The Accounting Game PDF

Accounting Game_CVR:Layout 1 3/5/08 2:23 PM Page 1 “Fantastic Learning Tool...Don’t let this book title fool you. It is not an oversimplification of accounting and financial principles. It is, however, a serious and very effective ex- amination of a very sma...

Accounting Game_CVR:Layout 1 3/5/08 2:23 PM Page 1 “Fantastic Learning Tool...Don’t let this book title fool you. It is not an oversimplification of accounting and financial principles. It is, however, a serious and very effective ex- amination of a very small but progressively complex business. There are not many books THE available on the market that make a complex and dry subject understandable and even ACCOUNTING GAME fun. This book successfully does just that.” —Amazon Reviewer The Clearest Explanation Ever of the Key Accounting Basics The world of accounting can be intimidating. Whether you’re a manager, business owner or aspiring entrepreneur, you’ve likely found yourself needing to know basic accounting…but baffled by complicated accounting books. What if learning accounting could be as simple and fun as running a child’s lemonade stand? It can. Updated d The Accounting Game presents financial information in a format so simple and & Revise so unlike a common accounting textbook, you may forget you’re learning key skills that will help you get ahead! Using the world of a child’s lemonade stand to teach the basics of managing your finances, this book makes a dry subject fun and understandable. As you run your stand, you’ll begin to understand and apply financial terms and concepts like assets, liabilities, earnings, inventory and notes payable, plus: from the Lemonade Stand Basic Accounting Fresh Interactive format gives you hands-on experience Color-coded charts and worksheets help you remember key terms Step-by-step process takes you from novice to expert with ease Fun story format speeds retention of essential concepts Designed to apply what you learn to the real world The revolutionary approach of The Accounting Game takes the difficult subjects of accounting and business finance and makes them something you can easily learn, understand, remember and use! Mullis & Orloff “The game approach makes the subject matter most understandable. I highly recommend it to anyone frightened by either numbers or accountants.” —John Hernandis, Director of Corporate Communications, American Greetings Basic Accounting Fresh Business/Finance/Accounting $19.95 U.S./$23.95 CAN/£10.99 UK ISBN-13: 978-1-4022-1186-7 ISBN-10: 1-4022-1186-4 from the Lemonade Stand UPC EAN www.sourcebooks.com Darrell Mullis & Judith Orloff  The Accounting Game Updated and Revised Basic Accounting Fresh from the Lemonade Stand Darrell Mullis and Judith Orloff Copyright © 2008 by Educational Discoveries, Inc. Cover and internal design © 2008 by Sourcebooks, Inc. Sourcebooks and the colophon are registered trademarks of Sourcebooks, Inc. All rights reserved. No part of this book may be reproduced in any form or by any electronic or mechanical means including information storage and retrieval systems— except in the case of brief quotations embodied in critical articles or reviews—without permission in writing from its publisher, Sourcebooks, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional ser- vice. If legal advice or other expert assistance is required, the services of a compe- tent professional person should be sought. From a Declaration of Principles Jointly Adopted by a Committee of the American Bar Association and a Committee of Publishers and Associations Published by Sourcebooks, Inc. P.O. Box 4410, Naperville, Illinois 60567 (630) 961-3900 FAX: (630) 961-2168 www.sourcebooks.com ISBN-13: 978-1-4022-1975-7 Previous edition cataloged as follows: Mullis, Darrell. The accounting game: Basic accounting fresh from the lemonade stand Darrell Mullis, Judith Orloff. p. cm. Produced by Educational Discoveries. 1. Accounting. I. Orloff, Judith Handler. II. Educational Discoveries (Firm) III. Title. HF5635.M953 1998 657—dc21 98-17214 Printed and bound in the United States of America. HS 10 9 8 7 6 5 4 3 2 1  TABLE OF CONTENTS Introduction v Pre-Test ix Chapter 1 1 Cash, Original Investment, Assets, Liabilities, Notes Payable, Owner’s Equity, Balance Sheets, Inventory, Earnings, Expenses Chapter 2 21 Gross Profit, Net Profit, Income Statements, Cash Flow Chapter 3 33 Retained Earnings, Loans, Credit, Accounts Payable, Notes Payable Chapter 4 45 Paid Labor, Accounts Receivable, Bad Debt, Interest, Prepaid Expenses, Accrual Method, Cash Method, Creative Accounting Chapter 5 71 Service Businesses Chapter 6 79 FIFO, LIFO iv T H E AC C O U N T I N G GA M E Chapter 7 97 Cash Statements, Fixed Assets, Capitalization, Depreciation Chapter 8 121 Profits vs. Cash Chapter 9 139 Taxes, Liquidation Chapter 10 147 Final Analysis – Improving Profits Post-Test 157 Answer Key 159 Glossary 175 Index 178 About the Authors 180 Diploma 181  INTRODUCTION H ow do people really learn? The answers and theories are endless. They include ideas ranging from genetic imprinting to osmosis and modeling and emotional intelligence. Brain research is voluminous in the 21st century. For now, though, please ask yourself: How do I learn? Isn’t that an interesting question? And, what do you learn? Do you learn infor- mation from reading, watching videos, using computers? Can you learn “people skills” without interacting with other people? Can you change behavior without a model of what the ideal behavior should look like? Feel like? Are there people you meet in your daily travels that you want to emulate? Do you emulate them? How does it work? Can you remember the words of the songs from childhood, but not the ones you listened to last week or even this morning? Questions and questions. More than any other thought process, questions help us learn. Remember what we heard about a baby’s first year of life? Babies learn more in that year than in all the years combined afterwards. Yet, in that first year, babies can- not pose questions in the way they will once they learn language. So, how do babies learn? And what can we take away from that to help adults learn more quickly, retain new information longer, and apply it immediately in their lives? So, what does this have to do with you and this book? Good question. The Accounting Game is written in a way that creates a specific learning experience for you as it teaches you the basic skills of accounting. We call the vi T H E AC C O U N T I N G GA M E learning method accelerative learning. What do you think that means? It is a learning methodology that uses all of your senses as well as your emotions and your critical thinking skills. If you can remember your kindergarten or elementary school classrooms, you will see many colored maps, letters and numbers, bold (even raw) drawings by each child, etc. You learned the alphabet by singing. You learned the multiplication tables by saying them out loud with each other. You laughed a lot. You were creative. Then, how you were taught began to change when you entered middle school or high school. Learning became more lecture, more black and white, more rote. You studied before tests and probably did well or maybe not. Yet, for all the endless homework and “cramming,” most of the information you learned in high school you don’t remember now. That’s because it went into your short-term memory so that you could pass the tests and move on to the next grade. Yet, look at all the things you remember from early childhood! While in elemen- tary school, much of the information you learned went directly to your long-term memory, because it was peppered with music, color, movement, smells, emotional experiences, and lots of play and fun. The methodology we use in this book in many ways parallels how you learned in grade school. We do this by accessing the part of your brain where long-term mem- ory lives. Now, the way to reach your long-term memory has to include emotion, because they reside in the same place in your brain—the limbic region. The truth is, because of the way we humans learn, we have to discover something ourselves to really learn it. This book is designed so you make dozens of discoveries. In short, you will learn a college semester’s worth of accounting in the time it takes you to interact with this book. This is quite a reversal, because business people and students have over the years found the subject of accounting quite difficult to master. Many have simply given up in frustration, others have decided to leave accounting to the “experts.” This book is for all of you who have hated accounting, had difficulty learning it, or ever thought you didn’t really “get it.” We think that most attempts to teach accounting fail because of too much attention to details and a failure to present the big picture framework of how it all works and fits together. In this book, we promise not to overburden you with details and to focus on what are really the key concepts of accounting that any businessperson needs to know.  