Today I will explain how accountants match costs to time since costs are often incurred retrospectively but profit is measured in accounting periods.
Two weeks ago I explained why every transaction has two sides to it in Understanding Finance: Two Sides To Every Transaction using a market trader as a simple example. Did you notice how I introduced the concept of spread costs over time?
I wrote about agreeing to rent the market stall the day before and that created an obligation to pay for the stall (a creditor) and an asset in the form of the rights to use the market stall the next day.
By the end of the day, the rights to use the market stall had expired so it was no longer an asset included in the Balance Sheet but a cost to be included in the Profit & Loss Account.
The Profit & Loss Account Is For A Period Of Time
Because the Profit & Loss account is for a particular period, a week, a month, three months or a year, it is essential that revenue and costs are properly allocated to the right periods.
If the matching isn't right, your Profit & Loss Account isn't right.
Items Are Held In The Balance Sheet
Costs that have been incurred but where there is not yet a transaction to process create an obligation to pay. For example a business will use electricity every day but will only be invoiced every month or three months.
To show the right costs, we recognise that we have used the electricity which is a cost in the Profit and Loss account, and the other side creates a creditor in the balance sheet.
These costs are called accrued charges and the creditors are called accruals.
Each time a Profit & Loss account is required, the accountant or bookkeeper will estimate the accrued costs. Large costs, for example electricity for a factory would be based on meter readings but most of the time the costs are assumed to be incurred at the same rate as the previous invoice.
Eg Invoice for electricity for the three months to 31 March 2008 = £6,000
So the sensible accrual for April would be around £2,000 (i.e. £6,000 / 3) although you may want to calculate it on days or working days.
£2,000 will be charged to the electricity cost in the Profit & loss Account and creditors will include the obligation to pay the electricity company £2,000.
At the end of the three months, you will have accrued £6,000 and when the electricity invoice comes in for £5,857.42, you have a small adjustment to make which will reduce the electricity charge in the next period.
It is not an exact science but you can see that it makes much more sense that having a big cost for electricity for one month, then nothing for two months and then a big cost again.
Accruals you incur the cost first and then pay for it afterwards.
Prepayments work the other way around. You pay first (or at least accept an invoice to pay) and then you benefit going forward in the future.
In the UK it is common to have to pay building rent 3 months in advance so at the end of March you have to pay for April, May and June. Let's say the payment is £10,500 to keep the numbers easy on 31 March.
In the March accounts, you have a prepayment of £10,500
In the April accounts, you have now used one third so you have a Rent cost of $3,500 and a prepayment of £7,000 (which represents the rights to stay in the property until the end of June - this is an asset).
In May, we have another £3,500 rent cost and the prepayment is now reduced to £3,500 which is then used up in June but we have to pay for the next quarter's rent so the prepayment at the end of June jumps back to £10,500.
Capital Expenditure, Fixed Assets and Depreciation
More accounting jargon but unfortunately if you are going to master accounts and understand finance, it is impossible to avoid some of this jargon.
A fixed asset is an item with an enduring value which is expected to last for longer than a year. A big computer system is a fixed asset. An automatic lathe is a fixed asset. If you have bought a business property, that is a fixed asset.
When you buy a fixed asset, the process is called capital expenditure and in a later article we will look at how you can decide whether it is a good idea to buy and whether the capital expenditure can be justified.
While the value is long lasting, fixed assets do wear out over time.
The pick up truck may last four years but by the end, it is unreliable and you need to buy another.
Accountants reflect this use of the value of the fixed asset through a cost called depreciation.
So if the truck costs £21,000 and is estimated to have a useful life of 4 years and only be worth £1,000 at the end of year 4, we have a cost of £20,000 to recognise over the four years.
If we decide that this cost should be incurred on a straight line basis, we charge depreciation of £5,000 to the Profit & Loss account every year. This is called a 25% depreciation rate because the estimated useful life is 4 years.
There are other depreciation policies which say that a great proportion of the value is used up in the early years.
After the first year of owning the truck, we have an original cost of £21,000 in the balance sheet, a £5,000 depreciation charge in the Profit & Loss account, and because every transaction has a second side, we have £5,000 accumulated depreciation in the balance sheet.
Original cost minus accumulated depreciation equals the current value of the fixed asset in the balance sheet and is known as net book value or NBV. For the truck this is £21,000 minus £5,000 = £16,000.
If buying companies have accruals and prepayments, selling companies have the opposite entries.
Just as a company paying property rent would spread the cost over the period of the rent, the owner of the building who is receiving the rent will have to spread the revenue over the future period.
The purpose of this matching is to make sure that the Profit & Loss Account reflects what is really happening in the business rather than the commercial arrangements.
This means that profit and cash flow can be very different and we will look at cash flow as a concept in the next understanding finance briefing.
I hope that this is helping you to understand, The Finance For Non-Financial Manager courses I used to run were very successful and gave business owners and managers a chance to understand their accounts in a way that they never could before.
I hope you found this third financial training article helpful and I would appreciate your feedback. By all means post finance questions that you would like me to cover although I won't be answering questions about the different accounting standards across the world.
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