Inventory is usually the largest current asset of any business that sells products. If the inventory account is greater at the end of the period than it is at the start of the reporting period, the amount that is actually paid in cash, by the business for that inventory, is more than what the business recorded as its cost of goods sold expense.
When the inventory is more than the goods sold expense, the accountant deducts the inventory increase from the net income in order to determine cash flow from profit. The prepaid expenses asset account works in much the same way as the change in inventory and accounts receivable accounts. However, changes in prepaid expenses are usually much smaller than changes in those other two asset accounts.
The beginning balance of prepaid expenses is charged to expenses in the current year, but the cash was actually paid out last year. This period, the business pays cash for next period’s prepaid expenses, which affects this period’s cash flow, but doesn’t affect net income until the next period. Simple, right?
As a business grows, it needs to increase its prepaid expenses for such things as hazard insurance premiums, which have to be paid in advance of the insurance coverage, and its stock of office supplies. Increases in accounts receivable, inventory and prepaid expenses are the cash flow price a business has to pay for growth. Rarely do you find a business that can increase its sales revenue without increasing these assets.
The lagging behind effect of cash flow is the price of business growth. Managers and investors need to understand that increasing sales without increasing accounts receivable isn’t a realistic scenario for growth. In the real business world, you generally can’t enjoy growth in revenue without incurring additional expenses.
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.