The Balance Sheet from the Profit and Loss Account Viewpoint
In fact a business needs many more assets than just stock. Where does the money for these assets come from? Assets are the first act of a two-act play. The second act looks at where the money comes from, or the sources of capital for businesses. As Chapter 1 explains, the balance sheet of a business is the financial statement that reports its assets on one side and the sources of capital on the other side.
Coupling the Profit and Loss Account with the Balance Sheet
Sales revenue generates the inflow of assets and expenses cause the outflow of assets. These increases and decreases in assets have to be recorded. Also, some expenses spawn short-term liabilities that have to be recorded. In short, accounting for profit involves much more than keeping track of cash inflows and outflows. Which specific assets and liabilities are directly involved in recording the sales revenue and expenses of a business? And how are these assets and liabilities reported in a business’s balance sheet at the end of the profit period?
We stress the dovetail fit between these two primary financial statements (the profit and loss account and the balance sheet). And don’t forget that business accounting also keeps track of where the money for the assets comes from – to invest in its assets, a business needs to raise money by borrowing and persuading owners to put money in the business. You shouldn’t look at assets without also looking at where the money (the capital) for the assets comes from.
A balance sheet doesn’t have a punch line like the profit and loss account does – the profit and loss account’s punch line being the net income line (which is rarely humorous to the business itself, but can cause some sniggers among analysts). You can’t look at just one item on the balance sheet, murmur an appreciative ‘ah-hah,’ and rush home to watch the footy game. You have to read the whole thing (sigh) and make comparisons among the items.
Most people intuitively understand that sooner or later sales revenue increases cash and expenses decrease cash. It’s the ‘sooner or later’ that gives rise to the assets and liabilities involved in making profit. The assets and liabilities driven by sales revenue and expenses are as follows:
- Sales revenue derives from selling products and services to customers.
- The cost of goods sold expense is what the business paid for the products that it sells to its customers. You can’t charge the cost of products to this expense account until you actually sell the goods, so that cost goes into the stock asset account until the goods are sold.
- The sales, administrative and general expenses (SA&G) category covers many different operating expenses (such as advertising, travel and telephone costs). SA&G expenses drive the following items on the balance sheet:
- The prepaid expenses asset account holds the total amount of cash payments for future expenses (for example, you pay insurance premiums before the policy goes into effect, so you charge those premiums to the months covered by the policy).
- The creditor liability account is the total amount of expenses that haven’t been paid yet but that affect the current period. For example, you receive a bill for electricity that you used the month before, so you charge that bill to the month benefited by the electricity – thanks to the accrual basis of accounting.
- The accrued expenses payable account is the opposite of the prepaid expenses asset account: this liability account holds costs that are paid after the cost is recorded as an expense. An example is the accumulated holiday pay that the company’s employees have earned by the end of the year; when the employees take their holidays next year the company pays this liability.
A final note: The bottom-line profit (net income) for the year increases the reserves or, as it is also known, the retained earnings account, which is one of the two owners’ equity accounts.