Understanding Business Accounting For Dummies, 2nd Edition (44 page)

Cash is paid when recording payroll, mailing, and some other expenses. In contrast, insurance and office supplies costs are prepaid, and then released to expense gradually over time. So, cash is paid before the recording of the expense. Some of these expenses are not paid until weeks after being recorded; to recognise the delayed payment the amounts owed are recorded in an accounts payable or an accrued expenses payable liability account.

One point we would like to repeat is that the company's managers should adopt benchmarks for each of these accounts that are connected with the operating expenses of the business. For example, the £1.2 million ending balance of accrued expenses payable is 20 per cent of the £6 million SA&G for the year. Is this ratio within control limits? Is it too high? Managers should ask and answer questions like these for every asset and liability connected with the expenses of the business.

Fixed assets and depreciation expense

As explained in Chapter 5, depreciation is a truly unique expense. Depreciation is like other expenses in that, like all other expenses, it is deducted from sales revenue to determine profit. Other than this, however, depreciation is very different. None of the depreciation expense recorded to the period requires cash outlay during the period. Rather, depreciation expense for the period is that portion of the total cost of a business's fixed assets that is allocated to the period to record an amount of expense for using the assets during the period. Depreciation is an imputed cost, based on what fraction of the total cost of fixed assets is assigned to the period.

The higher the total cost of its fixed assets, the higher a business's depreciation expense. However, there is no standard ratio of depreciation expense to the total cost of fixed assets. The amount of depreciation expense depends on the useful lives of the company's fixed assets and which depreciation method the business selects. (How to choose depreciation methods is explained in Chapter 13.) The annual depreciation expense of a business is seldom more than 10-15 per cent of the total cost of its fixed assets. The depreciation expense for the year is either reported as a separate expense in the profit and loss account (as in Figure 6-2) or the amount is disclosed in a footnote.

Because depreciation is based on the cost of fixed assets, the balance sheet reports not one but two numbers - the original cost of the fixed assets and the
accumulated depreciation
amount (the amount of depreciation that has been charged as an expense from the time of acquiring the fixed asset to the current balance sheet date).

The point isn't to confuse you by giving you even more numbers to deal with. Seeing both numbers gives you an idea of how old the fixed assets are and also tells you how much these fixed assets originally cost.

In the example, the business has, over several years, invested £11,305,000 in its fixed assets (that it still owns and uses), and it has already charged off depreciation of £4,580,000 in previous years. In this year, the business records £1,200,000 depreciation expense (you can't tell from the balance sheet how much depreciation was charged this year; you have to look at the profit and loss account in Figure 6-2). The remaining non-depreciated cost of this business's fixed assets at the end of the year is £5,525,000. So the fixed assets part of this year's balance sheet looks like this:

Fixed assets £11,305,000

Accumulated depreciation
(5,780,000)

Net amount included in total assets £5,525,000

You can tell that the collection of fixed assets includes both old and new assets because the company has recorded £5,780,000 total depreciation since the assets were bought, which is a fairly sizable percentage of original cost (more than half). But many businesses use accelerated depreciation methods, which pile up a lot of the depreciation expense in the early years and less in the back years (see Chapter 13 for more details) so it's hard to estimate the average age of the assets.

Debt and interest expense

The business example whose balance sheet and profit and loss accounts are presented in Figure 6-2 has borrowed £5 million on loans which, at an 8 per cent annual interest rate, is £400,000 in interest expense for the year. (The business may have had more or less borrowed at certain times during the year, of course, and the actual interest expense depends on the debt levels from month to month.)