Historical Cost Example

Let's say for example that you purchased a POS (Point of Sale) machine for $10,000 in 2001. Software, as we all know can be easily backed up and copied. If we keep the same operating system, chances are the software will not become obsolete. Therefore, the software should not lose any value. The hardware may change, but the software can still run, provided the copy of Windows did not come with the machine, thereby forcing you to upgrade. The added value to the software may include the scanned barcodes and the hardware and miscellaneous software configuration. The POS companies charge a great deal of money for installation and training, so we cannot fault businesses for trying to save money. Therefore, there are many businesses that choose to start from a clean slate and scan each item individually by themselves. They would also prefer to set up the hardware and software by themselves just to save some money. However, the process can take months, especially without proper training of the software. That is where the backup files of a POS come in handy. That backup file should theoretically add three months of value to the POS machine. Historical cost, the cost typically reported in the accounting of a company, will report the value of the POS machine to be $10,000, the cost they initially paid for it. When purchasing a business, one must look for this added value.

Discrete and Continuous data

There are two types of data: Discrete and Continuous data. Both data types can be quantitative in nature, while only discrete data can be qualitative. This means that continuous data cannot be put into categories or groups. Also, continuous data can be presented as a fraction or decimal, while discrete data cannot. Discrete data has gaps in its values, while continuous data does not. Anything that can be counted is discrete data, and discrete data does not have an infinite number of possibilities. An example of discrete data that can be categorized would be shares of a company's stock. There is a finite amount and it can be categorized into preferred or common stock. There is no such thing as a half of a share of stock. Stock price would be continuous data, because it can have decimals, and is quantitative in nature.

Importance of Cash Flows

Any business that has a difficult time creating cash flows, either right now or in the future, should be regarded as a red flag. It shows investors that either the company is struggling in its industry, or there is very poor management at the company. Either way, investors should avoid companies like that. There are plenty of companies that do not have problems creating cash flows, and even consistently pay out dividends to its shareholders (cash outflow) without hurting its business. Those companies are the ones worth investing

The Matching Principle

The matching principle is basically matching up all the expenses and any other costs of doing business that a company incurred during the current accounting period with all the revenue that the company took in during that same time. However, it should be noted that in order to understand the matching principle, the revenue recognition principle has to be understood, because expenses incurred in order to create revenue should be reported when the revenue is recognized. Some companies try to use revenue recognition principle to their advantage. For instance, a salesperson for Cisco Systems can make arrangements with a customer to order surplus inventory that gets delivered and invoiced right before the current accounting period is over. This way the salesman can get a bonus, and the customer can return the goods at the start of the next reporting period. The matching principle has to be applied in a situation where an equipment has to be depreciated over the expected useful life. Also, the principle should be applied when a company pays for insurance or licensing fees. Typically, the company gets billed every 6 months or every one year, but they enjoy the licensing and the insurance coverage every month, so the monthly cost should be matched to the corresponding revenue.

IRS information on depreciation

Cne question comes to mind as I read the IRS website's information on depreciation. When the IRS website says that property must have a determinable useful life in order to be depreciated, do they mean software as well? Some software programs cost more than the computer itself, and software programs, like land, do not go bad or have any wear and tear. Although certain software programs do become obsolete after a certain amount of years, there are those software programs, like a word processing program, that do not need updates or upgrades, because they perform universally simple functions efficiently enough for business purposes. Even if the computer breaks down, the software program can be used on the new computer.

Three form of business entities

A corporation is essentially a tax shelter for rich people. A corporation is treated as a person under law. There was a documentary that compared corporations to a psychotic person. The documentary showed how maximizing profit, which is the main objective of a corporation, was hurting our society. The people that form corporations use such business entities to exploit the workforce of third world countries and harm the environment by forming key alliances with friendly government officials. However, it should be noted that the rich people of this country get richer every day, so we should acknowledge that corporations are a great way to do business by minimizing the risks. Corporations cost more to form, but the small cost is worth it. Some corporations issue stock to raise capital, so they can be more competitive in their respective industries, as opposed to the limited capital of a sole proprietorship and partnership.A partnership exists when two or more people decide to go into business together. They both are financially liable for the debts of the business. However, some entrepreneurs circumvent this by forming a limited partnership whereas certain members can retain control over the business without risking their personal assets. A partnership can be riskier than a sole proprietorship in that all debts that a company builds up during the course of business is owed by all partners. However, if your partner(s) disappear to another country, you are left with the entire bill. It would be a mistake to think that going into a partnership with a person splits the risk of doing business, when in fact it doubles the risk, especially if your partner leverages your business without your knowledge. There have been numerous examples of business owners owing gambling debts incurred by their partners. In a situation like that, a corporation would have protected your personal assets if your company files for bankruptcy. A sole proprietorship is essentially a business entity that allows the owner of a business to get sued if someone is hurt financially, emotionally, or physically by his organization. It is not advisable to form a sole proprietorship given the many frivolous lawsuits that make it through the court system nowadays. Many new business owners try not to take on more risk than is necessary when they first start a business. However, many do not realize that by forming a sole proprietorship, they are essentially putting their exposing their valued personal assets (such as a house or car) to unnecessary risks.