INTRODUCTION vii You will learn the structure and purpose of the three primary financial statements— the balance sheet, the income statement, and the cash flow statement. You will learn how these fit together and their interrelationships. You will also learn the basic lan- guage of business—concepts like cost of goods sold, expenses, bad debts, accru- al vs. cash methods of accounting, FIFO and LIFO, capitalizing vs. expensing, depre- ciation, and the difference between cash and profit. Our promise is that you will get all this information in a fun and easy way that allows you to participate, interact, and discover all that you need to know. Many peo- ple need to have understanding and confidence in working with financial concepts, but are not ever going to be doing accounting details. If that is you, then this book fits that need, too. It is set up so that you can actually do financial statements as you are learning them. We invite you to “play the game” as you interact with this book (answers to the charts can be found in the Answer Key on pg. 159). Understanding all this information is nice, but what do you do with it? The final chapter will give you some tools for analyzing financial information and making bet- ter decisions for your company and your career. As mentioned, the information in this program was developed by Educational Discoveries, Inc. in the early 1980s in a one-day seminar, The Accounting Game™. The program was originally created by Marshall Thurber at the Burklyn Business School in the late 1970s. Nancy Maresh, a student at Marshall’s school, then took the program and developed The Accounting Game seminar. We offer our heartfelt thanks for their original genius and commitment to bringing this extraordinary pro- gram to life. We also want to thank all of the somewhere between 75,000 and 100,000 people who have attended the public and private seminars for the fun they have been and for the insights and suggestions that have helped us improve the teaching of this information. The Accounting Game is now offered in private seminars by Coastal Training Technologies Corporation. The Accounting Game continues to be the most successful financial seminar in the world. So, enjoy! Because if you enjoy this book, you’ll learn more in a brief time than you ever imagined possible. Judith Orloff and Darrell Mullis  PRE-TEST 1. Which one of the following items is not found on a Balance Sheet? A. Cash B. Gross Profit C. Assets D. Liabilities 2. Which accounting system most accurately reflects profitability? A. Cash Accounting B. Flow of Funds Accounting C. Accrual Accounting 3. An account receivable is: A. an Asset B. Owner’s Equity C. a Liability 4. Which of the following is most important to the daily operations of a business? A. Assets B. Retained Earnings C. Cash 5. When people speak about the bottom line, they are referring to: A. Net Profit B. Gross Margin C. Gross Profit x T H E AC C O U N T I N G GA M E 6. A prepaid expense is: A. an Asset B. Owner’s Equity C. a Liability 7. Is LIFO/FIFO a method of: A. Inventory Evaluation B. Profit Ratio C. Financing 8. Which would you find on an Income Statement? A. Expense B. Fixed Asset C. Liability 9. Which of the following expenses does not affect your cash position in running a business: A. Lease Expense B. Advertising Expense C. Depreciation Expense 10. Which of the following is a basic accounting equation: A. Net Worth = Assets + Profits B. Gross Profit - Sales = Gross Profit Margin C. Assets = Liabilities + Owner’s Equity T H E AC C O U N T I N G GA M E xi  CHAPTER 1 R emember how you learned to make money as a kid? There was baby-sitting and delivering newspapers. Shoveling snow off the neighbors’ sidewalk and driveway. Mowing lawns and taking care of other people’s pets and plants when they went on vacation. There is one business which, chances are, almost every kid tries at least once in his or her life. A tried and true operation as American as baseball and Mom’s apple pie. The Lemonade Stand. It’s this world of childhood, of lemonade stands and sunny days that we use in The Accounting Game. It’s hand-made signs and scraps of lumber turned into a humble yet proud establishment. It’s when saving up enough of your own money for a bike or a piece of sports equipment or horseback-riding lessons seemed the most important goal in the world. It’s when you had your first inkling about money, and wished you understood everything you needed to know about it. Now is your chance to go back, and learn what you need to know about the lan- guage of business, which goes by the name of Accounting. So, find a quiet space and relax. Read a paragraph of the italicized passage below, then close your eyes and visualize what you’ve just read. When you’re ready, go on to the next section, and the next… 2 T H E AC C O U N T I N G GA M E Let yourself slowly go back in time… Let’s go back, all the way back to grade school. Picture yourself somewhere between five to ten years old. Let yourself remember what your childhood grade school looked like. If you went to more than one school, just pick out your favorite. It’s the last day of school. The sun is streaming through the classroom window. You can’t wait for the final bell to ring one last time—then you’ll be free! Free to run out the door with all your friends! You’re young and safe and eager. Everything is possible. You feel creative, curi- ous, and excited, and know your success in life is absolutely assured. Let this picture settle into your mind. Take a deep breath. Enjoy it. The final school bell rings. You tell your teacher to have a good summer, and you rush out the door. It’s so warm and wonderful outside! The sky is blue and you look up and see a few white, puffy, clouds decorating the view like a happy cartoon. Kids are laughing. Lawnmowers are buzzing. Birds are chirping. You can smell fresh cut grass and the scent of flowers. You feel great. You reach home and go inside. Since it’s a special day, your mom or dad is home to meet you. You’re hot and excited, so you say, “What’s to drink?” And your mom or dad replies, “You’re in luck! I just bought some lemons and some sugar so let’s make some fresh-squeezed lemonade.” You get out a great big pitcher, fill it with water and ice, squeeze up some lemons, measure out the sugar, and mix up a batch of great tasting lemonade. This is going to be one fun summer! Take a moment and let this thought settle. Take a deep breath. You take your drink outside and sit under your favorite tree. The lemonade tastes out of this world! Then it hits you—people will pay good money for lemonade like this!  C H APTER 1 3 Ready? Good! In the garage is the stuff you need to make a lemonade stand: two wooden fruit crates turned on their ends, some old cans of paint and brushes, a hammer and some nails. You take an hour or two to put your stand together. It’s fun working with your hands and watching something of your own devising take shape. When you finish, you take a close look at your new place of business. If there’s a finer lemonade stand in the world, you sure haven’t seen it! Here’s your very own lemonade stand. Find some markers or stickers, and go ahead and decorate it, if you wish. Make it distinctively your own. Now that your place of business is ready, you need a product—and that takes money! You run to your bedroom and shake out all the quarters and nickels and dimes from your piggy bank. It adds up to FIVE DOLLARS! You transfer the money to the closest equivalent you can find to a bulletproof, x-ray proof, robber proof, impossible-to-open safety deposit apparatus—an old cigar box your uncle was about to throw out. You don’t want to mess with all those coins, so your mom or dad graciously exchanges all of them for five, crisp one-dollar bills. The five dollars go into the cigar box bank for safe-keeping. In case anyone doesn’t know the cigar box is off-limits, you take a marker and write on it: 4 T H E AC C O U N T I N G GA M E PRIVATE PROPERTY! KEEP OUT(OR DIE)! Okay, your money is safe. What do we call those five one-dollar bills? CASH! And what color is cash? Green! Now that you’re going to be rich, how are you going to keep track of the hundreds— no, millions! BILLIONS!—of dollars you’re going to make selling lemonade? You need some paper and a pencil, for sure. You need some way to keep a record of what money goes in and out of your business. This record keeping is what accounting is all about. You know enough about the world to know that one way grownups keep track of numbers is to keep score—like in baseball or golf, or whether your mom or dad last cleaned up after the dog in the back yard. You decide to create a scorecard for your business. Your scorecard allows you to keep track of things happening in your business. To better understand how money flows in and out of a business, though, we need a scorecard that shows two things: WHAT WE HAVE and WHO OWNS IT. Which means we need to draw a line down the middle of the scorecard. On the left side you’ll track things and stuff you have and use in your business. On the right side you’ll track who owns that stuff. So, your scorecard looks like this: The left side represents WHAT WE HAVE. The right side of our scoreboard represents WHO OWNS IT. Now that we have a proper scorecard, let’s back up a moment. You start the business with some Cash, specifically five dollars. Who has it?  