The Balance Sheet Pt 2

In this article I’m going to continue explaining how to use balance sheets. If you missed my previous tutorial check it out here The Balance Sheet.

Before I begin I received a request to better explain the difference between Accounts Payable and Notes Payable.

• Accounts Payable: Short term loans that are normally due in full within a month. This loan doesn’t have interest attached if it is paid on time.
• Notes Payable: Long term loans that require interest payments

You should now understand the difference, but if not leave a comment below.

I improved upon this tutorial with some great video tutorials which you can find here:

• Financial Statement Video Tutorial Part 1
• Financial Statement Video Tutorial Part 2
• Financial Statement Video Tutorial Part 3

Now before we create a new balance sheet we are going to:

• Pay off the $100 loan our uncle gave us including interest
• Hire someone to run our caricature booth for the weekend
• Buy inventory with a short term loan or an Account Payable

Paying Off the Note Payable

Your uncle called requesting his $100 be paid back to him in full plus the interest that was promised of 5%. Your uncle accepts his $105 payment and you thank him for believing in your new business. We need to do the following to the balance sheet to handle this transaction:

• Eliminate the note payable
• Decrease cash by $100
• Decrease earnings by $5 to handle this expense

Hire an Employee

You are invited to a wedding this weekend, but since you prepaid for the booth at the mall you need someone there. Thankfully Mark, your friend, knows how to draw caricatures and offers to fill in for you. You offer him $2 per caricature and he agrees.

Buying Supplies on an Account Payable

You run to the art supply store, but forget your money. You ask the store owner for your supplies on loan. You promise to pay her for them on Monday and she agrees to not charge you interest. This loan is an Account Payable because it is short term and doesn’t require an interest payment.

You get $200 in supplies:

• $140 for paper
• $60 for markers

You’ll have to remember to update your inventory and the accounts payable section of your balance sheet.

Your First Employee and Negative Earnings for Now

You send Mark off with the supplies and the additional $120 for your booth at the mall. To keep everything balanced you take the  $120 out of cash. This $120 is in addition to the previous prepaid expense.

Remember to delete that previous prepaid expense to the mall owner. You do this because it is now current. So, delete $120 from your earnings. After you do that you are left with this balance sheet.

Yuck! You had negative earnings. Don’t worry about it. The reason why you are negative is because we haven’t included the sales for the day. I did this on purpose so that you’d know it is possible to have negative earnings. Here is how I got these numbers:

• Cash ($195) = Previous Cash ($420) – Loan Repayment ($105) – Rent Expense ($120)
• Accounts Receivable ($0): Remember your friend didn’t pay back the loan? That’s why I didn’t count it
• Inventory Raw Materials ($200): You purchased $200 in supplies on credit
• Notes Payable ($0): You paid your uncle for the $100 loan
• Accounts Payable ($200): You purchased $200 in supplies on credit that doesn’t require an interest payment
• Retained Earnings ($220) = Prev. Retained Earnings ($390) – Booth Rental ($120) – Bad Debt ($50)
• Earnings Week to Date (-$125) = Prev. EWTD ($0) – Booth Rental ($120) – Interest Paid to uncle ($5)

The Balance Sheet After Weekend Sales

Mark sell all of the available caricatures for a total of $700 in sales! After you pay him $2 for each caricature he did ($280), you are left with $420 in sales.

On Monday you perform a few more transactions before you make your next balance sheet.

• Pay off the debt you had at the art store ($200)
• Buy liability insurance. You have to pay the first 3 months up front. ($60 for 3 months)

Don’t forget to make the required changes to the balance sheet.

Note: What would have happened to your balance sheet if you paid Mark $200 up front? Aside from having more cash in the end, you would have just included his fee in inventory. You treat employee salary’s as inventory.

Let’s update the balance sheet:

• Cash ($375) = Prev. Cash ($195) + Sales ($420) – Art Supply Loan ($200) – Insurance ($40)
• Earnings Week to Date ($95) = Prev. EWTD (-$125) + Sales ($420) – Art Supply Loan ($200)

Accrual Method Accounting

There are two ways to account for business financial changes. You can either use the Accrual or the Cash Method. We have been using the Accrual Method.

With the accrual method you you account for all sales or expenses, whether cash changes hands or not. This form of accounting was created when people started purchasing items on credit. Here are some examples of how you followed the accrual rules:

• When you sold the celebrity pictures, you counted it as a sale even though money wasn’t exchanged
• When we bought supplies on credit, we recorded them in inventory even though cash wasn’t decreased
• When we prepaid 2 months of liability insurance, we only accounted for the first month. We will account for future payments when that time comes along.

To simplify accrual accounting, just remember to account for earnings, payments and use when they occur, whether cash is exchanged or not.

Cash Method Accounting

With Cash Method Accounting, you account for transactions when cash changes hands.

Here I will walk you through two income statements. One will be based on the Accrual Method and the next the Cash Method. Here are the transactions that took place, that we’ll base our income statements on:

• $750 Sales
• $425 Cash Sales
• $250 Credit Sales
• $50 Beginning Inventory before Purchases
• $105 Cash Paid for Paper
• $45 Credit Used for Markers
• $200 Inventory Available for Sale
• $0 in Ending Inventory
• $200 Cost of Goods Sold

This is what the income statement would look like using the Accrual Method

You should understand how this was made if you saw the previous tutorial The Balance Sheet.

This is the income statement using the Cash Method:

What’s Different?

With the cash method you aren’t allowed to document anything that is not a cash transaction. This means:

• You can’t count the $250 in sales on credit
• You can’t count Beginning Inventory (You’ll see why in a minute)
• You can’t count the cost for the markers, because they were bought on credit

As you can see, both of these methods produce dramatically different results. And, the more your business is based on credit, the more dramatic the results will be. The accrual method is much more accurate, so why would anyone ever use the cash method? To avoid taxes!

Remember when I said above that I would explain why beginning inventory isn’t counted in the cash method? The reason why is that you are not allowed to use the cash method by law if you have inventory. Think about it. If you could, you could just reduce your profits by buying more inventory right before you pay your taxes.

Service industries can however use the cash method. Don’t think that a service business is getting away with anything though over the long term. They can just temporarily avoid taxes with the cash method.

Cooking the Books

One major benefit to having the option to use the cash method is that it provides the option to keep two sets of books. One set of books is based on the accrual method and looks attractive to banks, while the other provides short term tax savings. This is what people often mean when a company legally cooks the books. There are other ways, but this tutorial will not go into them at this time.

Also, to finish off this article you should know that it is legal for a business to switch from using the cash method to the accrual method, but not vice versa. The government allows this so that they can get their taxes quicker. Remember that if you have inventory, you are forced to use accrual method accounting.

That’s All Folks

I hope you better understand how to fill out and read a balance sheet. In the next article I’ll cover what the balance sheet of a service business looks like among other things.

If you have any questions, or would like me to do a tutorial on your chosen subject, leave a comment below.

Till Next Time

Think Tank