ART MATRIX PO 880 Ithaca, NY 14851-0880 USA 1 800 PAX-DUTY or (607) 277-0959, Fax (607) 277-8913 'The Paths of Lovers Cross in the Line of Duty.' ART MATRIX FINANCIAL PRINCIPLES OF OPERATION. The purpose of a business is to produce PROFIT from CAPITAL. The purpose of capital is to produce a PRODUCT. The purpose of a product is to produce a GROSS SALE. The purpose of a GROSS SALE is to produce REVENUE. The purpose of revenue is to produce full recovery of the original capital plus some profit. The purpose of profit is to EXPAND the business and to start the cycle all over again at a higher level of production. Revenue comes from French RE VENUE, to see again, namely to see again the money you spent producing the product, when you finally get it back from the gross sale. Income is the profit (or loss) realized from the gross sale. Profit and income are synonymous and can be either positive or negative. Negative income is loss. Note that you can have millions of dollars in revenues each year, money coming in, and still suffer negative income or loss, if the revenues coming in don't match or exceed the amount of capital used in the product going out. CAPITAL -> PRODUCT -> GROSS SALE -> REVENUE -> CAPITAL + PROFIT Capital is infused into and withdrawn from the business system by CAPITAL PARTNERS (such as myself and Jane). Usually ownership of the business is determined by the percentage of capital contributed by each partner, and usually the profits and losses are distributed to each partner according to the same percentage as their original investment. For example if one partner contributes $20,000 and another contributes $5,000 then an income of $10,000 would be distributed by $8,000 to the first partner and $2,000 to the second. Thus at the end of the first year the first partner would have a CAPITAL ACCOUNT of $28,000 (20,000 + 8,000) and the second partner would have $7,000 (5,000 + 2,000). Notice that the ratio of ownership does not change being 80/20 both before and after distribution of the revenue. Sometimes, one partner contributes the capital and the other contributes WORK. By arbitrary agreement then profits can be split between them however they see fit. In such a case though the ratio of ownership can change over time. For example if the first partner contributes $10,000 and the other $0, but at the end of the year they split an income of $4000 down the middle then the first partner's account becomes $10,000 + $2000 = $12,000 and the second partner has $0 + $2000 = $2000. What started off as a 100/0 ratio becomes a 6/1 ratio. As long as they continue to split the profits 50/50, over the years the smaller partner will continue to gain a greater percentage of ownership of the company until the percentage approaches the percentage used to split the revenue, in this case 50/50. In reverse fashion however, if the company loses money and the losses are split 50/50 the smaller partner will lose percentage ownership of the company and can even go negative, which means they owe the company money. Usually when a capital partner's account goes negative they drop out of the company and are no longer a capital partner. This means they will no longer get a cut of the profits, but also they are no longer liable for negative amounts in their account. Its a trade off. When a partner's capital account goes negative they are riding the wave of the money still extant from other partners. The other partners may agree to let the negative partner stay in. If the negative partner stays in and continues to get cuts of the profits when there are some, then they really ought to put more capital back into the system when their accounts go negative to keep their accounts positive. ASSETS and LIABILITIES The capital contributed by all the partners goes into a CAPITAL ACCOUNT which is a theoretical number keeping track of the partner's EQUITY in the system. Equity means rightful ownership. Although the capital account is just a number, the money represented by that number is ALWAYS present in some form in the business as some form of REAL ASSET. In general, real assets come in three forms, CASH ON HAND in some bank account, INVENTORY ON HAND in the form of product sitting around a warehouse, and CAPITAL EQUIPMENT ON HAND in the form of the means of production. In more complex systems assets can include LAND and BUILDINGS, INVESTMENTS, even GOLD and SILVER or other HARD CURRENCY. Another real asset is ACCOUNTS RECEIVABLE which is the money owed to you by those who have taken ownership of something you have sold them but have not payed for yet. TERMS is an agreement that you have with them that they will pay you within a certain time. 'TERMS 2 percent 10, NET 30' is business jargon which means they owe the whole (net) amount to you within 30 days, but if they pay within 10 days they can deduct 2 percent of the price. This motivates them to pay early. One's credit rating as a business is often affected by whether you pay your creditors within the terms that they allow. ART MATRIX offers NET 30 to almost anyone, but rarely do we get paid until 60 or 120 days is up. This is a problem mainly with schools who seem to pay when they damn well please. Counter balancing your REAL ASSETS are your REAL LIABILITIES. This includes ACCOUNTS PAYABLE which is the money you owe others for goods received but not yet paid for, DEBT which is loans others make to the company, and of course the CAPITAL remaining in the system which is always owed back to the capital partners. As we shall see, TOTAL ASSETS must always equal TOTAL LIABILITIES. TOTAL ASSETS equals TOTAL LIABILITIES Everything the company owns was GIVEN to it by its capital partners (including debt partners) thus its assets ARE its liabilities to its partners. Everything it owns (assets) it owes to its partners (liabilities). Asset and liability are just two different words for the same thing, what the company owns and owes. That assets can be kept as CASH, INVENTORY and EQUIPMENT does not change the fact