C H APTER 1 5 You’re right—you do! And, no doubt, you had to scrimp and save and keep your room clean and remind your parents a bunch of times to remember that the tooth fairy always leaves you some money when you lose a tooth. You worked hard for that five bucks! It’s yours and nobody else’s. Which means that it goes on the left side of the scorecard, as $5 in Cash. But it also goes on the right side since you own the $5. But what will you call this $5? The whole idea is to invest the five bucks in your lemonade stand. Right? So, what should we call the money that you originally shook from the piggy bank to invest in the lemonade stand? How about “ORIGINAL INVESTMENT”? Who owns the Original Investment? You, as the owner, do. So it goes on the right side of our scorecard. Let’s write in what’s happened, so far. Enter the five dollars in Cash on the left side and enter the five dollars in Original Investment on the right side. Next, enter the totals on the last line of each side. $5.00 $5.00 $5.00 $5.00 Notice anything about the two sides? They’re equal. The left side equals the right side. You now know an important rule about this financial scorecard. The left side will always, ALWAYS equal the right side! Repeat this rule, please. Tape it to your forehead. Put it under your pillow at night, so you will remember it in your sleep: THE LEFT SIDE ALWAYS EQUALS THE RIGHT SIDE! 6 T H E AC C O U N T I N G GA M E So far, so good. The weather is great outside and you’re ready to rock and roll! You can close your eyes and see the customers lining up around the block to sample your great tasting lemonade…until you realize that starting a lemonade stand will cost more than the original investment of five dollars because you have to buy stuff to make your lemonade. Who is most kids’ personal banker? Right, Mom and Dad. So you go to one of them (you know which one is more likely to say yes), and you say, “Here’s your chance to teach me the real value of a dollar. Here’s your chance to invest in a business sure to make lots of money. Here’s your chance to help a bud- ding billionaire. Here’s your chance to keep me out of your hair until dinnertime!” One of the reasons works, and Mom and Dad fork over TEN DOLLARS. You’re halfway out the door when Mom calls, “Hey, that ten dollars isn’t a gift! It’s a loan!” You stop short. “A loan?” you repeat, making the word sound as disappointing as possible. “What’s the matter? Don’t you love me?” “Nice try,” Mom says. This is all part of teaching you something about the real world. Okay, you still have the money, even after Mom makes you sign a piece of paper that says “IOU” at the top. Still, the ten dollars is yours to use, so you can add it to your Cash under What We Have. But you also owe it to Mom. So, since you don’t, in fact, “own” the ten dollars, we need to create a new category on the right side (Who Owns It) of the scorecard. You have, in fact, just signed a “note” that is “payable” to your mom. Businesses have a name for an IOU. It’s called Notes Payable. Go ahead and record these transactions. NOTES PAYABLE  C H APTER 1 7 So, we have the left side which represents what you have and use. And what do you have? Cash. And how much cash so far? Fifteen dollars. Businesses have a name for the WHAT WE HAVE. Do you know it? Assets. So, from now on, we’ll use Assets as our heading for the left side. On the right side, who owns that cash? You own five and your bankers (Mom and Dad) own how much? Ten. Since there are two owners on the right half, we will draw a horizontal line that divides the right side into two parts. The upper right side represents the people that the business owes money to…or to whom you are LIABLE. Are you going to have to pay back the ten dollars to Mom or Dad? (You’d better, if you want to see your next birth- day!) So, are you liable to them for $10? Yes. Which is why, from now on, we’ll label the top part of the right side, LIABILITIES. Notice we will use the color pink for liabilities. The lower right side represents the portion of the business you own; right now, that is your Original Investment. What do some people call the part of the business owned by the owners? Make a check mark by the answer below. (Hint: there may be more than one answer.) Equity Owner’s Equity Stockholders’ Equity Net Worth Did you make a check in front of all of the above? You should, because they’re all the same thing. For our sake, we’re going to call this lower right side, Owner’s Equity, and represent it with the color black. So, the right side has two parts: Liabilities (what you owe others) and Owner’s Equity (what’s yours). Remember we said the left side always equals the right side? Well, here’s the next accounting rule to remember: 8 T H E AC C O U N T I N G GA M E Assets = Liabilities + Owner’s Equity Repeat this equation. Write it on the palm of your hand. Put it under a magnet on the fridge. Program it as your computer screensaver. Here’s your scorecard again, with the proper accounting terms. NOTES PAYABLE $10.00 $ 1 5.00 $ 5.00 $ 1 5.00 $ 1 5.00 Before moving on—does the left side still equal the right side? It should. Always! Always! Always! You’re doing great. And, hopefully, you’re having fun. You’re making discoveries, maybe seeing things clearly for the first time. What’s a good way to capture such a beautiful moment? How about by taking a snapshot. What period of time does a snapshot record? Check one: A moment Longer than a moment The answer is: A MOMENT. Snapshots give us an image of where we are right NOW. This scorecard is like a snapshot. It gives us an image, frozen at a particular moment, of a business’s financial position—what you have and where it came from. So, this scorecard shows a moment in time, and the two sides are equal—or, as they say, “in balance.” So, from now on, let’s call this scorecard…  C H APTER 1 9 A BALANCE SHEET! But, for the moment, enough of this philosophical stuff about time and nitpicking over words—we’re here to start a lemonade stand! Having the money to start your business, you tell your mom and dad that you’re biking to the store for supplies. The money in your pocket or pack feels enormous! You bike as fast as you can, so you can spend the money before you somehow lose it. Or before any robber is stupid enough to even try and catch you on your fleeting bike. You make it to your neighborhood grocery store. It’s run by Mr. Pappy Parker, whom everyone calls “Pappy.” He has a large friendly face and a big nose. His eyes are blue, his eyebrows bushy gray. He’s bald and proud of it. Entering Pappy’s store, you feel like the happiest kid in the world. You check your pocket or pack. The fifteen dollars is still there. Phe-ew! You take out the folded piece of paper on which (with your mom and dad’s help) you’ve writ- ten the supplies you need to open your lemonade stand. 50 lemons 5 pounds of sugar 2 gallons of water The water you can get for free from your kitchen. The lemons and sugar you have to buy at Pappy’s store. Lemons sell for twenty cents apiece. Sugar sells at forty cents per pound. You’re pretty good at math, so go ahead and add up the cost of the goods you need to make lemonade: 10 T H E AC C O U N T I N G GA M E 50 lemons at 20¢ each = $ 5 pounds of sugar at 40¢ per pound= $ 2 gallons of water free Total Purchases = $ Having paid Pappy (who wishes you the best of luck with your new business), you load your supplies in your pack for the return trip. At home, you unload your supplies in the kitchen. Then, before you forget, you do a new scorecard that reflects the money spent buying goods to make your product. Since you spent twelve dollars on supplies, you need to take that amount out of Cash and record it somewhere new under Assets, since you’re now the proud owner of fifty lemons and five pounds of sugar. What do business people call the raw materials used in producing a product? Here’s a hint. The word starts with “I” and ends with “Y.” Need another hint? The inside letters are “N-V-E-N-T-O-R.” Did you guess “Inventory”? If so, you’re absolutely right! Inventory is a term for the raw materials, goods in process, and finished goods that a business plans to sell. Since you will use the lemons and sugar in your business, they are considered assets. So, Inventory is an Asset. Take a moment and fill in the scorecard. NOTES PAYABLE $10.00 $5.00 $15.00  C H APTER 1 11 Take at look at the last scorecard. Your cash is down, but it’s been converted into inventory. In other words, you exchanged one asset for another. Did this exchange change your total Assets? No. Your total Assets remain at fif- teen dollars. Was the right side of the scorecard affected by your trip to the store? No. The total Liabilities and Owner’s Equity remains at fifteen dollars. Does the left side equal the right side? Yes! So, you’re in balance! It’s time to make the lemonade. Being careful not to waste a drop of lemon juice or a speck of sugar, being care- ful not to spill after you add the water, you discover that fifty lemons plus five pounds of sugar plus two gallons of water make enough lemonade to fill sixty glasses. Let’s put this into an equation, to determine what your COST OF PRODUCTION is. 50 lemons @ 20¢ each $_______ 5 lbs. Sugar @ 40¢/lb. $_______ + 2 gal. Water, No Charge 60 Glasses= $ ______ Now that we know your total Cost Of Production, let’s figure out the cost per glass, or UNIT COST: COST of Production $____ = Cost per Unit (Glass) $_____ # of glasses ____ 12 T H E AC C O U N T I N G GA M E Hopefully, you came out with a Unit Cost of twenty cents. (Divide $12.00 by 60 glasses.) You now know that it costs you twenty cents to produce one glass of lemonade. Not just a glass of ordinary lemonade, but, in your humble opinion, the world’s best glass of lemonade. Then you ask yourself, “What will people pay for a glass of the world’s best lemonade?” You certainly need to charge more than it cost you, otherwise you won’t stay in business for long. But how much more? You ask around. You ask your family and your friends and your neighbors and your dog or pet turtle. You think about what restaurants charge for drinks. You remember that last summer the kid down the street (who you don’t like) got a dollar for his lemonade which was made from some awful-tasting powder mix. Not surprisingly (and to your secret delight), he only made a few dollars, and only because his parents felt sorry for him and bought a few glasses which they barely choked down. Your product is excellent. Still, you don’t want to charge so