Understanding Business Accounting For Dummies, 2nd Edition (43 page)

A small part of the total income tax owed on the company's taxable income for the year probably will not be paid by the end of the year, and the unpaid part is recorded in the
income tax payable
account.

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.

Sizing Up Assets and Liabilities

Although the business example shown in Figure 6-2 is hypothetical, we didn't make up the numbers at random - not at all. We use a medium-sized business that has £25 million in annual sales revenue as the example. (Your business may be a lot smaller or larger than one with £25 million annual sales revenue, of course.) All the other numbers in both the profit and loss account and the balance sheet of the business are realistic relative to each other. We assume the business earns 40 per cent gross margin (£10 million gross margin ÷ £25 million sales revenue = 40 per cent), which means its cost of goods sold expense is 60 per cent of sales revenue. The sizes of particular assets and liabilities compared with their relevant profit and loss account numbers vary from industry to industry, and even from business to business in the same industry.

Based on its history and policies, the managers of a business can estimate what the size of each asset and liability should be - and these estimates provide very useful
control
benchmarks
, or yardsticks, against which the actual balances of the assets and liabilities are compared, to spot any serious deviations. In other words, assets (and liabilities, too) can be too high or too low in relation to the sales revenue and expenses that drive them, and these deviations can cause problems that managers should try to correct as soon as possible.

For example, based on the credit terms extended to customers and the company's actual policies regarding how aggressive the business is in collecting past-due receivables, a manager can determine the range for how much a proper, or within-the-boundaries, balance of accounts receivable should be. This figure would be the control benchmark. If the actual balance is reasonably close to this control benchmark, the debtors' level is under control. If not, the manager should investigate why the debtors' level is higher or lower than it should be.

The following sections discuss the relative sizes of the assets and liabilities in the balance sheet that result from sales and expenses. The sales and expenses are the
drivers
, or causes, of the assets and liabilities. If a business earned profit simply by investing in stocks and bonds, for example, it would not need all the various assets and liabilities explained in this chapter. Such a business - a mutual fund, for example - would have just one income-producing asset: investments in securities. But this chapter focuses on businesses that sell products to make profit.

Sales revenue and debtors

In Figure 6-2 the annual sales revenue is £25 million. Debtors represent one-tenth of this, or £2.5 million. In rough terms, the average customer's credit period is about 36 days - 365 days in the year multiplied by the 10 per cent ratio of ending debtors balance to annual sales revenue. Of course, some customers' balances owed to the business may be past 36 days and some quite new. It's the overall average that you should focus on. The key question is whether or not a customer-credit period averaging 36 days is reasonable or not.

Cost of goods sold expense and stock

In Figure 6-2 the annual cost of goods sold expense is £15 million. The stock is £3,575,000, or about 24 per cent. In rough terms, the average product's stock-holding period is 87 days - 365 days in the year multiplied by the 24 per cent ratio of ending stock to annual cost of goods sold. Of course, some products may remain in stock longer than the 87-day average and some products may sell in a much shorter period than 87 days. It's the overall average that you should focus on. Is an 87-day average stock-holding period reasonable?

The ‘correct' average stock-holding period varies from industry to industry. In some industries, the stock-holding period is very long, three months or longer, especially for manufacturers of heavy equipment and high-tech products. The opposite is true for high-volume retailers such as retail supermarkets who depend on getting products off the shelves as quickly as possible. The 87-day average holding period in the example is reasonable for many businesses, but would be far too high for many other businesses.

SA&G expenses and the four balance sheet accounts that are connected with the expenses

Note that in Figure 6-2 sales, administrative, and general (SA&G) expenses connect with four balance sheet accounts - cash, prepaid expenses, creditors, and accrued expenses payable. The broad SA&G expense category includes many different types of expenses that are involved in making sales and operating the business. (Separate expense accounts are maintained for specific expenses; depending on the size of the business and the needs of its various managers, hundreds or thousands of specific expense accounts are established.)