that they are all owed to the partners, and any profits that the company generates is also directly owed to the partners. Thus what the company owns (assets) it owes (liabilities). CAPITAL There are two kinds of capital that a company can use. The first is RISK capital infused into the system by capital partners. Such people own the company, make its decisions for it and take the rewards and risks of the company. Profits are distributed to each partner according to what ever agreement they have or according to how much each has contributed to the whole. Losses are likewise distributed to each partner. Capital partners have no security in the company, if it loses money or goes out of business, they have no recourse, they can lose everything they have invested. In return they get the lion's share of the profits when there are any. The second kind of capital is DEBT capital or loans borrowed from Lenders. Lenders do not own the company but often try to have a say in how it is run; they won't loan money if they don't like how things are going. Lenders never get a cut of the profits, they only get a percentage interest rate on what they have loaned. However they usually have a secured interest in the company which means that for better or worse they MUST be paid their interest and the original amount of the loan on time. If they are not paid they may get to take the company away from the capital partners, while there is still something left to sell off. Because Lenders get paid back even if the company is doing bad, often out of risk capital if there are no profits to pay the loan, they do not take the same risk that the capital partners do and so they do not make as much money when things are good, they only get their percentage rate, but they ALWAYS GET IT, good or bad. The capital partners on the other hand may lose everything especially if they have to pay off the Lenders when things are going bad. This is a common dichotomy in the business world, those who capitalize the company own the company and take all the risk, they can lose everything with no recourse if their funds get eaten up. Lenders expect a sure return and security of their loan, so they do not get to split profits among themselves, they have to settle for a measly stream of revenue, but they are the first to be paid when things go bad. For example if someone lends you $900 for a month's rent but during that month you don't generate any revenue then at the end of the month you won't have the $900 to pay the Lender back. At this point he will have the right to take the company away from you and sell off its assets such as a car to recover his loan. This way the Lender takes no loss and you, the capital owner, take the whole loss. Even if you YOU sell the company car to raise the $900 to pay off the loan, you still take the loss of the car to keep your company. In this way the capital owner always takes the loss to pay off the Lender. This is why money coming from a capital partner is called RISK capital and money coming from a Lender is called DEBT capital. You might ask, can there be a company that has only Lenders and no capital partners? The answer is probably not, because the Lenders will want some risk capital in the system to assure them their loan will be paid back. You see when things are going bad the Lenders want to make SURE they are paid back so there must be some money in the system to cover the loan. Of course if the Lenders get the money then the person who put it in doesn't! That's what a capital partner is for. Thus Lenders usually won't even look at an enterprise unless it is well capitalized by capital partners, people who are willing to lose it all. ACCOUNTING There are two methods of ACCOUNTING that are generally accepted, the first is called the CASH method and the second is called the ACCRUAL method. In the CASH method, money is considered received only when you actually and physically receive it (depositing it into your bank is a good way to know this has happened) and money is considered spent only when you actually spend it (writing a check is a good way to know this has happened). In the ACCRUAL method, money is considered received when you EARN it, that means when you complete the deal and deliver the goods even if the money is not payed to you for months. Until then, the money owed you is carried as an ACCOUNTS RECEIVABLE and acts as revenue already earned, reportable and taxable (after deductions!). Money is considered spent when you INCUR the debt, that is when you take ownership of what you have bought even if you don't make payment for 30 or 90 days. This debt that you owe is carried as an ACCOUNTS PAYABLE and acts as money spent and deductible even though you still have it in the bank. You have it but it belongs to them, get it? The accrual method makes record keeping more complicated because money received this year may actually have been earned last year and already reported and taxed in last year's revenue. It's also hard to pay taxes on money you don't have yet, you don't have it to pay the taxes with! However the accrual method gives a more accurate view of the company's total assets and liabilities. The fact that someone owes you $10,000 does not show up in the CASH method. That's a handy asset to know about even if the cash is not yet on hand. A promise is almost as good as a fact. If you are also carrying an ACCOUNTS PAYABLE of $10,000, the fact that you owe $10,000 to someone else doesn't show up in the CASH method either but banks and things are just as interested in your promised liabilities as in your actual liabilities when they go to make you a loan. However if the business is doing well you can always keep your accounts payable equal to your accounts receivable so that neither you nor the banks fall into a false sense of how well the business is doing if you are using the cash method of accounting. The main advantage of the CASH method is the ease with which you can keep track of your earnings and report them