INTRODUCTION: THE ROLE OF ACCOUNTING IN A BUSINESS
1.9 ACTIVITIES OF RESOURCE ALLOCATION (INTERNAL INVESTING ACTIVITIES TO PREPARE FOR BUSINESS)INVESTING ACTIVITIES TO PREPARE FOR BUSINESS)
Now, the management of R&B Grill is ready to start working on preparing to open the business. It starts with securing a place to conduct its business. Let’s assume that the company leases an empty building as described in the next example (Example 1.4).
Example 1.4: There was an empty building available for lease that used to be a restaurant in town. On Jan. 1, a lease contract was signed for the building. Rent is set at $15,000 per month.
The landlord demanded a $100,000 deposit for future rent in
advance. Rachel and Brad agreed and leased the place for 5 years. The payment was recorded in the account named “Pre- paid Rent.”
In this transaction, R&B Grill has paid cash to secure a place for its operations. This spending is not an expense because the space has not been used yet. In other words, the Rent Expense has not been incurred yet. The payment was to create a deposit account that purchases a legal right to use the space.
The amount of cash paid has decreased the amount of its cash on hand (asset decrease) and the decrease of cash must be journalized in the credit side. The debit side records, though, the deposit for the “legal right” to use the place. This deposit account title is “Prepaid Rent.” In the Balance Sheet, this kind of asset is consolidated into the group of
“Prepaid Expenses.” (Many public restaurant companies’ balance sheets show the account title of “Prepaid Expenses.”) The journal entry and impacts will look like the following:
Table 1-06(A) Example 1-04 Journal Entry
Debit Credit
Impact Account Amount Account Amount Impact
A+ Prepaid Rent 100,000 Cash 100,000 A–
The journal entry shows the impact on each side, which is not a usual practice in accounting. “A+” stands for an increase in Assets, while “A-”
indicates a decrease in Assets. This presentation shows only to guide the readers to develop necessary knowledge to use accounting information in the long run. The interpretation of the transaction is that the company has obtained an asset item by paying cash. The “Prepaid Rent” gives R&B Grill the right to use the space for its business. Remember that “Prepaid Rent” is not Rent Expense yet. As time goes by, the company will spend its deposited amount to pay for the monthly rent. Only then, the amount spent each month will be recorded as monthly Rent Expense. All other Prepaid Expenses work the same way.
When this journal entry is posted, the relevant T-accounts are Cash and Prepaid Rent. They will look like the following:
The Cash T-account shows one record ($100,000) on the credit side, indicating there was an outfl ow of cash of $100,000. With this record, the company’s cash balance drops from $800,000 to $700,000. How- ever, it has obtained another asset (Prepaid Rent) in the same transaction.
Although its cash balance has decreased, its total asset value still remains the same. Simply, R&B Grill has invested its cash to secure the business site. If the Balance Sheet is prepared at this point, it will look like the following:
Table 1-07 The Balance Sheet After Lease Contract (Example 1-04) The Balance Sheet
R&B Grill, Inc.
On January ##, 2XX1 – after Lease Contract
Assets: Liabilities & Equity
Liabilities
Cash 700,000 Notes payable 150,000 Prepaid Rent 100,000
Equity
Common stock
– Rachel & Brad 450,000 Common stock
– Jane 200,000 Total Assets 800,000 Total Liabilities & Equity 800,000 Table 1-06(B) Example 1-04 Posting (Cash & Prepaid Rent T-accounts)
Cash Prepaid Rent
Ex 1-01 450,000 100,000 Ex. 1-04 Ex. 1-04 100,000
Ex 1-02 150,000
Ex 1-03 200,000
The next step covers the preparation of the business by installing equipment and furniture along with necessary contract works, such as plumbing, electricity, building cabinets and storage space, and other lay- out that supports operations. The next example (Example 1.5) introduces a simplifi ed scenario of such transaction.
