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Advanced Franchise Business Accounting - Part 2

Guest post by: Mary Tomzack

Article Overview: In FranchiseHelp's 3-Part Guide on EvanCarmichael for analyzing the profit potential of a franchise business, we provided basic descriptions of several important franchise business accounting terms. Some readers wanted to go beyond these introductory concepts, so we've written the following guide to Advanced Franchise Accounting Concepts. Read on for Part 2 of a 2-Part Series on Advanced Franchise Accounting Terminology.

Advanced Franchise Business Accounting - Part 2

In part 1 of our 2-part discussion of Advanced Franchise Accounting Concepts, we discussed GAAP (Generally Accepted Accounting Principles) and how Sales (Revenue) Recognition policies can differ across various businesses. Below we conclude the advanced franchise accounting guide by discussing how, contrary to popular myth, cash flow and profitability are notthe same thing, how costs differ from expenses (what? yes, it's quite true!), and what it means to have a non-cash expense.

If your head isn't spinning, it's time to break out the spectacles and your notebook so you can read on!





Part 2: Cash Flow vs. Profit, Costs vs. Expenses, and Understanding Non-Cash Expenses





Cash Flow is not the same thing as Profit

Cash flow reflects the total cash a business generates vs. the cash a business expends in a given period of time. Importantly, cash flow is not the same thing as profit (net income). For those not familiar with accounting rules, this disparity can seem highly counterintuitive, so it's worth exploring.

Profit is a GAAP measure of revenue minus expenses; as such, profit reflects whatever revenue and cost / expense recognition policy a franchise chooses to employ. Under GAAP accounting, revenue and costs / expenses may be recognized well before or well after the associated cash is actually obtained or expended. In addition, certain expenses may not reflect actual cash going out the door (see the discussion of non-cash expenses depreciation and amortization, below).

Cash flow, on the other hand, is a fairly cut-and-dry accounting of the movement of cash into and out of the company's bank account and therefore not subject to the timing and revenue / expense recognition considerations of a profit / net income calculation.

Costs vs. Expenses

In a profit and loss (P&L) statement, people often say that the numbers that drive the "loss" side of the analysis consist of costs and expenses. While the terms are often used interchangeably, costs and expenses are actually not exactly the same thing.

Both costs and expenses are forms of expenditures (in cash, labor, the consumption of assets, or otherwise) that a company will make in the course of its business. The distinction lies in how these expenditures are reflected in the company's financial statements. The following example should shed a bit of light:

Let's assume that you run an Express Oil Change service station. It's a sunny summer Friday and you're planning for next week's business, which you expect to be especially robust on account of people servicing their cars in advance of the July 4 holiday. You go out and purchase, from your parts supplier, $20,000 worth of air filters.

Your business, at this moment, has incurred a $20,000 cost. But should you record that cost as an expense? The answer is no. The cost is not yet reflected on your profit and loss (P&L) statement as an expense, but is instead recorded on your balance sheet as a $20,000 asset known as "inventory".

During the following week you end up using $15,000 worth of the $20,000 of air filters you had purchased to service your customers. (Note that we're talking about the amount you were charged by your supplier for the air filters, not the amount you charged your customers for the filter installations). To reflect this on your books, you record a $15,000 expense on your P&L. (Confusingly, this expense is classified as "cost of goods sold" or "cost of sales" on the profit and loss statement). Meanwhile, the unused $5,000 worth of air filters remain on your company's balance sheet as inventory.

The following week, you use up the remaining $5,000 of air filters, so the inventory on your balance sheet is reduced by $5,000 and you record a $5,000 expense on your P&L. In this manner, then, your $20,000 air filter cost was eventually expensed on your profit and loss statement.

How do you decide when to record a cost as an inventory item on the balance sheet as opposed to an expense on the P&L? Generally speaking, revenues and expenses are matched. Until you actually use up the inventory, its cost remains an inventory asset on your balance sheet. When you later recognize the revenue that was generated by using up your inventory, you reduce your inventory by its cost and reflect that cost as an expense (cost of goods sold / cost of sales) on your P&L.

Note that there are some costs that get immediately expensed on the P&L (i.e., they are never recorded on the balance sheet). For example, in most businesses, costs not directly associated with acquiring, producing, or delivering the product will be immediately expensed (typically, in the period in which they occur). For example, "overhead" costs such as rent, the software you use to do your accounting, your monthly phone and internet bills, your costs of the marketing, etc. are generally recorded immediately as expenses.

Non-Cash Expenses

A discussion of profit and loss calculations must mention non-cash expenses such as depreciation and amortization.

Depreciation and amortization are sister concepts, with the distinction that depreciation deals with tangible assets and amortization with intangible assets:

• The concept of allocating the cost of a tangible asset over its useful life is called depreciation. For example, if a company buys a machine for $1 million and the machinery has an estimated useful life of five years (the IRS provides guidelines for useful life of various assets), the machinery would likely be "depreciated" (its consumption expensed on the P&L) over a period of five years at a rate of $200,000 per year.
• Amortization refers to the allocation of the cost of an intangible asset over its useful life. For example, if an individual buys a 5-year franchise license that with a franchise fee of $25,000, the franchise fee would probably be amortized (expensed on the P&L) over five years at a rate of $5,000 per year.

Why are depreciation and amortization referred to as "non-cash" expenses? The reason is that there are no cash expenditures going out the door as a company expenses the consumption of a tangible asset (depreciates it) or intangible asset (amortizes it) over time. The cash paid for the asset, if any, was expended back when the asset was first acquired (e.g., when the machine was purchased or the franchise license was obtained). Since the asset is being used up over some period of time, the company will expense the cost of the asset over time on its P&L in the form of depreciation or amortization.

Closing Thoughts on Advanced Franchise Accounting

A discussion of accounting can go much, much deeper, to be sure, with all kinds of complexity, exceptions, and special rules. However, once you grasp the concepts described above, you will have an extremely solid base from which to work with your accountant to analyze nearly any franchise opportunity in great detail.

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Article Tags: accounting terminology, accounting terms, business accounting, business model, business plan, cash flow vs profit, franchise accounting concepts, franchise accounting lessons, franchise accounting terminology, franchise accounting terms, franchise amortization, franchise business, franchise business accounting, franchise business model, franchise business plan, franchise depreciation, franchise investments, revenue and sales accounting



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