to the government for tax purposes since each transaction is directly tied to your bank account via deposits or checks. Your bank account acts as an immediate and totally accurate record of all money coming into and going out of the system. Any accounts receivable or payable that you might have is just not considered. For example if you sell $5,000 of postcards on Dec 31, 1991 but don't receive payment for them until 1992, then the revenue is not registered until the next year in 1992. However if you BUY $5,000 of envelopes on Dec 31, 1991 but don't pay for them until 1992, you can't deduct their cost from gross sales until you actually pay for them in 1992. So its fair. In the end this is why everyone wants to get 30 day terms from their suppliers and are hounded to give 30 day terms to their customers. If you are forced to give 30 day terms to your customers, but none of your suppliers will give you 30 days to pay your bills, then all your money is either out the door in product still waiting to be collected on, or out the door paying off all your bills, and you don't have any to pay your taxes! So the more money you have out the door in product waiting 30 days to be collected on, the more you need to put off paying your bills for 30 days because you just don't have any cash around. ART MATRIX Art Matrix works on a strictly CASH ACCOUNTING basis, and because we are a small business we have no land or buildings to deal with nor other complicated assets and liabilities. Therefore for the purpose of this discussion we shall stick to the primary three real assets, CASH, INVENTORY and EQUIPMENT. In the same fashion the only real liability that Art Matrix has is the CAPITAL REMAINING in the system which is owed to its capital partners. Since total liabilities equals total assets, CAPITAL REMAINING IN THE SYSTEM = CASH + INVENTORY + EQUIPMENT. Each of these things can be considered to be represented by an account which keeps track of how much asset is kept in each form. For example you might have $10,000 in CASH, $5,000 in INVENTORY and $5,000 in EQUIPMENT. The sum total of those three accounts add up to the total assets of the company and must equal the total liabilities of the company. Since the only liability of our company is its capital remaining in the system which is owed to the two capital partners me and Jane, we have the equation LIABILITIES ASSETS ----------- ---------------------------- CAPITAL = CASH + INVENTORY + EQUIPMENT $20,000 $10,000 + $5,000 + $5,000 CAPITAL RECOVERY A BUSINESS EXPENSE is anything that causes money to leave the system other than a direct withdrawal of capital by a capital partner, which is called a CAPITAL OUT or CAPITAL WITHDRAWAL. A GROSS SALE is anything that brings money back into the system other than a direct infusion of capital from a capital partner, which is called a CAPITAL IN, or CAPITAL INVESTMENT OR DEPOSIT. Usually a business expense is made in order to produce a product which is then sold to produce a gross sale. Presumably the product is sold for a price that covers all of the cost of production of the product plus some. Any extra amount is called profit which, if left in the system, expands the capital base of all the capital partners. This expanded capital can then be used to expand the business, which means buy even more product to sell. ART MATRIX is a totally self supporting business. That means it supports not only the cost of its own production cycles, but also all the living expenses of its two capital partners. These living expenses, such as rent, food and clothing are NOT considered valid business expenses even though they are necessary to the production of our product. Can't work naked or hungry you know. Therefore these expenses come out of profits as capital outs, its money that each capital partner takes out of the system during the year for living. If the business is successful, even after a whole year of supporting its two capital partners, there will STILL be a certain amount of unwithdrawn profit left over that will STAY in the system and this will go to expanding the business. If the business is NOT doing well, there may not be enough profit during the year to support the living expenses of the capital partners in which case their capital withdrawals will start to eat into their original capital. As we shall see later, a business can be considered to be making a 'profit' and thus have to pay taxes on that profit, even though the profit is not enough to cover the basic living expenses of its capital partners. Thus although the 'business' might be making a 'profit' as far as the government is concerned, the whole life system will be operating at a loss. Eventually all capital will be eaten up if it continues, and the capital partners will starve to death. BUSINESS EXPENSES BUSINESS EXPENSES are made out of ORIGINAL CAPITAL to produce a product. After the gross sale of that product is made, the business expenses are then DEDUCTED from GROSS REVENUES to RECOVER CAPITAL and determine PROFIT. The purpose of a business deduction is to recover the original capital invested in the business expense in the first place. What is left over from the gross sale after the capital is recovered is profit. Taxes are only paid on profit. Everything you buy in a business is a valid business expense, but WHEN you are allowed to deduct it depends on its PERSISTENCE. Everything you buy has a persistence. Rent for example has no persistence at all, you pay the rent and at the end of the month it is gone, you owe rent again. Telephone and utility charges also have no persistence and so they may be deducted as soon as you pay for them. Other things like stationary and boxes also have no persistence because they are too much of a pain in the butt to keep track of as inventory. Thus these expenses are deducted from gross sales as soon as they are made. Inventory on the other hand has infinite persistence, that is until you sell it. Let's say you spend $5000 on postcards. You may NOT