Assets vs. Liabilities
Making a profit in a business is derived from several different activities in many different areas. Some times profit-making can get a little complicated because, just as in our personal lives, business is run on credit more often than not. Many businesses sell products to their customers on credit and their accountants use an asset account called accounts receivable to record the total amount owed to the business by its customers who haven’t paid the balance in full. Much of the time a business hasn’t collected its receivables in full by the end of the fiscal year, especially for such credit sales that could be transacted near the end of the accounting period.
The accountant records the sales revenue and the cost of goods sold for these sales in the year in which the sales were made and the products delivered to the customer. This is known as the accrual basis accounting, pursuant to which revenue is recorded when sales are made and expenses are recorded when they are incurred, as opposed to the cash basis accounting pursuant to which sales are made and paid for at the same time. When sales are made on credit, the accounts receivable asset account is increased and when the cash is received from that customer the cash account is increased and the accounts receivable account is decreased accordingly.
Profit-making
The cost of goods sold is one of the major expenses of businesses that sell goods, products or services because even a service involves expenses. It means exactly what it says in the sense that it’s the cost which a business pays for the products it sells to customers. A business makes its profit by selling its products at prices high enough to cover the cost of producing them, the costs of running the business, the interest on any money they’ve borrowed and income taxes. The money left over after such expenses are paid is profit.
When the business acquires products the cost of these goes into what is commonly known as the inventory asset account. The cost is deducted from the cash account or added to the accounts payable (liability) account, depending on whether the business has been paid with cash or credit.
When discussing assets and liabilities the conversation sometimes segues into another area in accounting that also deals with certain other assets of a business which are not cash assets. Instead, these are the type of assets that can be depreciated and, as such, can be counted as expense [can be expensed] over several years. Depreciation is a term we hear about frequently, but don’t always understand how it works even though it is an essential component of accounting. Depreciation is an expense that is recorded at the same time and in the same period as other accounts.
Fixed assets
Long-term operating assets that are not held for sale in the course of business are known as fixed assets which include, buildings, machinery, office equipment, vehicles, computers and other equipment. Such fixed assets can also include items such as shelves and cabinets. The main difference between depreciation and other expenses recorded by a business is it allows the accountants to spread out the cost of a fixed asset over the years of its useful life to a business, instead of charging the entire cost to expense in the year the asset was purchased. Therefore, each year in which the equipment or asset is used bears a share of the total cost.
Let’s take a look at an example: Cars and trucks are typically depreciated over five years with the idea being to charge a fraction of the total cost to depreciation expense during each of the five years, rather than just the first year. Depreciation applies only to fixed assets that you actually buy, not those you rent or lease, and depreciation is a real expense, but not necessarily a cash outlay expense in the year it’s recorded. The cash outlay does actually occur when the fixed asset is acquired, but is recorded over a period of time.
Earnings retention
Depreciation is deducted from sales revenue to determine profit, but the depreciation expense recorded in a reporting period doesn’t require any true cash outlay during that period. Depreciation expense is that portion of the total cost of a business’s fixed assets that is allocated to a specific period to record the cost of using those assets during that period. The higher the total cost of a business’s fixed assets, the higher its depreciation expense.
Taken together, these three areas of running a business are as important of any other aspect of that business except that these activities are not used as tools to promote, advertize, improve products and services, or in any way to attract more clients and customers in order to sell more and/or create more income; but with proper and adequate accounting they are used effectively to retain more of the business’s income thereby creating more profit for that business in most instances.
