Balance Sheets and Income Statements
This week I was reviewing some basic finance and accounting files in my computer when I came across an old presentation on the flow of costs, revenue recognition, matching principle and how Balance Sheets and Income Statements are recorded. The presentation was rather boring and poorly put together but it did make me think about how small businesses, without accounting or finance departments, can apply these principles in day to day operations
I will focus more on the matching principle on this post and cover revenue recognition on another. The matching principle basically tells us that we must recognize costs to match expenses used to generate revenue in the period in which the expense occurred. How we recognize a cost, whether is capitalized or not, will determine if the expense becomes an asset on the balance sheet. Regardless of recognition the expense will be listed as an expense in the Income Statement. The diagram below illustrates the process:
But how does this work in real life? How does a business owner apply this principle? Let’s use a goat farmer as an example. Suppose you are a brand new goat farmer and want to purchase some breeding stock for your farm. This is a cost, now we have to decide if it’s capitalized or not. Breeding stock will probably be on the farm for use for a couple of years, it’s probably expensive (a good buck can go for up to $5,000.00) and you expect to produce revenue from them (selling the kids that are produced) so this is an asset. In the balance sheet an owner would record the value of the breeding stock, book value which is what the owner paid for them, as an asset. In the income statement the expense is recorded. Now say that a month later you decide to buy hay and some iron supplements for your stock. This is another cost. Will it be on the farm for a couple of years? Probably not. Is it expensive? Maybe $100 so it’s not that expensive. Will you produce revenue from the hay? No. The hay and feed are not recorded in the balance sheet, they are recorded in the Income Statement.
But why do this? Why go through the extra steps of identifying and recording the expenses this way? Let’s look at the same operation two years from now. Now the breeding stock have produced kids. Are the kids an asset? What about the costs associated with the kids? Are they recorded on the Balance Sheet and Income Statement? If the farm operation consists of selling 6 month old kids the correct recognition is essential if the farmer wants to understand if the operation is profitable or not.
Record keeping to create balance sheets and income statements can be tedious but absolutely essential for every small business owner.