Friday, November 09, 2007

My adventure into accountings

Phew, nearly 'dieded' trying to put all the accountings I've learnt today into practice.

I went to the library to borrow this book, "Accounting demystified - a self-teaching guide". I long wanted to pick up accountings so that I can understand financial statements better, so what better time than now? :) I tried to read up on the financial ratios but doesn't make sense to me, cos I think I do not know what those entries in the statements mean, and what is the relationship between balance sheet, statement of cash flow and income statements.

I want to break out of the accounting jargons (like I did for TA), so I went to read up about it. I guess I don't need a very detailed knowledge, just a very fundamental knowledge of the principle of accountings should suffice. I came home inspired and ready to do my first balance sheet.

Balance shit! Can't balance...then after trying for nearly 2 hrs, I think I got the hang of it. Now I really understand what is meant by the double-entry system and the accrual method of accounting. Hmm, damn interesting :) Finally made sense to me.

Here's what I did (WARNING: This is going to be long)

I opened a stall called Bully the bear (BTB) to sell some sausages. I think it'll make a great snack at a nearby traffic junction (it's illegal, i know, but this is fictional yah?). This shall be my first step to my first million :)

I only have $1000, which is my seed money to start the whole business. So initially, my statements look like this:

Not very impressive, yes. To start my business, I need $500 to buy 250 sausages, and another $200 on a fryer, pan and other fixed assets. Those high grade sausage are oil free, so I just need a fryer and pan to start cooking them. Other fixed assets include perhaps a signboard, some gloves (I'm a illegal BUT hygienic hawker) perhaps.

Now my statements look like that above. I paid $700 (500 + 200) in cash to get my sausages and fixed assets, so immediately in my cashflow, I subtract $700. At the same time, I converted the $700 into $500 worth of inventory (that's my sausages) and $200 worth of fixed assets (that's my fryer,pan,signboard etc). The link between cashflow statements and balance sheet is that the cash at the end of the period becomes cash at the left side (asset side) of the balance sheet. Did I put in double entries? Yes, that's the point. Oh btw, I capitalise my fryer/pan/sausages instead of expensing it. More of that later.

Now I'm ready to do some business. First I must decide the price to sell my sausages so as to make a profit. I will get a profit as long as I sell each sausage above the cost used to produce the sausage. This cost can be divided into 2 types - direct cost and indirect cost. Direct cost are cost that goes directly to produce the sausage (duh) - like the raw sausages itself. Indirect cost are cost that are used to pay for the things that will generate the business - like my fryer, pan, signboard (debatable issue - is fryer/pan indirect? I put it as indirect because one day I plan to expand my business to sell not only sausage. So if I sell other things like chicken wings, the same fryer and pan can be used, hence the fryer/pan isn't used to exclusively make the sausage, so it's indirect).

Each sausage cost $2 (500/250 = 2). The indirect cost I calculate my capitalising it, instead of expensing it. These are just 2 ways of depreciating assets. I'll skip expensing it till next time. I'll just capitalise my fryer/pan/signboard. You know, after frying my sausages, my fryer and pan starts to break down. The signboard also like want to spoil don't want to spoil already. This means that the fixed assets loses its value, so I must find some way to devalue it - or depreciate it over time. For me, I just use the $200 indirect cost, divided by number of sausages, which gives me $0.80 per sausage.

In summary,
my direct cost - or cost of goods sold (COGS) - is $2
my indirect cost - or operating expense - is $0.80

Let's sell something! Since my total cost is $2.80, I just agar agar sell at $3.50, sure make my first million like that.

First day of business, I sold 100 sausage at $3.50. I do not accept credit, so customers pay me on the spot when they get their delicious sausages. For that,

I collected $350 in cash (3.50 x 100 = 350) with
COGS as $200 (2 x 100 = 200) and
operating expenses (indirect cost) as $80 (0.80 x 100 = 80).

All the above can be found in the income statement, which just records the sales i did, regardless of whether I actually received the payment in cash or credit. More of that later.

Here's how my statement look like now:

Haha, balance sheet balances on both sides, with net income in the income statement reflected in the retained earnings on the equities side of the balance sheet, and ending cash on the cash flow statements reflected in the cash on the assets side of the balance sheet.