deduct any of that $5000 from any gross revenues until you actually sell the postcards. At that time you may only deduct the capital invested in the postcards you actually sold. The amount deducted is called COST OF GOODS SOLD. This may sound complicated, but its easy to do. For every year that you are in business you should always have two numbers handy, the amount of inventory on hand at the beginning of the year and the amount of inventory on hand at the end of the year. The ending inventory number for one year becomes the same beginning inventory number for the next year. You find your inventory number at the end of the year by counting up all the unsold product you still have lying around your warehouse, and you add up how much you spent on it all. If you have 100 video tapes unsold and each one cost you $8 to buy then you have $800 in unsold video inventory at the end of the year. Do this for every item you sell and keep a VERY careful record of it. Each year you should have a sheet of yesteryear's inventory. All products that you sell should be listed on the left, then next to each product name you should list how many of that product you had at the end of the year, then how much each unit of that particular product cost you, then on the right the total value of on hand inventory at the end of that year. Then you add up all the right hand numbers and that gives you your total inventory for the year end. Then the next year you make a copy of the same sheet, and you fill in all the numbers for the present year. This gives you your inventory number for the present year. If you added new products to your product line make sure you add them to your sheet whether or not you had any in stock at the end of the year. They will merely show up as 0 units and 0 dollars on hand. Each year you should have one of these sheets of the year ending inventory. The ending inventory for any year is the beginning inventory for the next year. Thus for each year you now have a beginning and ending inventory. COST OF GOODS SOLD The following is how you calculate (at the end of the year) how much you spent on all the items you ACTUALLY SOLD during the year. Take the dollar value of the inventory you had at the beginning of the year and add to that the dollar value of all the new inventory you bought during the year. From this number subtract the dollar value of the inventory still lying around at the end of the year. This gives you the dollar value of the inventory you actually sold, and THAT is the capital you want to recover by deducting it from any gross revenues you might have had during the year. This number is your COST OF GOODS SOLD. BEGINNING INVENTORY + NEW PURCHASES - ENDING INVENTORY = SOLD INVENTORY By the way when you figure the dollar value of beginning, added and ending inventory you always use the cost YOU PAID FOR IT, NEVER the price you sell it for to your customers. Now you know what 'Closed for inventory' means! Everyone is busy counting bubble gum. Lastly, equipment has a finite persistence, usually arbitrarily determined by the government. Cars last 3 years, (recently it has been changed to 5) electronic equipment lasts 5 years, office tables last 7 years and land and buildings can last up to 30 years. Because each year that goes by detracts from the value of such items, it is considered that a certain loss takes place to the business during each year, and this is called depreciation. For oil and gas wells it is called depletion. For land and buildings it is called amortization. Don't ask me. For example it is considered that a personal computer will last 5 years, and at the end of the first year 1/5 of that computer is gone. Thus because 1/5 of that computer is no longer persisting as an asset in the company you are allowed to deduct from your gross sales for that year 1/5 of the cost of the computer as a business expense. The remaining 4/5 continues to exist in the company as an asset under the heading of capital equipment. When you first bought the computer, although you 'spent' the money to buy it, it is not considered a deductible business expense because you merely moved money from one asset called CASH, to another asset called EQUIPMENT. However at the end of the year that equipment has lost 1/5 of its value, and it hasn't moved back to CASH, its GONE, thus it becomes a business expense at that time and should be deducted from any gross revenues you had during the year to determine your profit. The purpose of ALL business expenses is to produce a product, and the purpose of ALL products is to produce a profitable gross sale, and the purpose of deducting business expenses from gross sales is to 1.) recover the capital invested in the business expense in the first place so that you can start the cycle over again, and 2.) determine your profit so that you can pay your taxes on it, and then use the remaining profit to expand your business or eat and enjoy life. For example say you infuse $1000 capital into a company, and spend $900 on rent during the first month (leaving $100 in capital remaining). During that first month you have a gross sale of $2000. You may deduct the $900 spent on rent from the $2000 gross sale, RETURNING THAT $900 TO CAPITAL, so that at the end of the month you have your original capital of $1000 ($100 + $900) back intact, leaving you with $1100 ($2000 - $900) in profit on which you will have to pay taxes ASSUMING THERE ARE NO OTHER EXPENSES. That $1100 profit by the way gets added to the $1000 in recovered capital making the new capital remaining equal to $2100. (It will be a bit less after you pay your taxes on the $1100.) The increase in capital from $1000 at the beginning of the month to $2100 at the end of the month represents the $1100 profit made during the month upon which you pay taxes. Thus $900 of your capital entered the system as CASH, spent some time as rent, and was recovered as CASH again once some gross sales were made. By the way, if during that month you fail to make any gross