Example 1.5: Rachel and Brad decided to purchase a new set of furniture and fi xture for the dining room and new sets of kitchen equipment. Following the industry norm, these are consolidated into an asset account of FF&E (Furniture, Fix- ture, and Equipment). The Manufacturer’s Suggested Retail Price (MSRP) was $550,000, but the entire set was on sale for
$500,000. One half was paid in cash up front, and the other half was put on account for 2 years. The vendor decided not to charge any interest on the balance if R&B promises future pur- chases from them. Rachel and Brad agreed to do so. The FF&E will be used for 5 years.
This type of spending is called a capital expenditure, which stands for an internal investment. This should not be mistaken for an expense.
The defi nition of an expense will be provided later in this chapter. The huge spending in this transaction has brought in a large amount of equip- ment and furniture. They are all asset items. “FF&E” is the commonly used account title for these. The purchase of the FF&E in this transaction includes cash spending (Assets decrease; A-), and an unpaid amount that has become a debt (Liabilities increase; L+). Another fact to notice is the two different amounts for the FF&E. The MSRP is $550,000 and the purchase price is $500,000. This is an example of an Accounting Princi- ple called the Cost Principle or the Historical Cost Principle. Under this principle, accounting only records the actual amount paid for any items.
The MSRP or any other values are irrelevant in accounting. Thus, the amount of $500,000 should be recorded. Following the rules introduced earlier, the journal entry of this looks like the following:
Table 1-08(A) Example 1-05 Journal Entry
Debit Credit
Impact Account Amount Account Amount Impact
A+ FF&E 500,000 Cash 250,000 A–
Notes Payable 250,000 L+
Table 1-08(B) Example 1-05 FF&E Purchase Posting
Cash FF&E
Ex 1-01 450,000 100,000 Ex 1-04 Ex 1-05 500,000 Ex 1-02 150,000 250,000 Ex 1-05
Ex 1-03 200,000
Notes Payable
150,000 Ex 1-02 250,000 Ex 1-03
It must be noticed that the Notes Payable T-account is now updated to include the current example (Example 1.5) in addition to the ear- lier record of $150,000. Now, R&B Grill has increased its liabilities to
$400,000. This result will change the fi nancial position of the company as follows:
From now on, the description of each journal entry will be elimi- nated. As mentioned, this transaction includes two entries to the credit side. A journal entry that has multiple records at least on one side is called a “composite entry” in technical term. The interpretation of this journal entry is that the company has obtained an asset item (FF&E) by paying cash for one half and incurring a liability for the other half.
The relevant T-accounts, after posting, are presented in the following Table 1.8(B).
Table 1-09 The Balance Sheet After FF&E Purchase (Ex. 1-05) The Balance Sheet
R&B Grill, Inc.
On January ##, 2XX1 – after FF&E purchase Assets: Liabilities & Equity
Liabilities
Cash 450,000 Notes payable 400,000 Prepaid
Rent 100,000
Equity
FF&E 500,000 Common stock
– Rachel & Brad 450,000 Common stock
– Jane 200,000 Total Assets 1,050,000 Total Liabilities & Equity 1,050,000
The new balance sheet in Table 1.9 shows three items of assets owned by R&B Grill, which is $1,050,000 in total. The total assets have been fi nanced by $400,000 of Notes Payable (Liabilities) and by $650,000 of the investment made by the owners (Equity). As a result, this company owns assets of $1,050,000. Its creditors claim $400,000 on the assets, while the investors can claim the rest that is $650,000. In summary, the liabilities and equity of a business is also described as the claim of each stakeholder group – creditors and owners – on the entire assets of the business.
Even after installing equipment and furniture, R&B is not ready to open its door to accommodate customers. The company still has to go through a few more steps that include purchasing fi re insurance. The next example (Example 1.6) introduces the transaction of fi re insurance purchase.
Example 1.6: Rachel, as the operating manager, purchased fi re insurance for 1 year. The annual premium of $18,000 has been paid in cash in advance.
The prepayment of the annual premium of insurance is another Pre- paid Expenses. Its nature is the same as that of Prepaid Rent introduced in Example 1.4 earlier. The journal entry is shown below.