much as to scare away business. So, after concluding your research and pondering this important matter for a second or two, you decide to charge fifty cents a glass. Finally, the big day arrives. The day your lemonade stand opens for business. It’s a warm, sunny, glorious day, full of promise, and there’s, like, hundreds of people out walking their dogs and riding bikes and doing chores. Best of all, they all look incredibly thirsty! In just a couple of hours, your cigar box starts to fill with quarters, dimes, nickels, pennies—and dollars! You can barely keep up with the demand. Your arm is about to fall off from pouring so many glasses of icy, cold, delicious, fresh, totally natural and organic lemonade, but you don’t care because business is so good! By the time you close up for the day, you’ve sold fifty—as in 5-0—glasses of lemonade! You add up all of the coins and dollars. You sold twenty-five dollars of lemonade, on only your first day! Life doesn’t get much better than this. Then you remember that you had to spend money to make the lemonade. It cost 20¢ per glass, so it cost $10 to make 50 glasses. Now you figure if it cost $10 and you sold it for $25, you have $15 above and beyond your costs. Do you know what that’s called? Profit or Earnings, right. In order to figure out your earnings, you need to  C H APTER 1 13 subtract the COST OF GOODS SOLD (what it cost to make the fifty glasses of lemonade you sold) from your SALES (the money brought in by selling lemonade). The result of this subtraction is what business people call GROSS PROFIT. Sales $____ Cost of Goods Sold (50 glasses @ 20¢ each) $____ Gross Profit (Earnings so far) $____ Let’s reflect the day’s business on a scorecard. Remember, you sold fifty glasses of lemonade, which cost you ten dollars in Inventory to produce. Thus, the amount in Inventory was substantially reduced. In return, though, in came twenty-five dollars of Cash, representing the sales of fifty glasses. Go ahead and record these changes. NOTES PAYABLE $10.00 $5.00 $15.00 Does the left side equal the right side? No. How much more do you have on the left side than the right side? Fifteen dollars. Who owns that fifteen dollars? You do. So we add $15 to Owner’s Equity. But the earned $15 was not part of the Original Investment. So, what do you think we need to do? Yes, add another category to 14 T H E AC C O U N T I N G GA M E Owner’s Equity. We earned that $15, so we’re going to add EARNINGS WEEK TO DATE to the Owner’s Equity section. Reflect your Earnings Week To Date on the right side of the next scorecard. Then add up the new total Liabilities and Owner’s Equity. Now, how much is on the left side? Thirty dollars. $10.00 $ 5.00 $15.00 $30.00 How much is on the right side? Thirty dollars. Does the left side equal the right side? Yes. What basic rule of accounting does this represent? Assets = Liabilities + Owner’s Equity. When did you earn that fifteen dollars? Just now. And, who do the earnings belong to? Me, me, me! Have things changed on your scorecard? And how! So, take another mental snap- shot, one that records your first day running a lemonade stand—and making a profit! That evening, as you practically have the money you made already spent in your mind, Mom and Dad drop a bombshell. Those glasses you used at your lemonade stand, the ones you handled so care- fully and afterwards washed ’til they sparkled and returned to the cupboard without as much as a scratch or chip on them—the glasses you borrowed from the kitchen— guess what.  C H APTER 1 15 Mom and Dad want to give you a lesson about running a business, and, without warning, decide to charge you a GLASS RENTAL FEE of two dollars!! Talk about tough love! You keep your mouth shut, but secretly you’re convinced that Mom or Dad saw you making a profit and now want a piece of the action! Worse yet, the next day, your best friend (or the kid you thought was your best friend) announces that he or she wants to be paid one dollar for a sign he or she painted for the lemonade stand. Well, you decide, two can play this game! That afternoon, you decide you want to move the stand off your front yard, to the neighbors at the corner, which is sure to attract more business. Only problem is, the neighbors have been none too happy with you ever since they paid you to water their lawn while they were on vacation and you left the water on for about, oh, five hours too long and flooded their basement. But, hey, that was last summer, when you were just some silly kid. Now you’re a budding businessperson running your own enterprise. Nervous as a cat in a dog kennel, you knock on the neighbors’ door. You explain your situation. To your relief, nobody mentions the flooded basement. They’re impressed with your initiative, and suggest a fair price for the use of their front yard. Now that you’re a real business person, with real sales and expenses, you pay the neighbors two dollars to rent a spot on their lawn. Two dollars for glass rental. A dollar for advertising. Another two dollars to rent the location. Stop and figure out your EXPENSES. Glass Rental $______ Advertising $______ Rent $______ Total Expenses = $______ 16 T H E AC C O U N T I N G GA M E Expenses are the costs of doing business other than those related to producing your product. You have to pay these expenses, regardless of how much or how lit- tle lemonade you make or sell. Things like glass rental, advertising, rent, and other things not directly related to the cost of making your product are in this category. You pay your expenses out of Cash. Record the change on the next scorecard. $10.00 $ 5.00 $15.00 $30.00 Does the left side equal the right side? No. In order to make both sides equal, you need to take five dollars off the right side. How about taking it out of the ten dollars you owe in Notes Payable? On second thought, the way Mom and Dad are acting, you might have to pay a finance charge for the original loan if you even broach the possibility! What will the expenses reduce? Expenses reduce earnings. So, you need to reduce your Earnings Week to Date by the amount you’ve incurred as Expenses in that period. Do so on the next score card.  C H APTER 1 17 Now, does the left side equal the right? Yes! Your cash is dropping but you still have enough left to pay off the ten-dollar IOU owed to Mom and Dad. You decide to do it, knowing your lemonade business will soon be challenging the likes of Nike, Disney, and Coca-Cola; even Microsoft! You find the least wrinkled dollar bills and count out ten of them. Then you put them inside a card, which reads: Thanks for the loan! I love you! The card, in turn, goes into an envelope, which you seal and present to Mom and Dad. They open the envelope, read the card and pocket the ten bucks with a big smile. “You did good. We’re so proud of you!” They both give you a big hug. It’s a proud, proud day! They give you back the IOU, which you tear up. Life doesn’t get much better than this! To pay off the IOU, you took ten dollars from Cash. But it allows you to reduce to zero the amount owed to Notes Payable. Record this transaction on the next scorecard. 18 T H E AC C O U N T I N G GA M E Does the left side equal the right side? It does. So, what kind of scorecard is this? A Balance Sheet. And what does a balance sheet always have to do? Balance. Let’s look at the purpose of a balance sheet. The left side is Assets. Assets as a word isn’t very kid-friendly. So, think of assets as THINGS AND STUFF. THINGS & STUFF PEOPLE WE OWE OWNERS The right side is Liabilities and Owner’s Equity. Some more not very kid-friendly words. Liabilities represents the people you owe money to. And Owner’s Equity is  C H APTER 1 19 what you, as the owner of the business, own. Who owns things? Well, people, of course. So, think of the right side as PEOPLE. Thus, the purpose of the Balance Sheet is to connect things to people. It shows you the things you have in your business. Then it connects the things you have to the people who own or have a claim on those things. Now, go back and count how many Balance Sheets you filled out during this first week of your lemonade business. A lot! Because you filled one out for each transaction. Would you normally fill out a Balance Sheet every single time you have a trans- action? No. How often a Balance Sheet is filled out varies from business to business. Banks, since they handle a great deal of money, do it on a daily basis. Some other busi- nesses do it weekly, monthly, quarterly, and yearly. (A year is considered the basic accounting cycle.) Since you plan to continue selling lemonade through the summer, we will use a week as our accounting period and do balance sheets with each activity. Boy, you’re doing great! But does a Balance Sheet tell you everything that hap- pens in a business? Look back at your last Balance Sheet. What happened this week at your lemonade stand that isn’t recorded on the Balance Sheet? Does the Balance Sheet show you what your sales were for the week? No. Does it tell you what the Cost of Goods Sold is? Nope. Did you buy some inventory this week? Yes. Remember the trip to the store for supplies? Did you sell some of your product? Sure did! Does the balance sheet tell you how much Inventory you bought and sold? No. Does it tell you how much you paid for all your Expenses (like the glass rental, advertising, and rent for using the neighbors’ lawn)? No way! Does it tell you how you made your Earnings? No. NO! And enough already with these questions! Would a business want to know all of these things? You bet! The problem is, you can’t find them by looking at a balance sheet. What will we need to do? Create another scorecard. 