Basic Accounting Equation

The basic accounting equation is Assets is equal to Liabilities plus Stockholders' equity. Of course, this can be rearranged to be Asset minus Liabilities is equal to Stockholders' equity and so forth. The importance of this equation cannot be overlooked, because the equation helps stakeholders of a company keep track of its financial health. The balance sheet illustrates this equation by listing assets on the top and liabilities and stockholders' equity on the bottom. The balance sheet is similar to a real estate appraisal in that both provide a report of financial condition on a specified date. The real estate appraisal, for example, is the value of a property on the date the appraisal was conducted. It does not matter if the house burned to the ground the next day, because the real estate appraisal is still accurate in its reporting. The same goes for the balance sheet. The drawbacks of simply using the balance sheet is that a balance sheet is only accurate the day it was prepared, and it does not provide the entire picture of a company's financial health. Therefore, the Retained earnings statement, statement of cash flows and income statement are also used in financial reporting. The Retained earnings statement relates to the income statement and balance sheet in that all three use some of the same information. For instance, the Retained earnings uses the net income calculated by the Income Statement. Furthermore, a company's retained earnings is also reported as stockholders' equity in the balance sheet.

Good Communication

Partners in a partnership have to exercise good communication skills. Otherwise, the business will eventually get sold or go bankrupt because of the resentment and paranoia the owners feel towards each other. If only partners can work together so maybe they can eventually form a corporation, go public, and become really successful. The Apple guys, the Yahoo guys, the Google guys, and the Microsoft bunch all did it.

Basic Accounting Equation

The basic accounting equation is ALOE where Assets = Liabilities + Owner's Equity. This is usually found on the balance sheet and can give a pretty good snapshot of where a company stands - provided there were "alterations." Retained earnings falls under shareholder's/owner's equity in the balance sheet and represents the accumulated amount of income a company still possesses after taxes and dividends. That means that any earnings left over after obligations, the company can use to re-invest and build the company. A statement of retained earnings can read as follows: Beginning Balance Retained Earnings + Net Profit - Dividends - Taxes = Ending Balance Retained Earnings.The income statement displays a specific period of time. A basic equation for this accounting instrument is:Sales - COGS (Cost of Goods Sold) = Gross Profit - Expenses - Depreciation - Other Expenses = Earnings Before Interest and Taxes (EBIT) - Interest - Taxes = Net Income/Net Profit-LossThink of the balance sheet as the foundation of the business and the income statement as a quick summary of time. This statement is also known as the Profit & Loss (P&L). Using an income statement we can compare gross margins, expenses increase/decrease, and even specific product revenues increase/decrease - if it was so detailed. A statement of retained earnings is usually attached to the income statement with the formula and data mentioned above. I have found these forms to be the key pieces to a business plan to be approved by lenders. They will generally try to pieces together the same information through bank statements, tax returns, etc. but once you have established a relationship with a bank through honest and consistent reporting of financial data and status, it should be easier to get a loan. In my experience with these, I have also seen many such statements "fudged" by sellers that, at times, are so blatantly wrong that you can immediately use it to determine the character of the person you will be dealing with. Imagine that, using accounting to describe a person.

Assets and Liabilities

Assets represents what a company owns and this can be defined in three categories: current assets, capital assets, and other assets. Current assets include cash, inventory, and accounts receivables. Cash in the bank (our favorite and most liquid), inventory on hand and ready to sell, and A/R tell a company's story of liquidity. Capital assets provide operating capability for a company, are more permanent that current assets, and tend to have value for many years (can also be depreciated). Capital assets include property, machinery, and equipment. In the other category lies my favorite, the difficult to define and possibly the heart of risk in business and investments, GOODWILL. In running my own business over the last 6 years, I have become familiar with these concepts (though I could use more learning here) through success and, more notably, failure. In understanding current assets, I have grown from trying to build more digits in my bank accounts to investing the funds in short-term cash instruments such as CD's, MMA, and Treasuries to mid-term instruments such as bonds and equities to long-term instruments such as real estate. This has helped returns. In managing accounts receivable, I try to work within a shorter repay period than the credit extension granted me by my suppliers (typically 30-42 days). Managing this spread can mean the difference between paying debt with my own money or with supplier money. My inventory management relies heavily on turnover ratio and is critical to the same spread in A/R versus A/P. Turning inventory within the period of credit decreases my own cash investment and allows me to make money off the supplier cash. Capital assets provide deprecation and long-term quantifiable value to a company. Machinery, equipment, and property can also be used as collateral for business funding - too bad banks don't lend on goodwill. Goodwill is a difficult term to define and even more difficult to value. In purchasing a business, I try to discover the actual costs/values of the assets I mentioned above and then try to negotiate the amount of goodwill the owner is asking for. The best approach is to ask for "proof" along the lines of foot traffic, average ticket count, and other measures that may paint a better picture of future value. On the sell side, I try to build the best case for the max amount of goodwill I can get. In recent years due to the lax credit standards and increase in home equity, I have been able to sell (flip) businesses for 100% to 200% gain in a very short time. Insane. I can attest to that being purely "goodwill."

My Background

I am in the retail business. I purchase, operate, and flip (when opportune) businesses in that realm. The recent easy money conditions and free spending has allowed me to make money on the spread between acquiring depressed businesses and selling into wild optimism and (home) equity appreciation. I make no mistake in recognizing that this has less to do with my ability and more to do with opportunity. Much like my benefiting from the rise of the Dow from under 10,000 to over 14,000 in the last few years, I understand that while I have positioned myself to take advantage. A rising tide lifts all boats and I had better be smart about what I have earned and learn how to navigate the downturns that are sure to be ahead.