sales, then you have no gross sale to recover the capital from and it is GONE. Your capital accounts would remain at $100 ($1000 - $900) and you would not have any capital left to reinvest in rent again. This is called going out of business the hard way. THE CYCLE OF CASH CAPITAL is usually put into the system (and removed from the system) as CASH. This is called CAPITAL IN and CAPITAL OUT. Any time a partner puts money into the system they increase their capital account. Any time they take money out of the system for personal use, they decrease their capital account. Since food, clothes and personal shelter are NOT valid business expenses for a partnership, any withdrawal of funds for these and other basic living expenses always act as capital out. An example of CAPITAL IN is shown in line 1 of Figure 1. Here $10,000 is being added to the system. It shows up on both sides of the ledger because liabilities must always equal assets. It shows up as $10,000 CAPITAL IN (COMPANY'S LIABILITY TO CAPITAL PARTNERS) and as $10,000 CASH (A COMPANY ASSET). BUSINESS EXPENSES B/E Money spent on certain expenses is immediately lost to the system. Such items are the business part of rent, telephone, stationary, postage etc. Once the money is spent it is gone, there is no more asset to account for it. Thus it gets deducted from CASH and from CAPITAL. This is shown in line 2 where -$100 dollars was spent on envelopes leaving $9900 left in CASH and CAPITAL. GROSS SALES G/S Money received for services rendered is immediately added to CASH and CAPITAL and increases the assets and liabilities by just that amount. Let's say the business receives $100 for services rendered, this $100 is added to CASH and CAPITAL and is shown in line 3. INVENTORY Money spent on inventory is transferred from the CASH column to the INVENTORY COLUMN. For example lets say that you buy $5000 of postcards and stock them in your bedroom. $5000 is deducted from the CASH column and $5000 is added to the INVENTORY column. The CAPITAL amount is not changed as the total assets of the company have not changed, it has just been moved from CASH to INVENTORY. CAPITAL still equals CASH + INVENTORY + EQUIPMENT in line 4 of Figure 1. VALUATION OF INVENTORY Inventory is always valued at the cost you paid to produce it, never the cost you want to sell it for to others. It has not been sold yet! The government figures you can always resell it for what it cost you to make it, if you have to get rid of it. However if the market value of your inventory (what you can sell it for to others) drops below your cost of production then you are allowed to value your inventory at the market value, but then you would be taking a loss against your original capital investment in that inventory. This is called evaluating your inventory at the 'lower of cost or market value'. Unless you have stocked up on something you can't sell, you always want to value your inventory at your cost. GROSS SALES AGAIN G/S Let's say you sell the $5000 of inventoried postcards for $10,000, that's a 100 percent mark up. Of the $10,000 that you receive $5000 is your original capital tied up in the postcards, and the other $5000 is profit which will be used to pay off business expenses and feed your partners. The first $5000 which is original capital invested in the postcards transfers back to CASH leaving INVENTORY at $0. However the second $5000 which is profit also transfers into CASH but must ALSO be added to CAPITAL because it represents an actual increase in total assets of the system. This is shown in line 5. LOSS Let's do this again but create a loss this time. Let's buy another $5000 dollars of postcards, this is line 6 of Figure 1. Assume that the market for postcards has gone sour and you can only sell them for $3000. Not only have you not made any profit on the deal you have lost some of your original capital invested in the postcards. The $3000 you get from the sale of your postcards transfers back to CASH. INVENTORY becomes $0 again, and CAPITAL must lose $2000 which was lost in the deal. This is line 7. VALUATION OF ACCOUNTS RECEIVABLE A/R ACCOUNTS RECEIVABLE is always valued at the cost you wish to sell the product for, never the cost you paid for it. INVENTORY is valued at the cost your paid for it, ACCOUNTS RECEIVABLE is valued at the cost you want to sell it for. That is because inventory has not been sold yet and has no promises attached to it, so its value is lower than accounts receivable. Although you have not yet been paid for accounts receivable at least you have been PROMISED payment for it and that alone increases the value of the sold product from your cost to whatever you sold it for (market value). However you may NEVER get paid what is due to you, thus a pack of postcards in inventory valued at your cost of $5.00 can be more valuable to YOU than a pack of postcards in someone else's hand with a promise to pay $10.00 for it. But as far as tax reporting purposes are concerned, inventory is valued at 'cost' and accounts receivable is valued at 'market'. ACCOUNTS RECEIVABLE A/R Accounts receivable are not reported using the CASH METHOD, therefore it is possible to show a loss across year end boundaries when you have sold and shipped some of your inventory but have not yet received payment for them. For example line 8 shows the purchase of yet another $5000 of postcards. They are then sold for $10,000 and shipped on the last day of December. This is line 9. Since the postcards are out of your house they are no longer in inventory thus INVENTORY drops to $0. But no payment has been received either, thus CASH does not increase by $5000 to make up for the $5000 drop in INVENTORY. It's as if the postcards were lost totally. All you have is a promise from the buyer to pay for them in the future. Thus CAPITAL must also drop by $5000 to reflect the $5000 drop in INVENTORY. The $10,000 he has promised to pay is carried in ACCOUNTS RECEIVABLE. However using the CASH method accounts receivable are not considered