It would probably be ideal if business and life were as simple as producing goods, selling them and recording the profits. But there are often circumstances that disrupt the cycle, and it’s part of the accountant’s job to report these as well. Changes in the business climate, or cost of goods or any number of things can lead to exceptional or extraordinary gains and losses in a business.
Some things that might alter the income statement can include downsizing or restructuring the business. This used to be a rare thing in the business environment, but is now fairly commonplace. Usually it’s done to offset losses in other areas and to decrease the cost of employees’ salaries and benefits. However, there are costs involved with this as well, such as severance pay, outplacement services, and retirement costs.
In other circumstances, a business might decide to discontinue certain product lines. Western Union, for example, recently delivered its very last telegram. The nature of communication has changed so drastically, with email, cell phones and other forms, that telegrams have been rendered obsolete. When you no longer sell enough of a product at a high enough profit to make the costs of manufacturing it worthwhile, then it’s time to change your product mix.
Lawsuits and other legal actions can cause extraordinary losses or gains as well. If you win damages in a lawsuit against others, then you’ve generated an extraordinary gain. Likewise if your own legal fees and damages or fines are excessive, then these can significantly impact the income statement.
Occasionally a business will change accounting methods or need to correct some inevitable errors that had been made in previous financial reports. Generally Accepted Accounting Procedures (GAAP) require that businesses make any one-time losses or gains very visible in their income statement; so it is important that small business as well as major corporations pay close attention to these principles.
Making a profit in business is derived from several different areas. It can get a little complicated because – similar to monetary activities in our personal lives – business is run on credit as well. Many businesses sell their products and services to customers on credit, and as such, adhere to certain accounting principles.
Accountants use an asset account called accounts receivables to record the total amount owed to the business by its customers who haven’t paid the balance in full yet. Much of the time, a business hasn’t collected its receivables in full by the end of the fiscal year, especially for such credit sales that could be transacted near the end of the accounting period.
The accountant will record sales revenue and the cost of goods sold for these sales in the year in which they were made and the products delivered to the customer. This is called accrual-based accounting, based on the fact that it records revenue when sales are made and records expenses when they’re incurred as well.
When sales are made on credit, the accounts receivable asset account is increased. When cash is received from customers, then the cash account is increased and the accounts receivable account is decreased. The cost of goods sold is one of the major expenses of businesses that sell goods, products or services. Even a service involves expenses.
Therefore what this means exactly is what it says: The cost that a business pays for the products it sells to customers is the cost of goods sold. A business makes its profit by selling its products at prices high enough to cover the cost of producing them, the costs of running the business, the interest on any money they’ve borrowed and income taxes, with money left over for profit.
When the business acquires products, the cost of those products goes into what’s called an inventory asset account. That cost is deducted from the cash account, or added to the accounts payable liability account, depending on whether the business has paid with cash or credit.