20 T H E AC C O U N T I N G GA M E We learned that a Balance Sheet shows us a moment in time, like a snapshot, but we need for our second scorecard to give us a record of events happening over a period of time. Events like buying inventory, making your product, selling it, and incurring expenses are happening over time. What type of camera records a period of time? Something in the act of happening? A movie or video camera, of course. So, we need a financial scorecard that acts like a motion picture. It will cover a period of time and shows motion. It has a beginning and end, just like a movie or video. Luckily, this second type of scorecard exists, and it goes by a number of names. Do any on this list sound familiar? Operating Statement. Income Statement. Profit & Loss (or P & L) Statement. All of these terms represent the same type of financial statement. But, for our purposes, let’s go with Income Statement. If you need a break—maybe all of this talk about lemonade has made you incred- ibly thirsty—now’s a good time. If you do take a break longer than a few minutes, you may want to review this section before moving ahead. If, on the other hand, you have the stamina of a camel, next we’re going to take up the Income Statement.  CHAPTER 2 I magine how the first people to see motion pictures must have felt. Before the invention of the movies, the only way to capture the world was static—a frozen image, like a photograph or a painting. Then, with the first motion pictures, people were able to see the world as it really is! Always moving and changing. With things happening simultaneously at different places. At the end of the last chapter, we said that if the Balance Sheet is like a snapshot of a business, then the Income Statement is like a movie. Does a photograph have a beginning and an end? (No, unless you wish to enlist some strange philosophical argument that will bore even your best friend.) Now, does a movie have a beginning and an end? (You get two chances to answer, and the first one doesn’t count!) Thus, an Income Statement has a beginning and an end. Now, since we’re talking about a financial scorecard and not some zillion-dollar Hollywood extravaganza, what exactly does an income statement show us? It’s called an income statement, so let’s start by asking how income is generated in our lemonade business? From…what? Did you say, “Sales”? Very good! 22 T H E AC C O U N T I N G GA M E So, we begin with sales. Did it cost us any product to generate those sales? Yes. We need to find a name for what it costs us for goods sold. Hmmmm. Any ideas out there? Well, I’m going out on a limb now, but, with your permission, may I be bold enough to suggest Cost of Goods Sold? Now, what does Cost of Goods Sold mean? The important thing is this: Cost of Goods Sold relates only to what? Our product or our lemonade. Okay, let’s do some figuring. If we subtract out the Cost of Goods Sold, not all the other stuff we spent money on, from Sales, what do we get? Gross Profit. Gross Profit is sales minus cost of goods sold. (Net Profit is something different, which we’ll get to shortly.) Sales -COGS (Cost of Goods Sold) = Gross Profit Why do we call it gross profit? The word “gross” in German means “big” or “fat,” so why is this the “fat profit”? Because we haven’t taken out all the other costs of doing business. And what are examples of some of the other costs of doing business? Did I hear someone say, “Expenses”? If so, you’re right!  C H APTER 2 23 Just to have our lemonade stand open out on the sidewalk did we have certain expenses? Yes! We had glass rental and rent to the neighbors for our location and some advertising. So, are Expenses the cost of being in business, regardless whether or not we sell a single glass of lemonade? ’Fraid so! A moment ago, we said the lemonade or the Cost of Goods Sold is subtracted from our Sales and then we’ve got our Gross Profit. Now, let’s subtract out all the other Expenses and we get what? (Now, those of us curious about Net Profit, chime in!) Sales -COGS = Gross Profit -Expenses = Net Profit Notice how Net Profit is at the bottom line of this formula? So, it stands to reason that Net Profit is often called the…? Bottom line. You can see that our Income Statement separates costs into two categories— Cost of Goods Sold for all the costs of producing our product, and Expenses for all the non-production costs of running the business. For a business that does not have a tangible product (i.e., a service business) the two categories are Cost of Sales or Cost of Services and Expenses. Now, go back to Chapter One and put in the numbers for the formula below, so we can see where we stand with the bottom line. 24 T H E AC C O U N T I N G GA M E Sales $______ -COGS $______ Gross Profit $______ -Expenses $______ Net Profit $______ Let’s take a moment and review. The purpose of the Income Statement is to keep track of sales minus Cost of Goods Sold, which gives us Gross Profit. Then, we subtract all the other Expenses, which gives us our what? Net Profit. What is another name for net profit? Net Income or the bottom line. So—earnings, net profit, net income and the bottom line—are they all the same? Absolutely! Okay, let’s get back to business! We’re going to go through a detailed Income Statement line by line. You may want to get a straight edge (a ruler; even an enve- lope or a piece of paper will do), to help you keep things clean and simple.  C H APTER 2 25 INCOME STATEMENT INC OME STATEMENT Begin: Monday A.M. End: Sunday P.M. SALES $ Beginning Inventory $ + Purchases Sugar Lemons Total Available for Sale $ - Ending Inventory = C OST OF GO ODS SOLD GROSS PROFIT = EXPENSES = TOTAL EXPENSES NET PROFIT $ We said that an Income Statement was like a motion picture in that it has a begin- ning and an end. This length of time can be a week, a month, a quarter of a year, etc. Whatever the length, it’s called the ACCOUNTING PERIOD. Remember when you were a kid and how it was hard to look beyond the next day or two, much less well into the next week or month? Remember how agonizing it was to wake up early and have to wait and wait and wait and wait until your after- noon party guests started to arrive? So, since we’re running a lemonade stand, let’s not make our accounting period too long. Say, a week. So, let’s begin on Monday and end on Sunday. Wow, we’ve been in business one whole week! That’s longer than a lot of good ideas last. Do you remember what our total sales were for the week? If not, check back in Chapter One. Hopefully, you came up with twenty-five dollars in total Sales. Put it all the way to the right on the Income Statement. Why? Because it’s a total figure, and we’re going to do something with it in a little while. 26 T H E AC C O U N T I N G GA M E By the way, you probably notice that it’s pretty awkward to have to go back to look up all the information. Do you know how a business organizes the information so it is found easily? Businesses create what’s called a GENERAL LEDGER, which is a moment by moment record of every thing that happens. In the good old days of business, every entry in the General Ledger was recorded by hand. (Remember Scrooge poring over his ledger in A Christmas Carol?) Today, almost all businesses use a computer. The software is programmed to create categories for each item and sums them for the financial statements. Let’s drop down to the next line. What’s it say? Beginning Inventory. Did we have any inventory before we started this week? No. We didn’t even have a business before this week! So reason dictates that the amount of the Beginning Inventory is what? Zero. Go ahead and write it in. Then, to start the business, you went and bought what? Sugar for $2.00 and Lemons for $10.00. Write that in. Drop down to the next line. Given all this, how much available for sale did you have during the week? (Beginning Inventory + Purchases.) But did you sell it all? No. Drop down to the next line. What do we subtract out? The lemonade not sold. What’s it called? Ending Inventory. Okay, since we didn’t sell it, we can’t count it as a part of the Cost of Goods that we actually sold. Right? Right. Drop down to the next line. Math time. Take Beginning Inventory + Purchases - Ending Inventory. The result is the actual Cost of Goods Sold. Which is…? (Write your answer on the Income Statement.) Write in the COGS. While you are doing it, notice that this figure is also where? On the right. Which means we’re going to do what with it? Subtract it. Now, subtract the Cost of Goods Sold from our Sales—and what do you have? (Write it in the next line, way to the right). What do we call this amount. It’s our Gross Profit!  