to be an asset. For one you don't really know how much he will really pay you. Although he has 'promised' to pay $10,000, he may only pay $7,000 or he may pay you $11,000. Thus accounts receivable is only an idea and therefore is not considered a real asset for the cash method of accounting. For this reason it looks on line 9 like CASH is at $8000 along with CAPITAL, representing a whopping $5000 loss from line 8. And that is the way you would report it at the end of the year for tax purposes, a $5000 loss. PAYMENT RECEIVED When payment for the postcards is finally received, that is you get a check for $10,000, this goes into CASH and CAPITAL leaving ACCOUNTS RECEIVABLE at $0. This is line 10. Normally when cash moves from CASH to INVENTORY the capital account does NOT decrease by that amount because asset levels have not changed, they merely moved from CASH to INVENTORY. The sum of CASH + INVENTORY + EQUIPMENT = CAPITAL remains the same. Therefore when the sale of inventory is finally made and cash moves BACK from INVENTORY to CASH, the capital accounts do not increase except by the amount of the PROFIT. In this case however when cash moved from CASH TO INVENTORY AND THE INVENTORY WAS SOLD BUT NOT COLLECTED ON, the capital accounts WERE decreased by that amount at year end showing a loss. Therefore when payment is finally made and cash moves back to CASH not only does the capital account increase by the amount of the profit ($5000) but also by the amount of the original capital ($5000) which was declared lost in the previous year and which is now fully recovered. A slight complexity that you gotta watch out for. The only answer to this is to get on the accrual system but that is even more complex. This is really no big deal, any time you sell inventory to someone there is always a short period of time between when you send the inventory out the door and when you actually collect on the payment owed to you for the sale. During this time you have neither the inventory on hand nor the payment due you. Thus your capital accounts drop for a moment by the value of the inventory you just unloaded. But then when you finally get paid, your capital accounts come back up to where they were plus or minus any profit or loss you made on the deal. It's only when this happens across a year end boundary that you might pay any extra attention to it, mainly because it generates an apparently excessive loss in one year followed by an apparently excessive profit in the next. Its really only a problem when you come to pay taxes on the two years as will be explained below. WHAT DO YOU PAY TAXES ON? You only pay taxes on profit, never on original capital recovered from a deal. For example if you put $5000 into postcards and turn them around for $7000, you have made a $2000 profit. You NEVER pay taxes on the original $5000 recovered, you only pay taxes on the $2000 profit. Of course you would take all OTHER valid business deductions from that $2000 profit first before you paid taxes on it! The original cost of production, in this case $5000, is just ONE valid business expense. But you also have lots and lots of other ones, like rent, telephone, utilities, car and gas etc. There is one exception to this rule and that is when the transaction takes place across the year end boundary. If you buy $5000 of postcards and sell them before the end of the year but do not get paid for them, then you can report a $5000 loss and you must decrease your CAPITAL by -$5000, as you no longer have the cards in INVENTORY and you no longer have the CASH either. It looks like you have suffered a $5000 loss, which is fair as you may never get paid for them. Thus you are under reporting your revenue for that year by the amount of capital 'lost' in the deal. When you finally get paid for the postcards in the next year, the full amount of $5000 (capital) + $2000 (profit) must be added back to both CASH and CAPITAL, and the full amount is considered revenue and is taxable. This is because the spurious -$5000 loss (of capital) you declared the previous year when you sold the postcards is balanced by the spurious $5000 'profit' (regain of capital) you made this year when you got paid for them. Thus you under paid your taxes last year, and over paid your taxes this year. Unless tax rates have changed it all balances out. The remaining $2000 is true profit and is of course always taxable once you finally get it. The whole idea though is that once you start having lots of these year end transactions, its time to get on the accrual system where accounts receivable and accounts payable are all recorded as income and expenses whether or not you have received or made payment for any of them. This evens out this year end problem. On the accrual system, if you sell the postcards you get to deduct th cost of the postcards, and you must declare the revenues due to you for them even if you haven't received them yet and won't until January of the next year. The pain is that once you DO receive the money in January, your bank account says the deposit was received in January, but you have to remember that the money was ALREADY DECLARED as revenue in the previous year and you already paid taxes on any profit you might have made on that money, and you certainly don't want to pay taxes twice!. So you got to remember to not include that money in this year's revenues too! It's a pain. Suddenly your bank statement doesn't give you the whole story and you need to start really keeping books. For many business, the year end is the biggest time of year for them, around the Holidays in December and such, and you get bigger and bigger orders in November and December as all the stores want to stock up, and of course you don't get paid until January or February. So its not a small problem, this year end thing, and frankly the only real answer is to get on the accrual system eventually. CAPITAL EQUIPMENT CAPITAL EQUIPMENT is usually your means of production, such as computers, telephones, tables, office