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Secret To Success

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Business Directed Retirement Account

Jim Rohn: How to Have Your Best Year Ever

With the accrual basis of accounting there 4 business statements prepared: 1. Income statement 2. The statement of retained earnings 3. The balance sheet 4. The statement of cash flows.

The income statement is used to show the company’s net income or profitability, in cash-basis accounting a small business might still prepare an income statement because it helps the owners in estimating their profitability. This income statement in cash-basis accounting is more like a statement of cash follows in accrual-basis accounting. There would be no need for a business owner to do double work, with that stated, they would not create a statement of cash flows. Most small business owners since they are often the only equity investor would have no need to provide a statement of retained earnings. A company using cash-basis accounting would prepare balance sheet even if the assets, liabilities, and equity would be over or understated. It is a good idea to have a general account as to the value of your assets. Small business owners or cash basis accounting systems would take into account how much cash is on hand, property, plant, equipment, and supplies; as well as how much money do we owe.

In my experience with small business owners using cash-basis account often provide me with a collateral list of all of their assets, and they list their liabilities on what we call a debt schedule. We often ask for a personal financial statement to determine the credit worthiness of a potential borrower. 

Accrual Accounting and Adjusting Entries

What would a company do that followed cash-basis accounting? This question is just one more reason why accrual-basis account is the preferred method of accounting. A company that pre-paid their insurance in cash-basis accounting would take the entire expense when they sent cash to the insurance company. Ultimately the transaction would look like this: Debit insurance expense and credit cash. The expenses in that month would be overstated. Companies that constantly overstated their expense would have a hard time making sound financial decisions. This is also true for external users. If they are looking to invest in a company that overstated their expenses and under stated their assets, the external users might underestimate the amount of money they could lend to the company providing a cash shortage later in the year for a company. Not have enough cash to operate properly is why a lot of businesses are forced to close their doors.

Why is inventory important for a business? How is inventory different from other assets of the business?

All businesses are in business to make a profit. A company has two choices; it can sell a service or sell a product. Inventory is important for a business because inventory is the item that product companies sell to make a profit. Without having any inventory to sell, a product based company cannot make a profit. Whether a company buys inventory “just in time” to make it and sell it or the company has inventory on hand, the inventory items must be bought and then re-sold at a higher price. Inventory is different from other assets of the business. Companies do not intend to add value to their “other assets” and re-sell them. In the book Financial Accounting Tools for Business Decision Making Kimmel explains, “A company’s gross profit (rate) may be expressed as a percentage by dividing the amount of gross profit by net sales” (Kimmel, 2011). The cost of inventory is the expense used to calculate the gross profit. By matching the correct inventory expense to the revenue earned, a company can determine the gross profit. However, all assets of a company should assist to generate revenue for the business; inventory is sold to generate that revenue. I find the financial services industry fascinating. Obviously financial service companies earn service based revenue. Like product based companies you have to manage the cost of capital. Cash in the company acts like inventory in a merchandising company.

Kimmel, P., Weygandt, J. & Kieso, D. (2011). Financial accounting tools for business decision making. Danvers, MA: John Wiley & Sons, Inc.