C H APTER 2 27 Now, what do have to subtract next? Expenses. Our Expenses include…what? Well, there was Glass Rental and Advertising, and Rent. Go back to Chapter One for the actual costs, then write them on your Income Statement. What are your total Expenses? Add up the Expenses. Notice that this total figure goes where…? All the way over on the right. Which means we’re going to…? Subtract it. Subtract it from what? The Gross Profit. Which leave us with…? Our Net Profit In what amount? (Write it down on the Income Statement.) Take a moment and wipe your brow and rest your racing pulse. Now compare the numbers on the Income Statement to the numbers on your last balance sheet that is on page 18. Do you see any numbers that are the same on the Balance Sheet and Income statement? Earnings and Net Profit. So, are these two figures the same—Earnings week to date (on the balance sheet) and Net Profit (on the income statement)? Yes! A while back we compared financial scorecards to snapshots and motion pic- tures. Let’s try looking at them in another way. A Balance Sheet is like the map of the state you live in. What do you see on a state map? (Cities, main roads, rivers, mountains, etc.) Basically, a pretty big picture short on details. Let’s focus on one item on the Balance Sheet: Earnings. Pretend it’s like the city or town you live in. The state map shows you where it is, but does not give you any details. What kind of map do you need to see the streets, the streams, the local land- marks? (A city or town map. ) It’s like a blow up and that’s what the Income Statement is. It’s a blow up or detailed “city map” of how we got to our Earnings. The Balance Sheet just says you had $10 in Earnings. The Income Statement shows that you had $25 in Sales, $10 in COGS, and $5 in Expenses. Returning to the world of accounting, we take earnings week to date on the Balance Sheet and blow it up and what do we get? The Income Statement! 28 T H E AC C O U N T I N G GA M E Let’s look at the numbers on your last Balance Sheet in Chapter One and the Income Statement we just filled out on page 25. $ 1 3.00 $ 0.00 $ 2.00 $ 5.00 $ 10.00 $ 1 5.00 $ 1 5.00 INC OME STATEMENT Begin: Monday A.M. End: Sunday P.M. SALES $ 25.00 Beginning Inventory $ 0.00 + Purchases Sugar 2.00 Lemons 10.00 Total Available for Sale $ 12.00 - Ending Inventory 2.00 = C OST OF GO ODS SOLD 10.00 GROSS PROFIT = 15.00 EXPENSES Glass Rental 2.00 Advertising 1.00 Rent 2.00 5.00 = TOTAL EXPENSES NET PROFIT $ 10.00 Where, again, are the two financial statements related? Net Profit and Earnings. Any other number the same? YES! Inventory Why do you think our Ending Inventory is on the Balance Sheet and the Income Statement? Because we haven’t used it!  C H APTER 2 29 We can’t take it as part of our Cost of Goods Sold because we haven’t sold it. So, we subtract it from our total available for sale. And on the Balance Sheet, since we haven’t sold it, does it have value? Yes! Is it something we can sell at another time? Yes! So, we leave it here in Ending Inventory. So this is the end of the week, and what kind of Balance Sheet is this? An Ending Balance Sheet. And, if this is an Ending Balance Sheet, what kind of inventory is this? Ending Inventory. Let’s just look at these two financial statements and how they’re linked together. We started with what kind of Balance Sheet on Monday? A Beginning Balance Sheet. And we ended on Sunday night with our what? Ending Balance Sheet. They give us two snapshots in time. Now, the truth is, we actually completed a bunch of Balance Sheets—one for each transaction. We will keep doing that throughout this book, but companies just generate a Beginning and Ending Balance Sheet at the start and end of their accounting period. So, at the start of this week, our beginning inventory was what? ZERO. And end- ing Inventory is what? Two Dollars. Our beginning Earnings are what? Zero. And our ending Earnings are what? Ten Dollars. The thing that connects the beginning and ending balance sheets is what? The movie or the Income Statement. It’s like this. The Beginning Balance Sheet shows us where we started, the Ending Balance Sheet shows us where we are, and what shows us how we got there? The Income Statement. 30 T H E AC C O U N T I N G GA M E You’re doing great! Both as an entrepreneur and in understanding the basics of accounting. Since you’re doing so great, here’s a little challenge. One item that occurred this week does not show up on our final Balance Sheet or on the Income Statement. Here are three questions for you: What item is it? Why is it not on either statement? What does the absence of this item tell us about our record keeping so far? The answer to question one is, the loan payback to Mom and Dad. Why is that not on the Balance Sheet? Because it’s paid back. A loan only shows up on the Balance Sheet when you still owe it. To understand why it’s not on the Income Statement you have to ask yourself how you got the money. Did you earn it? No. Your parents loaned it to you. Did it really cost you anything to pay it back? Not really, you just gave them back their money after using it for a while. So the principal of a loan, the actual amount bor- rowed, does not go on an Income Statement because you didn’t “earn it.” What would have affected Earnings? Interest. Interest on the loan which would have shown up as an expense. Thank goodness Mom and Dad didn’t think of that! Getting to question three—what does this tell us about our records? They are incomplete. Guess what, two financial statements do not present the whole picture! You need at least three statements. And what is the third one? (You probably already know, but just in case, what was affected both when you got and paid the loan? Of course, CASH FLOW. So, the third statement keeps track of Cash Flow. We will develop it in detail in a later chapter.) Phew! It’s the end of the week. Want to work on Sunday? What? And miss a great day to relax, to hit the local swimming hole or pal around with friends? Let’s take Sunday off.  C H APTER 2 31 What are we going to do with those ten glasses of left over Inventory? Put it in the refrigerator and put a sign on it that says: For commercial use only! Do not touch upon penalty of death! Time for a break. Before you leave, give yourselves a gold star for doing such a good job your first week in the business. Good Job!  CHAPTER 3 I t’s Monday. A sunny morning, with the promise of getting really hot by noon. Which can mean but one thing to you, the budding beverage billionaire. It’s a great day to be selling lemonade! Last week wasn’t bad, for a beginner. But from now on, well, look out world! First, let’s take a look at our last Balance Sheet. $ 1 3.00 $ 0.00 $ 2.00 $ 5.00 $ 10.00 $ 1 5.00 $ 1 5.00 34 T H E AC C O U N T I N G GA M E Now, this Balance Sheet is for which week? Last week. Therefore, it’s what kind of Balance Sheet? Ending Balance Sheet. So, this is last week’s Ending Balance Sheet, and where is our ending Inventory? In the refrigerator. And now it’s Monday morning and you go and open up the refrigerator and what’s in there? Your lemonade, or someone has some serious answering to do! Let’s say, for the sake of household peace, that, sure enough, your lemonade is still in the fridge. This Ending Inventory from last week becomes what kind of Inventory for this week? Beginning Inventory, right! One last time: the ending Inventory automatically becomes what kind of Inventory? Right! The Beginning Inventory for the next week. The Ending Balance Sheet is for last week, so we need to make what kind of Balance Sheet for the beginning of week number 2? Beginning Balance Sheet. There’s one more thing we need to do to convert last week’s Ending Balance Sheet to this week’s Beginning Balance Sheet. Do you know what that is? The earnings. The earnings we have were good for which week? Last week, the first week of our business. As a result, these earnings are now what? History. What are earnings that are history, or earnings from past accounting periods called? Retained Earnings. Yes, Retained Earnings, and we need to make room for our earnings for when? This week. We’re going to take these earnings from last week and roll them up into a new category called Retained Earnings, making room for this week’s earnings. We will do this to a sing-along so everyone sing to the tune of “Roll Out The Barrels.” Ready? A one, and a two… Roll up the earnings, lemons are turning to gold. Roll up the earnings, lemons are turning to gold. You’ve got your earnings rolled up. Now, you should have $10 in Retained Earnings and zero in Earnings Week to Date. Complete the Balance Sheet below, to reflect this.  C H APTER 3 35 Retained Earnings will show us all the earnings in a business from when? From prior accounting periods. What exactly are Retained Earnings? We said they are earnings from past accounting periods. There are only two things that happen to earnings—you either retain them in the business or distribute them to the owners of the company. In a cor- poration, a distribution of earnings means the company pays a dividend to the stock- holders. Earnings that have not been distributed are retained in the company. For this week, our earnings will be recorded in Earnings Week to Date—because we always work in the current period. Let’s review. At the beginning of each new week in order to update our Ending Balance Sheet to make it a Beginning Balance Sheet we’re going to do what? Roll up the earnings and retain them in the company and convert Ending Inventory to Beginning Inventory. Great! Now we’re ready to start the new week. As you wake Monday morning, you think, Why stay small? There’s no time like the present to start growing my lemonade business. Real businesspeople don’t go on borrowing money from Mom and Dad. Real businesspeople borrow money from a real bank. 36 T H E AC C O U N T I N G GA M E After breakfast, you put on clean clothes and brush your hair. Then you get Mom or Dad to drive you to your neighborhood bank. You show the banker your financial statements. The banker is dressed in a really nice suit that is incapable of attracting even a speck of dust. Meanwhile, while clean, you’re dressed in sneakers, jeans, and a T-shirt that says KIDS RULE!! As you sit in a chair that’s too big, you have to remind yourself to stop kicking your legs and to sit up straight and look grownup. “I’ll be a good customer, I promise,” you tell the banker in a squeaky voice. “You won’t have to worry about getting your money back. I bor- rowed ten dollars from my parents and already paid it back.” The banker looks up and