equipment, sound equipment calculators, cars, etc. It is considered to have a useful life of from 3 to 7 years; most electronic equipment is expected to last 5 years. When money is spent on equipment, money is moved from CASH to EQUIPMENT. This is shown on line 11 of Figure 1, where $10,000 has been taken out of CASH and spent on a personal computer. CAPITAL does not change because the equipment bought is considered to be an asset of the same value as the money it took to buy it. The catch is that at the end of the year, equipment that is supposed to last 5 years is considered to have lost 1/5 of its value. Thus at the end of the first year, the system suffers a loss of $2000, and this is shown in line 12. If there is no revenue for that year, and if nothing else happens, then a loss of $2000 would be reported as the final profit for tax purposes. (No you don't pay taxes on losses! And in fact you can carry over these losses to deduct against future year's profits if there are any before you pay taxes on THOSE profits!) The idea here is that if you buy something for the business and it RETAINS ITS VALUE then you are NOT allowed to deduct it as a business expense against gross revenues. The only thing that you are allowed to deduct as a business expense are LOSSES. Let's say you buy some tape to package your postcards. As long as you have the tape which you bought, then you still have the value you invested in it. You are not any poorer for having bought the tape because, although you no longer have the cash you used to pay for it, you still have the tape. You merely moved your assets from one form to another. But let's say you then use all the tape to wrap your postcards and send them out the door. The tape now becomes part of the expense used to make and deliver your postcards. Once the postcards go out the door, you no longer have either the cash OR THE TAPE!. Thus the tape is GONE, along with its ASSET VALUE, its value is no longer part of your assets. NOW you can deduct the cost of the tape, the value that you lost in using it. In general you can only deduct the value of your assets that you lose in the course of production. The value of your rent is gone in one month. The value of your computer is supposed to last 5 years. After the first year, you still have your computer, right? You can still use it, its no worse off than it was when it was new. Its not getting used up the way rent and tape get used up. But anyone will tell you that equipment does not last forever, worse it gets obsoleted about every 5 years, thus you sort of have to throw your computer away every 5 years and get a new one even if the old one is still working. Thus you are allowed to consider that 1/5 of your computer's asset value is lost every year. Thus after the first year you can deduct 1/5 of its value from your gross revenues. Likewise in the next year your computer will lose another $2000 of its value. But let's say that this year there is also a $3000 revenue for services rendered. The -$2000 is subtracted from EQUIPMENT and CAPITAL as before, but the $3000 is added to CASH and CAPITAL. This shows that the CAPITAL has increased overall by $1000 even though there was a $3000 revenue during that year. That is because the $3000 revenue is offset by the -$2000 loss on the personal computer leaving a profit of only $1000. This is line 13. Remember you only pay taxes on profit. The point of this is that you only pay taxes on the $1000 left over from the $3000, and the $2000 gets to stay in capital free from taxes refreshing the $2000 lost from capital due to the computer depreciating. After five years of this, you will have $10,000 in capital ready to buy a new computer, but only of course if you make enough in revenues each year to cover the $2,000 loss incurred by the rust and rot of metallic depreciation. This depreciation is called capital recovery of equipment. Depreciation refers to the idea that the value of the equipment depreciates over time and that loss of value acts as a valid business expense to be deducted against gross revenues. This schedule of deducting 1/5 of your equipment's value every year is called the STRAIGHT LINE METHOD of depreciation. The government makes it a tad more difficult in they assume that you did not have the equipment for all of the first year you had it. They assume that on average you will have had newly bought equipment for only 1/2 of the first year. Thus you are allowed to only deduct 1/2 of 1/5 of the computer's value in the first year. Then during years 2 through 5 you can deduct 1/5 for each year. That leaves a remaining 1/2 of 1/5 to deduct in the 6th year. There are other methods for depreciating equipment, one is called the Accelerated Cost Recovery System or ACRS for short. This allows you to recover more of your equipment's value during the first years, and less during the later years. This is helpful to those who have little capital and have to bear the brunt of paying the full expense of the computer during the first year and then not having enough money to pay taxes with! It's the government being kind to the little guy. Remember half of this accounting nonsense has to do with corralling what you are supposed to pay taxes on which is why I keep bringing them up. LIFE AND THE GOVERNMENT What the government considers a profit and what your life considers a profit are two different things. For example the government does not allow you to deduct your basic living expenses such as food, shelter, clothing, basic education and commuting expenses from your revenue before you pay taxes. Therefore although you may be turning a 'profit' as far as the government is concerned, (and thus paying taxes on that 'profit'), you actually may be just scraping along or even losing money as far as your whole life system is concerned. Such decisions about what is deductible and what isn't is an arbitrary decision on their part and has nothing to do with theoretical correctness. It is obvious that the costs