactions one more time. TRANSACTIONS: You purchase a mobile lemonade stand for $20 cash. Estimated life of the mobile unit is 10 years. You purchase some more pre-made lemonade, and the price has increased to $30 cash. (But, remember, we only had $21 cash and put $9 on account.) You have sales of 100 glasses of lemonade @ 50¢ /glass, for $50 cash. You decide to pay yourself a salary for $4 cash. You depreciate the mobile unit using accelerated depreciation (2 x straight line base). Include all of the first year’s depreciation. You pay 25% of net profit before taxes. 137 C H APTER 8 INC OME STATEMENT Begin: Monday A.M. SALES Beginning Inventory + Purchases + Labor Total Available for Sale - Ending Inventory = C OST OF GO ODS SOLD GROSS PROFIT = EXPENSES • • • = TOTAL EXPENSES NET PROFIT BEFORE TAXES INC OME TAXES NET PROFIT AFTER TAXES End: Sunday P.M. $ $ $ $ Okay. Let’s review the Income Statement. Sales? $50.00. Beginning Inventory? $10.00. Purchases? $30.00. Total available for sale? $40.00. Ending Inventory? $10. Wow! We still got some old and by now highly suspect lemons on the Balance Sheet! We’re going to have to figure out what to do with these rotten lemons soon. Cost of Goods Sold? $30.00. What’s the Gross Profit for the week? $20.00. Expenses? Salary, $4.00; Depreciation, $4.00. Total Expenses? $8.00. So, our Net Profit before taxes? $12.00. What did Uncle Sam take? $3.00. Leaving us with a Net Profit After Taxes (NPAT) of…? $9.00. 138 T H E AC C O U N T I N G GA M E Now, fill out the week’s Cash Statement. CASH STATEMENT COLLECTIONS WEEK ________ $ INVENTORY PAID FIXED ASSET INVESTMENT EXPENSES PAID CHANGE IN CASH $ ________ BEGINNING CASH + ________ ENDING CASH $ ________ What was the change in cash? Plus five. The Beginning Cash was $41, so you should have $46 in Ending Cash. Check to see if you do. Well, that completes another full week! You’re doing great! You’re really enjoying the lemonade business and learning about accounting. Which isn’t to say that now you’re not ready for a little break. You are, especially when you learn that the family is jumping in the car and heading to one of your favorite destinations. Which is (write the answer below). ____________________________________________________ Just remember to send us a postcard, okay?