nods. “Look at my balance sheet,” you say proudly. “I have $13.00 in cash. I have some inventory, no debt, and I started my business with five bucks and I had earnings last week of ten dollars.” The banker glances over your scorecard, and nods. “Impressive,” the banker says. “There are a lot of grownup businesspeople who don’t keep this good a record.” You’re pretty sure the banker just complimented you, though it’s hard to tell because the banker’s eyebrows and lips hardly move. “Do you give loans to kids?” you ask. “We don’t discriminate because of a potential customer’s age, gender, religious, racial, or ethnic identity,” the banker says. Which you’re pretty sure means “Yes” to your question. “Look at my income statement,” you go on. “Last week I had sales of $25. My gross profit was $15, these are my expenses, with a net profit of $10. Would you loan me $50.00?” Impressed, the bank loans you $50.00 cash. “Hey, thanks,” you tell the banker. “I appreciate your interest in my business. You won’t be sorry! Come by my stand on your way home.” You start to leave, but you can’t help but turn back and say, “You know, with an original investment of $5 and a  C H APTER 3 37 net profit of $10, that’s a 200 percent return on my investment. Hey, how’s the bank doing?” Smiling, the banker wishes you well. Now, please demonstrate what just happened on the next scorecard. First, what comes in? Cash. So bring in $50. $0.00 $0.00 $5.00 $10.00 $0.00 $15.00 $15.00 Are we in balance? No. Who do we owe now? The banker for $50.00 Where do we show it? Notes payable. Demonstrate this on the next scorecard. 38 T H E AC C O U N T I N G GA M E $63.00 $50.00 $50.00 $2.00 $5.00 $10.00 $0.00 $15.00 $6 5.00 $6 5.00 Are we in balance now? Yes! By the time you get home from the bank, it’s already lunch. It looks like it might rain. So you decide to give yourself the rest of the day off. (It helps when you’re your own boss!) But you’re afraid that the lemonade in the fridge might not last until tomorrow. You decide to sell your remaining inventory for $2.00 to your best friend at cost, for cash. Your best friend is always thirsty and loves your lemonade, so it’s a win-win. The only downer to an otherwise glorious day is that, since you’re home, your mom and dad insist you clean up your room. Show the financial results of what just happened. How? By reducing inventory? Yes, the whole thing. But if you reduce inventory to zero, where do the two dollars go? Well, your friend gave you two dollars, so add them to your Cash.  C H APTER 3 39 $50.00 $6 5.00 $50.00 $ 0.00 $5.00 $10.00 $0.00 $15.00 $6 5.00 $6 5.00 Are we in balance? Yes! What happened? The two dollars’ worth lemonade turned into what? Two dollars in Cash. Did anything change in terms of total assets? No. Did we have sale? Yes. We just didn’t make any what? Profit. Will this transaction show up on our Income Statement? Yes. As part of what? Total Sales. Make a reminder to yourself to put this into your sales total when you fill out your Income Statement at the end of the week. After you return from your very brief vacation (interrupted by having to clean your room), you need to make up some new lemonade. You overhear Mom and Dad talk- ing about paying their account at the grocery store, where they have a charge account. Hey, you think, maybe I can set up an account. It’s worth a try, right? You tell your parents your idea and they say it’s worth a try. So, you get your bike out of the garage and pedal like crazy (watching for cars and crazy dogs, of course) down to the grocery store. 40 T H E AC C O U N T I N G GA M E Outside, you wait to catch your breath. You check your appearance in the big window. You moisten the tips of your finger with a little spit and plaster down the hair which got messed riding your bike. Your parents hate when you use spit, but this is an emergency! After all, you want Pappy Parker, the grocer, to see an entrepreneur, not just some sweaty kid. “Hey, Pappy,” you say, entering the store. “I’m in business now, just like you. It’s tough competing against the really big companies, isn’t it? Us little guys need to stick together. How about one businessperson helping out another? I’d like to buy 10 pounds of sugar at 40 cents/pound, for a total of $4.00.” “I can handle that,” Pappy says with a wink. The grocer’s store is a family business. It sells everything from great fresh produce to racks of snacks in one big room. Even though the place is crowded with stuff and the linoleum on the floor is, like, fifty years old, you like it better than the enormous, impersonal supermarket. One reason is that good ol’ Pappy gives every kid who comes in a free cookie! Another reason is the great customer service that the Pappy and everyone else working at his store provide. The grocery staff knows every customer by name. And you’ll always remember the time Pappy wouldn’t let your mom buy some fruit that looked too ripe. Instead, the ol’ Pap left the register and selected the best piece of fruit on display, then gave it to your mom for free. Yes sir, that Pappy sure knows how treat his customers right! You really like good ol’ Pappy. He’s like your favorite uncle—or grandpa. This gives you the courage to add, “And I’d like to purchase the sugar on credit.” “Credit? Tell me, please, why would I give you credit?” “Well, you give my parents credit. Can I have credit too?” “But your parents work for a living,” Pappy points out. “I’m working for a living, too,” you reply. “I’m selling fresh lemonade.” “Lemonade? Is it good lemonade?” he asks. “The absolute best, most totally awesome lemonade in this part of the galaxy,” you say.  C H APTER 3 41 “That good? Are you trying to put me out of business?” Pappy says this with a smile. “Just the opposite,” you quickly respond. (It amazes you that every so often the ol’ brain charges in with a great reply!) “After all, the more lemonade I sell, the more lemons and sugar I’ll need to buy from you. Plus maybe paper cups and napkins. And maybe one day I’ll add cookies, which I’ll get from your bakery because they’re the best around.” You run out of great ideas and hope it’s enough to win over Pappy. He lives in the neighborhood and always gives free stuff to your school. Pappy’s known you and your family for a long time. “Well, it sounds like you figured it all out,” he observes. “Maybe one day you’ll help me out with my business?” “You’ll give me credit?” you ask hopefully. “I’ll give you $4.00 in credit,” Pappy says, handing you a piece of paper to sign. Home, you unpack the grocery sack. What financial category is packed inside? Inventory. What kind of inventory? Sugar. How much sugar? $4.00. What color? White—just checking! Did you pay CASH for the sugar? No! Is this a great country, or what?! Do we owe money? Yes. In order for the grocer to keep track of the credit, what have we set up? An account. And it’s payable to whom? The grocer. What do businesses call this sort of thing? ACCOUNTS PAYABLE. So, now we have our second kind of liability. We had the note with the banker and now the account set up with the grocer. Demonstrate this latest transaction below. 42 T H E AC C O U N T I N G GA M E What’s the difference between the two kinds of liabilities? The Notes Payable from the bank shows that the bank gave you what? Money! And the Accounts Payable with the grocer shows that the grocer gave you what? Sugar or Inventory. So, is it fair to say that Notes Payable has to do with money owed to someone else for money received, and Accounts Payable has to do with some things we got for our business which we have to pay for someday? Yes. In other words, for Notes Payable we got cash and for Accounts Payable we got goods or services. There is another difference between Notes Payable and Accounts Payable. It has to do with time. Generally speaking, a loan from a bank (Notes Payable) and a credit account (Accounts Payable) from a store have different payback periods. In other words, one is for a short time and one is for a longer time. Which is which? Accounts Payable is short-term, usually due in full in maybe thirty days. Notes Payable is long-term, maybe several years. That’s why Accounts Payable is the first item in Liabilities—they are generally ordered as they come due.  C H APTER 3 43 Any other difference? HINT: What’s one thing all bank loans come with that store credits generally don’t come with providing you promptly pay off your balance? Interest! Which has interest? Notes Payable. Usually, Accounts Payable does not have inter- est unless you don’t pay on time. In both cases, we’re establishing what? Credit! Hey, we’re pretty sharp entrepre- neurs! Or at least a lot like Mom and Dad and most other businesses and consumers! We owe people money! Talk about feeling grownup! Now that we have some credit, it’s time to buy some other supplies. You buy 100 lemons at 20 cents/lemon. You want to keep in good with the grocer so you pay in cash. The amount goes out of Cash, and into…what? Inventory. How much inventory? Twenty dollars in lemons come in. Again, what did we do? We exchanged $20.00 in cash for what? Twenty dollars in inventory. Did we, in fact, exchange one asset for another. Yes. Bring the next scorecard up to date, reflecting these transactions. 44 T H E AC C O U N T I N G GA M E Are we in balance? Yes. You should have $69 in Assets, $54 in Liabilities, and $15 in Equity; the sum of the right side total is $69. You’re doing great. You’re especially patient with all this record-keeping stuff. But, believe me, you’ll be glad later. Now that our financial record-keeping is up to date, it’s time to take a break (if you wish). Then, let’s make up a fresh batch of the world’s greatest lemonade!  