Lesson 3
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Lesson 3
Back to our accounting. First, we debit fixed assets for $5,000 and then we credit cash for $1,000, the amount we pay. Then, we credit short-term loans for $4,000, the amount on our short-term loan. Our balance sheet is now updated. Cash went down $1,000, fixed assets went up $5,000, and short-term loans were added to for $4,000. This did not affect our income statement, our profit and loss.

Some assets can be depreciated. What’s depreciation? Well, it’s where you write off an asset over time. The concept is that certain assets wear out over time. So, the IRS allows us to write them down. If we purchase a piece of equipment for $15,000, and figure to sell it for $1,000 after seven years, we can depreciate $14,000 over seven years. We can use any of several methods. The straight-line method would allow us to depreciate $2,000 per year.

There are several methods that allow us to accelerate our depreciation. Why would we accelerate depreciation? Well, let’s consider a truck that produces a fixed amount of revenue every month. As it gets older, repairs amount up. The older it gets, the more is costs to keep it running. If we use accelerated depreciation, we would have lots of depreciation expense at first and less later. As the truck ages, the cost of repairs will increase, making up for the lower depreciation cost. And this way, the cost of the truck would be level, matching the income. Talk to your tax advisor about which method of depreciation you should use.

So, we are going to depreciate $1,000 of the truck’s value. We have to debit depreciation $1,000 and credit fixed assets, or a reserve for depreciation, for $1,000. Your tax advisor will know exactly how you should be doing this.

When we recalculate our financial statement, we see that fixed assets have been reduced by $1,000. The truck is now net of depreciation and our depreciation expense has increased our loss to $1,500.

For our sample business, we are going to purchase some inventory -- $20,000 worth. We need to debit inventory for $20,000 and credit accounts payable for $20,000. Accounts payable means we purchase inventory from vendors on an open account, promising to pay at a later date -- typically, not longer than 30 days. Some vendors will offer a little discount if we pay the account in a hurry, say one or two percent. We need to recalculate again, and we see that inventory has increased by $20,000 and accounts payable has also increased by $20,000. We are in balance because we have a $20,000 debit and a $20,000 credit. Notice that purchasing inventory did not affect the profitability. The only time we make money is when we make a sale. We can lose money by paying expenses – even when we have no income.

So, it’s time to make a sale. We sell $20,000 to a customer who wants to pay in 30 days. We account for it by debiting accounts receivable for $20,000 and crediting sales by $20,000. Notice that this transaction takes us into profitability. We show earnings of $18,500 -- $20,000 in income, less the $1,500 in expenses. Actually, this is only half of the transaction. The second part to this sale is the cost of the sale, the inventory. We account for it by debiting cost of goods sold for $10,000 and crediting inventory for $10,000. Hopefully, we do not sell our inventory for the same price that we bought it. Of course, if we do not reduce our inventory, we have 100% profit. It’d be nice, but not likely.