Lemons and Sugar and Water are Assets… Oh my!!
So building on my post about double entry accounting, we will continue on the path using the lemonade stand example.
If you remember a child borrowed ten dollars from their parents. They had the $10 in cash… an asset.
Now before they set up their stand they will need to acquire some initial ingredients. Lemons and water and sugar.
This is what we would call Inventory. Let’s say that they spent all of the money they had.
Keeping our double-entry bookkeeping in mind we now have to make an entry. Since we have taken away our cash we are deducting this a credit to cash, and a debit to inventory. Both are considered assets, and thus we don’t take anything out of balance.
Why are these assets? And what exactly is inventory?
Remember an asset is anything that can hold future value for you. But what does that really mean?
There are many different things that could hold future value you for you. This means can make you money or allow you to exchange this for something of else that may bring you value.
There are several different types of inventory that are out there, but we will leave this simple yet again.
Inventory is generally something you have that you will sell to someone else in order to again generate cash. So why have it in the first place?
I’m glad you asked. In this simple example, other people can go out and buy lemons, sugar and water and make their own lemonade, but for whatever reason maybe they can’t or like the convenience of buying it and not making it. Maybe they don’t have the time or whatever reason.
So these ingredients that you have end up being what we call Raw Materials, something you are taking as a basic good you have purchased from a third party to change the nature of the good and make into a different good.
Works In Process
There are sometimes in between that we can take these raw materials and change them into something that is called a Work In Process (WIP) that is anything that you have changed the nature of the raw material, with Labor, or a persons touch, and created something that is not quite finished.
Let’s say maybe at this point you have squeezed some lemons and gathered some lemon juice. We will ignore the things you used to store the lemon juice, or how you are making the lemonade at this point.
If you set this aside you could store this and call it semi-finished WIP, that is something that you don’t intend to sell, but for purposes of accounting would be able to count as an individual item different from the raw material and consider it a separate material.
Take lemons and make… Finished Goods
So we have taken our lemons squeezed them and then mixed it with our sugar and water and “poof” we have a finished good. This is something that you have taken raw materials and using labor, have now made a product that you intend to sell to someone.
领英推荐
But how much is that now worth in your inventory. You have now built some value into these finished goods. There are several ways to determine the value, but in keeping simple we will use what is called variable costing. This is the total cost.
Let’s say that you have worked for one hour and you value your time at $10. Because of course you make some good lemonade. And you were able to make 10 glasses of lemonade, you have now turned your inventory of raw materials and labor into a value of $20. So your lemonade is $2 per cup. (Simple math for you who hate math, ??)
But my double entry accounting how did I add $10 to my inventory, where is my subsequent credit, as for every piece I add I need to have a corresponding credit to keep in balance. And where did my raw material go? (As a note we accountants like to put things in brackets when we are making them negative)
So I will walk you through the steps:
What is labor consumption?
Wait, what?!?
Where does the credit go? So your credit would go to your income statement in anticipation of your future expense of paying off your labor.
The method that I am describing actual lends to something called accrual accounting. This is a method of accounting that tries to match the benefit of the expense with the sale of the good.
There is also expense accounting where any credit to cash gets debited to expense. Most larger businesses do not operate in this sense so I will not utilize this within my teaching.
Anyway back to this thing about labor consumption. So essentially I get a credit in my profit and loss or income statement. At this point I do not have any employees so the credit I have is for my value of my hours worth of time.
Or another way you could look at it as well is that you could put this credit into a labor liability. Which is something you have a future obligation for a cash outflow.
How do I recoup my cash and the value for my hard work?
I’m glad you asked. That would be a good logical question, but prior to answering let’s review what we already went over.
So far what have worked in would be called a general ledger. This would be your chart of accounts, or the amount of debits and credits that you have recorded classified in different accounts.
Currently after buying your raw materials and making your lemonade you would have the following:
As you can see, everything still balances Assets + Liabilities and Equity = 0. Or Assets = Liabilities + Equity. See knowing Algebra from school is very handy here.
Next time we talk about the balance sheet we will look at how you will use the lemonade to get back your cash and get some more and start to discuss the income statement.
Thanks for reading my newsletter, The Accounting Hero and your interest in Accounting Topics, where I share Accounting Tips and education. If you want more tips, please consider subscribing and also sharing this within your network if you know anyone that has any questions on Accounting and its methods.