Examining Your Asset Accounts
The activities of a business involve inflows and outflows of cash, as you know. What you might not know, however, is that the profit-making process also involves four other basic operating assets, explained here to give you a more realistic picture of what’s involved in making a profit.
Many businesses use an accounts receivable asset account to record amounts owed to the business by its customers. Accounts receivable asset accounts allow a business’s customers to buy on credit. In most cases, your business doesn’t collect all its receivables by the end of the year, especially for credit sales that occur in the last weeks of the year. You record the sales revenue and the cost of goods sold expense for these sales as soon as you complete a sale and deliver products to the customers.
This is one feature of the accrual basis of accounting, which records revenue when you make sales and records expenses when you incur costs. When you make sales on credit, the accounts receivable asset account is increased; later, when you receive cash from the customer, cash is increased and the accounts receivable account is decreased.
The cost of a product your business acquires for the purpose of sale goes into an inventory asset account. This inventory asset account records the costs of acquiring only products that your business hasn’t yet sold.
A business that sells products needs to have a stock of those products on hand to sell to its customers. This stockpile of goods on the shelves (or in storage space in the backroom) waiting to be sold is called inventory. The cost of unsold products doesn’t get listed as an expense until the products are actually sold; so, the acquired but unsold products are listed in the inventory asset account. In this way, the cost of goods sold expense is correctly matched against the sales revenue from the goods sold.
Prepaid expense asset
Prepaid expenses are the opposite of unpaid expenses. For example, a business buys general liability insurance (in case a customer slips on a wet floor and sues the company), and insurance premiums must be paid ahead of time, before coverage starts. The premium cost is allocated to expense in the actual period benefited. At the end of the year, the business may be only halfway through the insurance coverage period, so it charges only half the premium cost as expense. So at the time that the premium is paid, the entire amount is recorded in the prepaid expense account, and for each month of coverage, the appropriate fraction of the cost is transferred to the insurance expense account.
Buildings, machinery, and office equipment are fixed assets that not held for sale in the ordinary course of business. Depreciation refers to spreading out the cost of a fixed asset over the years of its useful life to a business, instead of charging the entire cost to expense at once. That way, each year of use bears a share of the total cost. For example, company cars are usually depreciated over five years; the idea is to charge a fraction of the total cost to depreciation expense during each of those five years.