Accounting for dummies. A fictional scenario that helps to simplify financial statements.
There are businesses and then there are profitable businesses. It’s important to know the difference. In an attempt to keep things simple, take the example of Sally’s Children’s Party Catering Service and her attempt to understand what’s really going on. You need to keep track.
Three friends are standing talking at a backyard party, while a fourth friend is close enough to overhear the conservation. Sally Jester runs The Children’s’ Party Catering Service. One of her friends, Jerry Cynic, doesn’t think what she is doing can be considered a business while Jim Jovial, a second friend, supports her. A third friend, Harry Nosey, is close enough to hear them but not close enough to engage in the conservation. It’s informative to listen in on the conservation. Imagine the questions that can be asked in evaluating Sally’s party catering business and apply them to any ideas that you may be contemplating as a business opportunity.
Status of Sally’s Business
It starts with Jerry thinking that Sally is getting fleeced in her business. To him it’s more of a charity than a business. Sally, protecting her baby, says she’s not being fleeced; that people pay her very well for what she does. She charge $5.00 per child and, in her mind she makes a fair profit for every party that she organizes.
“You know, there was no one else in this community doing this type of work when I started. Now, there’s barely a children’s birthday party, an Easter or Halloween party put on without my help. I don’t mind if I say so. I’m a success!”
While Jim appeases her by saying that the main thing in life is to be happy and enjoy doing what you’re doing, and if you’re making a profit, that’s a bonus, Jerry persists.
“But you’re not making money at all, or at least, are you sure you’re making money? Have you ever sat down and calculated what you earn against what it costs you in money, material and time, and seen what that means?”
After bickering back and forth, each defending their own argument, Jim attempts to clarify things. “If you’re charging people money for goods and services, you’re running a business. If you’re making a profit doing it, you’re running a profitable business.” But the bickering continues.
“She’s running a charity organization,” insists Jerry.
Sally protests. “But I like what I’m doing.”
“Well,” says Jerry, “you should charge more for your parties.”
“And lose my clients and my involvement?”
“Think about it.”
“She’s thought about it,” says Jim in support.
“I like what I’m doing,” Sally continues to insist and walks away.
Sally is intercepted by Harry Nosey. Harry wonders if she feels as strongly about what she’s saying as she’s making out and she admits she doesn’t have enough information to really have a strong opinion about the whole situation and needs help. Thence the suggestion of an accountant.
“Well,” says Harry, “I’ve arranged to bring in an accountant to have a look at the business that you started. What do you call that business?”
“The Children’s Party Catering Service…”
“Right…! Well, you’re exactly in the same position as many small business people who don’t have all the data they need to form an opinion of their actual status. Why don’t you go and see the accountant, Norm Numbers, and he’ll explain a few things.”
“Okay, I’ll go.”
Sally is about to be introduced to two types of statements:
- a balance sheet
- a profit and loss statement
The scene changes to a family room. Bob and Sally Jester are sitting at the bar talking with Jim Jovial prior to the arrival of Norm Numbers, an accountant, when the doorbell rings. It’s the accountant.
Norm and Sally go to a table and Norm invites her to sit down, then explains that Sally’s husband, Bob asked him to assess the business she’s running, and to see how profitable it is.
“Oh! Well what’s my profit?” she spits.
“Well, let’s start off by noting that, based on some grocery slips of some stuff you asked Bob to get you recently, you spend about $2O on the average on food for each party.
“I guess so, I don’t know.”
“And then you consume about $5 to $6 on party materials like hats, whistles, little presents, and so on. Yeh…?”
“I guess so.”
“That’s about $25. Let’s call it $26. You charge $35 per party on the average, right?”
“That leaves $9.”
“So that’s my profit?” asks Sally.
“No…! You see, you use your car to get there, so you drive a certain number of miles, and gas is expensive. The standard car mileage for business use is usually calculated at $0.50 a mile nowadays.