Table 1-10(A) Example 1-06 Journal Entry
Debit Credit
Impact Account Amount Account Amount Impact A+ Prepaid Insurance 18,000 Cash 18,000 A–
R&B purchased protection by depositing the annual premium in advance. This deposit will be used for monthly insurance expenses during the next 12 months. The relevant T-accounts after posting and the updated Balance Sheet are presented below.
Table 1-10(B) Example 1-06 Posting
Cash Prepaid Insurance
Ex 1-01 450,000 100,000 Ex 1-04 Ex. 1-06 18,000 Ex 1-02 150,000 250,000 Ex 1-05
Ex 1-03 200,000 18,000 Ex 1-06
Table 1-11 The Balance Sheet After Fire Insurance Premium (Ex. 1-06) The Balance Sheet
R&B Grill, Inc.
On January ##, 2XX1 – after Fire Insurance Purchase
Assets: Liabilities & Equity
Liabilities
Cash 432,000 Notes payable 400,000 Prepaid Rent 100,000
Prepaid insurance 18,000 Equity
Common stock
– Rachel & Brad 450,000 FF&E 500,000
Common stock
– Jane 200,000 Total Assets 1,050,000 Total Liabilities & Equity 1,050,000
Let us assume R&B Grill is ready to start its business. To serve cus- tomers, Rachel and Brad must have inventory. Example 1.7 presents the purchase of inventory.
Example 1.7: Inventory (F&B) of $80,000 was purchased. One half of the amount was paid in cash and the rest was put on account for 1 month. The journal entry of this transaction is presented below.
Table 1-12(A) Example 1-07 Journal Entry
Debit Credit
Impact Account Amount Account Amount Impact
A+ Inventory 80,000 Cash 25,000 A–
Accounts
Payable 55,000 L+
Purchases of inventories are considered as short-term investing activities of a business. This spending is not an expense. As shown in the journal entry in Table 1.12(A), this transaction has increased the com- pany’s Assets by $80,000 (in the “Inventory” account) and decreased its Assets by $25,000 (in the “Cash” account), and it also increased its Liabilities by $55,000 (in the “Account Payable” account). This transac- tion, in its nature, is exactly the same as previous examples of purchasing other asset items. When inventories are consumed over time, only the amount of the used inventory will be recorded as an expense. The follow- ing Table 1.12(B) presents the T-accounts when these records are posted.
It must be noticed that the unpaid amount for the purchase is put into the “Accounts Payable.” It is a Current Liabilities account that records the amount to be paid within 1 year. On the other hand, “Notes Payable”
account belongs to the long-term Liabilities and is used for the amount to be paid for longer than 1 year. Following Table 1.13 shows the updated Balance Sheet after this transaction.
The balance sheet (in Table 1.13) presents a few items in the asset side with the total of $1,105,000. The liability section shows two different accounts – Accounts Payable and Notes Payable. All examples recorded so far have changed the fi nancial position of R&B Grill as shown on the current balance sheet. However, R&B Grill has not even served a single
Table 1-12(B) Example 1-07 Posting
Cash Inventory
Ex 1-01 450,000 100,000 Ex 1-04 Ex 1-07 80,000 Ex 1-02 150,000 250,000 Ex 1-05
Ex 1-03 200,000 18,000 Ex 1-06 25,000 Ex 1-07
Accounts Payable
55,000 Ex 1-07
Table 1-13 The Balance Sheet After Example 1-07 Inventory Purchase The Balance Sheet
R&B Grill, Inc.
On January ##, 2XX1 – after Inventory Purchase Assets: Liabilities & Equity
Liabilities
Cash 407,000 Accounts Payable 55,000 Inventory 80,000 Notes Payable 400,000 Prepaid Rent 100,000
Prepaid
Insurance 18,000 Equity
Common Stock
– Rachel & Brad 450,000 FF&E 500,000
Common Stock
– Jane 200,000 Total Assets 1,105,000 Total Liabilities & Equity 1,105,000
customer yet. With no customer served, there is no revenue. It is time to discuss the operational dimension of the business that brings in revenues and incur expenses.