CHAPTER 4 N ow that you’re a pro at mixing lemonade, you make up a good sized batch. The batch takes fifty lemons (@ 20¢/each) and five pounds of sugar (@ 40¢/lb.), to make sixty glasses. What’s the cost of production? Before we answer, let’s add another element. So far, you have made all your own lemonade, but this morning you decided to take off some time to go biking with friends. Still, you want to have the lemonade stand opened as soon as you return. So, you ask your older sister if she’ll make the lemonade for you. Most of the time you and your sister are pretty good buddies. But, suddenly, with your friends waiting outside, she turns into Scrooge! “Why should I do you any favors?” she asks. “Come on,” you plead. “Just this once. I promise I won’t bug you the next time you’re on the phone.” “That’s not good enough,” she replies. “I’m no dummy. I’ve heard all that cash rattling in the cigar box. You have to pay me if you want your lemonade ready.” Well, she has you now. Boy, wait until you’re rich and famous! See her come crawling for a favor then! But that’s a few years down the road, and now your friends are screaming for you to hurry up. “You win,” you say with a sigh. “How much do you want?” She smiles. She never is very modest in victory. “I want one dollar to make 60 glasses.” 46 T H E AC C O U N T I N G GA M E First, you get angry at her smugness, then, you force yourself to calm down and decide to pay it. After all, business is business. “Fine,” you agree. You give her the buck and head out the door. Once on your bike, with your friends, you reason this out. A dollar in labor cost is too much for sixty glasses—and it will lower your profit. But you figure you can afford it just this once. A while later, refreshed from your ride, you return in time for the afternoon sales and see, to your relief, that your sister has done her job well. There in the refrigera- tor are 60 glasses of fresh lemonade. Say, maybe this boss thing isn’t so bad, after all! Seriously, let’s look at our Inventory. We’ve got two types of Inventory here. What do we call the lemons and sugar? Raw materials. And what kind of inventory is lemonade? Finished goods. Now, while we (or Big Sister) were making it, what kind of inventory was it? Work-in-process—or WIP. Work-in-process is a big item for manufacturing companies. We go from raw materials to work-in-process to finished goods. We didn’t use up all of our raw materials, though, for this batch. As a result, we have both raw materials and finished goods in our inventory. Are the raw materials considered available for sale? Yes. For record-keeping purposes, all Inventory is available for sale. Before we greet our afternoon customers, let’s fill out another Balance Sheet to reflect that we’ve just paid labor to make our product. $5.00 $10.00  C H APTER 4 47 How did you account for the labor? It reduced Cash by $1.00. Here, though, is where it gets a little tricky. Many people would say, let’s expense it and reduce our earnings. However, in this case, you cannot expense the dollar—and you may know why. It has to do with the job Big Sister was doing—specifically her labor was to produce your product. Literally, her labor increased the value of the Inventory—so, in truth, you should have taken the $1 from Cash and added $1 to Inventory. As a result, Cash is now $44 and Inventory is $25. Note that our Balance Sheet from now on will separate raw materials and finished goods. You should have $12 in raw materials and $13 in Finished Goods, and $25 in Total Inventory. You can see now that the Cost of Production labor is “tied up” in inventory. That $1 cost cannot be recognized (or expensed) until the Inventory is sold. That’s one rea- son companies closely manage inventory quantities and always want to sell it quickly. So, let’s get selling! It’s a hot day and you’re sweating, but it’s OK because sales are very, very good. Your new location pays off, and easily earns back what you spent renting it. Kids from other neighborhoods—total strangers!—come by on their bikes, having heard about your great lemonade. Some friends come by, with their tongues practically dragging on the pavement. “Please, please, give us some lemonade!” “Give?” you repeat. “We left our money at home,” they explain. “But we’re good for it, we promise!” Since they’re friends, you let them buy their lemonade on credit. By the end of the afternoon, your arm is about to fall off from pouring so much lemonade. But it’s all worth it when you total up your sales. 60 glasses for 50 cents each 40 glasses cash and 20 glasses on account What’s your total sales? Thirty dollars. Twenty dollars Cash. Ten dollars on Account. 48 T H E AC C O U N T I N G GA M E Let’s review what happened here. Did you sell all the lemonade you made up? Yes. How many glasses did you sell? Sixty. What goes out of the business? Inventory. How much? Thirteen dollars. What comes in? Cash. Cash for how much? Twenty dollars. So we get $20 for the forty glasses we sold for Cash. What else happened? Some of your friends said they wanted to buy some lemonade, but they didn’t have any money. Their parents hadn’t given them what? Their allowance. So, they wanted to buy now, and pay when? Later. Did you, ever kind and wonderful and always on the outlook to increase sales, decide to sell to them? Yes. Admit it, did it make you a little nervous. A bit. Sure. Did you make a record of the sale? Yes. Sure, the kids on credit are your friends and all—but this is business! You got out your little notebook and recorded these sales... Ted, 1 glass,.50, Natalie, 2 glasses, 1.00…etc. What did your friends do? They set up an account with whom? Right, with you! Did those thirsty kids get the lemonade? Sure did. Was it a sale? Yes! You just didn’t receive any…what? Cash. So, you had to set up an account. Is this money owed to you right now? Yes! Pretty soon, though, you’ll want to go out and receive what? The green stuff, Cash. So, if you have to set up an account and plan to receive the cash from your friends, the account is called what? Accounts Receivable. Is an Account Receivable something we have? Yes. That means it’s a what? An asset. Since it’s money we are going to get soon, is it almost cash? Yes. What color should we make it? Almost green. Did your friends promise, promise, promise to pay you? Yes, And even did a pinkie swear! They said they were good for it. (And if you can’t trust your friends, who can you?) But, honestly, have they paid you yet? No, not yet. but they better! They said they were going to get their allowance at the end of the week? Yes, Right before they chugged down the lemonade.  C H APTER 4 49 Was this a good idea? Why do businesses let people set up accounts? Ever hear of “buy now, pay later”? Right, to generate more sales! Bring the next scorecard up to date, to show the changes in assets. $4.00 $50.00 $54.00 $5.00 $10.00 $0.00 $15.00 $69.00 So are we in balance? No. What do we need to show? We need to record our profit or earnings for the week. So how much did we have in total sales? $30. We had $20 in cash and $10 on account. How much did it cost us in lemonade? $13.00 So if it cost us $13.00 and we sold it for $30.00, what’s our profit or earnings for this sale? $17.00 Record your profit or earnings below. 50 T H E AC C O U N T I N G GA M E $4.00 $64.00 $50.00 $10.00 $54.00 $12 $12.00 $0 $5.00 $10.00 $15.00 $86.00 Are we in balance? Yes. Good job! Congratulate yourselves! Give yourself a high five! Put on a great CD or turn on your mp3 player and dance to the music! Unfortunately, in business as in life, there are good times and bad times. No sooner are you dancing around your room than the phone rings. It’s a friend of yours telling you that one of your other friends, Johnny, the incred- ibly thirsty one who bought eight glasses on account has—gasp!—moved away! After throwing yourself to the ground and stamping the floor with your fists and crying, you conclude that this moved-away, no-good friend is unlikely to pay his debt. Given this sobering realization, you also conclude that this act of treachery will have a negative impact on your business and your financial records. Are this eight glasses a loss? Of course! What do you call this kind of loss? Bad Debt. This Bad Debt expense = $4.00 Now what are we going to do? Even as you regain control, you still can’t believe it! That kid promised to pay you! He even gave a pinkie swear, which is like the highest oath a kid can take! You figured he was good for it. But now he’s left town. Oh, well, at least he didn’t leave town thirsty—thanks to you!  C H APTER 4 51 Do we have to recognize the loss? Yes. We had $10.00 in Accounts Receivable, four of which belonged to that totally rude and worthless weasel cheater and all-around bad kid who you were once foolish enough to trust and call your friend. He’ll probably end up in prison, or politics—or both! So what are we going to do? You list your options. Send out the collection agency. Hire a hitman. Hire a lawyer. Tell your parents. Get your big brother or sister to beat him up. Put a spell on him so he stays short his whole life. E-mail the President to call out the National Guard. But you’re a business person, remember? So what do we do to recognize a bad debt? Reduce Accounts Receivable? Sadly, yes. Reduce it by how much? Four whole dollars. Are we in balance now? No. Is the Bad Debt a cost of doing business? Yes. And a cost of doing business is called what? An expense. And expenses always reduce what? Earnings. So, reduce earnings by $4.00 to reflect the bad debt expense. 52 T H E AC C O U N T I N G GA M E