involved to feed, clothe and shelter you and get you to and from work are fundamental business expenses necessary for the operation of your business. Why is gas for the company car a valid business expense but food for the worker is not? The point is your life is a business no matter who you are or what you do, you can't take a breath without consuming something and producing something. The question is, are you producing a profit and recovering your capital or are you dissipating your resources away? Remember that the PURPOSE of a business deduction is to recover your original capital invested. If you got taxed on the whole gross sale including your original capital you would be loosing a piece of your capital just for using it in a production cycle. For example let's say you invest $5000 in postcards and you sell them for $5000. That is zero profit, you just recovered your capital. It would be a bitch to have to pay taxes on that $5000 now wouldn't it? This would anti motivate anyone from risking their capital and would FORCE people to sell things for a profit to make up for the tax loss on their capital. No one would ever do the good deed of selling things for cost because cost would be a loss. Whether your original capital investment involves buying a car and feeding it gas and oil, or buying a room for you to sleep in and feeding your self spaghetti, what's the difference? All these expenses are just your original capital investment in the production of your product and are valid business expenses and therefore deductions in the over all scheme of life. To consider the money spent on your car a business expense and the money spent on YOU taxable profit is an arbitrary and capricious action of people who are trying to get you to work for their living. Now there is nothing wrong with taxes, someone has to pay for the roads and other commonly shared means of production that no one can buy or own alone, and in fact taxes are just another form of business expense. It is also perfectly OK for the people of a land to determine just how they want their taxes to be determined and how they should be taken out of their gross revenues, but once some joker in a suit and tie starts to tell you that this is not just an agreed upon decision but is somehow TRUTH and RIGHT, then you have crossed over into the area of mental and financial slavery. If you stick to the understanding that taxes are just another necessary business expense to support the infrastructure of existence, an expense you must pay whether or not you are making a profit or even any revenue at all, then you will be able to keep taxes in perspective. You have to pay rent whether or not you have any income (profit), right? Just so, you must pay for the roads and the armies of the land. It is quite fortunate that taxes are tied to income. Our land lords should be so kind. You can be kicked out of your apartment for not having any income, imagine what would happen if you could be kicked out of the COUNTRY for not having any income. In any case what this all boils down to is, PEOPLE ARE ONLY HAPPY WHEN THEIR WHOLE LIFE SYSTEM IS TURNING A PROFIT, Burn it in Stone. This is true because when a person's whole life system is turning a profit, all of their fundamental and personal operating business expenses are being covered by their revenue including food, clothing and shelter, AND TAXES, leaving some profit over to expand their life and its enterprises. This means a life without fear, because you would have everything that you normally fear NOT having such as food, clothing, shelter and basic education for yourself, your mate and your children. In such a system the taxes you pay to the government are just another business expense which you shell out to pay for the roads, the national defense and everyone who is indigent and hates the government. How those taxes are figured makes very little difference as long as the value you buy with your money matches the value of the money you buy it with. In other words as long as you get what you pay for. It is not even necessary that taxes be tied to income (profit). The cost of your rent does not change with the amount of income you are making, so why should the cost of using the roads? The cost of using the roads remains the same even if you don't have the income to pay for them at all. If you don't have the income to pay your rent, you don't get to live in the apartment. If you don't have the income to pay for the roads maybe you shouldn't get to use them either. I guess the government considers it kinder that you should be able to use the roads when you are destitute than have an apartment to live in. At least you could go to work, even if you had no place to return to in the evening. Thank the Lord for small mercies. LIFE SOLVENCY So take a look at your life, ask yourself where your original capital is coming from, what you want to produce or what service you want to give, how much you should charge for it and how much it will cost you to produce it including food, clothing, shelter and basic education for you, your mate and your children. Your mate and your children by the way are part of the TOTAL ASSETS of your whole life system, just as you are, so of course their upkeep is just as deductible as the company fleet. A mate and a fleet of children used to be a life necessity. Don't forget to figure into your life's costs the taxes you will owe to the government. Then ask yourself how much you would like to expand each year to guarantee your survival. If your net worth (total assets) are decreasing each year or even just staying level you are a losing proposition. The only security there is, is in affluence and steady expansion. This gives you a significant margin for failure. Once you have figured all this out, you will know how much revenue you will need to earn each year to turn a reasonable LIFE profit. And if you turn a reasonable life profit, THIS will lead to a financially happy and fearless future. Prosper and flourish. Homer