“So that’s a bit more off that $9. Also, you have a pile of stuff in your pantry; hats, knives, forks, spoons, stirs, and bits of furniture that you use at your parties?”
“Yes… but that’s just stuff from home”
“$500 worth…! If you had that $900 invested, you’d be making interest. Now… that’s a bit more off your $9 in profit. But it isn’t profit, you see, because you work about 12 to 19 hours on each party, don’t you?”
“So when you’re calculating your profitability, you should pay yourself some money for the time you work before you calculate your profit, say $0.50 an hour?”
“$0.50 an hour…?”
“That gets it down to zero. You haven’t made a profit at all.”
At this point Sally gets up and leaves to talk to her husband, Bob at the bar. She’s upset that she’s only making $0.50 an hour and doesn’t want to work for that. She wants be a real businesswoman.
Norm, the accountant hears this as he too walks over to the bar. “Bob,” he says, “we’ve got this highly non-dramatic thing, the financial statement, to go through. Frankly, it’s boring.”
“I know,” replies Bob, “but I’m not trying to have you show how financial statements are made. I’m just trying to get you to show Sally why they’re useful; what benefits come from them.”
Sally relents and she and Norm join Bob and Jim at the bar.
“Jim, you’re looking worried,” says Bob. “What’s the matter?”
Well…” responds Jim, “to tell you the truth, I think the whole thing on financial statements is a waste of time.
“Now, you’re saying that partly because they’re a bit more complicated and you can’t understand them. How do you run your own personal business then?”
“My grandmother does it for me.”
“Could I interrupt a moment?” interjects Norm.
“Sure…” says Bob. “Everybody, this is Norm Numbers, an accountant friend of mine.”
“Well… listen up Jim,” says Norm. “They are not really all that complicated.”
“Maybe Norm is right,” suggests Jim. “Let’s me have one more attempt to understand it as well.”
Financial Statements: Balance Sheet
Statements can be confusing to some people, so Norm starts off slow, almost treating Sally and Jim like dummies. “There are two sorts of financial statements,” he begins.
“There are two types of financial statements,” Jim repeats. “I got it.”
“The first one is the balance sheet,” smiling at the thought of Jim repeating things.
“The balance sheet…”
“The balance sheet… That’s a statement made of what you own, and what you owe at a given point in time, so that you know exactly where you are at least at one moment: what you own, which is your inventory, the cash you have in the bank, the money people owe you—“
“The cash register…”
“Yeah, all that stuff: your equipment in the store.”
“That is what you own. That goes on the left hand side of the sheet.”
“On the other side, you’ve got what you owe: the bills you haven’t paid yet, and to that you have to add the owner’s equity.”
“And what’s the owner’s equity?”
“That’s what you’ve put into the business.”
“The cash register…”
“No… The money that you’ve put in that is still left in the business. So what you own…”
“Has to equal what you owe…”
“It has to equal what you owe.”
“It has to equal what you owe, plus your own equity.”
“Now, that tells you where you are at a certain spot. That’s a balance sheet.”
Financial Statements: Profit and Loss
“What’s the other thing?” asks Jim.
“The other thing is your profit and loss statement – Are you listening? Now, that covers a period of time, over, say, usually a period of 12 months. Now… that lists first of all, your earnings, your income- whether or not you’ve actually received it- during this period.”
“No, no, that’s…”
“Not my salary…”
“No…. What the business did and will receive. What was paid and owed into the business by customers buying the goods…”
“Plus bank interest….Below that, you’ve got expenses that were necessary to achieve these earnings: buying the goods, paying the people who work for you, and so on, including paying your own salary. And what’s left over after is the profit.”
“The profit,” interjects Sally.
“The profit for the period,” stresses Norm.
“Okay. That’s the profit for the period,” says Jim.
“So, you’ve got the balance which is at a point in time and the profit and loss statement which covers a period of time,” says Norm in summary (see images below).
“I think I got it,” says Jim.
“Me too,” says Sally.