2nd day as I wasn't caught yet, I went on selling. This time, I did better as word spread around, I sold a total of 100 sausages and received it in cash, then another 50 sausages but received in credit. They no money to pay but promised to pay me the next day, so I anything lah.

I get $350 in cash (3.50 x 100) and $175 (3.50 x 50) in accounts receivable.
COGS is $300 (2 x 150 sausages), so the final COGS is the initial 200+300=500 reflected.
My fixed assets I take it as depreciated fully (strange, i know, cos fixed assets are called fixed if they depreciate after more than 1 yr, i should have expensed it instead of capitalising it).

Here's how it looks:

Still balanced.

I'll continue the story of BTB sausage next time. I learnt everything once I put those transactions into the statements. Next time I'll explore expensing items, and perhaps explore a little about how I actually started with my $1000 seed money (did I borrow it from bank or sell my stake in the business?)

Thks for protonoid for pointing out that the $1000 initial seed money should be placed in capital stock or a separate capital accounts, not placed under retained earnings. Retained earnings is used for money earned from the last accounting period.

Thks so much for pointing out the mistakes, I'll remember it!


Protonoid said...

Nice summary of basic accounting.

1 mistake to point out though. Because you started with $1000, you shouldnt record it as Retained Earnings, but instead as Capital Stock, or in a separate Capital account.

Retained earnings is more to record the amount of profit generated by the company. =D

Im almost done with my 1 financial accounting module, yay!

la papillion said...

Hey protonoid,

Thks for pointing out that mistake! I was a bit confused over where to put in my $1000, so I just put into the retained earnings as it seems the most logical entry.

I'll remember that, thks!

(haha, if i post more accountings, can help me point out more mistakes? more the merrier, thks!)

sm@ll.fry said...

Hi lp,

Great entry! Wa this is good stuff! I've also been trying to demystify accounting, but still very blur. Following through your excercise has helped me to understand better as well! Well done!

Will you be examining financial ratios of your business later? Maybe even sell stock and let us value it?! Haha just some suggestions!

Have a good sunday!

Protonoid said...

"(haha, if i post more accountings, can help me point out more mistakes? more the merrier, thks!)"

Yeah sure, no problem =D

la papillion said...

hey thks everyone! fishman, didn't know my accountings can help someone understand, haha :) You must have followed it really closely.

Financial ratios not yet. I still want to work on my financial accountings yet. Next time i'll look at the impact of using debt equity and stock equity on net income :)

Mike Dirnt said...

LP very nice illustration. But its good if you put the period or day on top of the balance sheet and income statement.

i got lost for awhile while opening too many windows. haha coz they all look identical

about the depreciation of assets, you mentioned can be done through expenses and capitalise? you choose the latter for this example right. but its under expenses on the income? im a bit blur this part

la papillion said...


Thks for your suggestion. As I said before, I'm a newbie at the time I was doing this. Now I've seen enough balance sheets to make it look like the real thing :)

Before i tell you what is the difference between expensing and capitalising, you should know that there is a difference between cost and expense. If I buy something for $1000, the cost of $1000 can consist of $300 of asset and $700 of expense.

The cost of buying something that can be 'expensed' or 'capitalised'. Let's say I bought a machine at $1000 and wanted to capitalise it. This means that I straight away add the $1000 to the assets column of balance sheet and deduct $1000 from cash flow (assume i fork out $1000 to buy that machine). If I assume that the machine can be used for 10 yrs, I'll linearly depreciate the machine at $100 per year. This $100 per year will be deducted in the income statement and reduces my earnings, but it did not affect cash flow anymore (since I already straight away reduce $1000 in cash flow already). That is also the reason why to find operating cash flow, we need to 'add in' depreciation.

If I choose to expense it, it means that $1000 will be put under 'cost of goods sold' in income statement, straightaway reducing my earnings by $1000 (hence reducing my equities (retained earnings) by $1000). At the same time, I'll also deduct $1000 from cash flow (reducing my assets (current assets) by $1000). Still balanced! But take note, there will not be any depreciation charges for expensing the $1000 machine.

To summarise, to expense an item is to take a one-shot pain of reducing net income of that year of purchase by the cost of that item, no depreciation after that. To capitalise an item, we put it all into asset first, then slowly reduce the value of that asset and reducing each year by a fixed depreciation charge to the net earnings from the year of purchase.

Cheam hor?!

Mike Dirnt said...

thanks LP for the lenghty explanation