This book will teach you how to prepare the income statement and the balance sheet of a company WITHOUT using debits, credits, or T accounts. You can use an Excel Template or this website’s accounting tool to visually see the income statement and balance sheet being constructed.

No Debits, Credits, and T accounts

Debits, credits, and T accounts are a legacy of the historical accounting methods. Many still believe that you cannot prepare financial statements without using debits or credits or T accounts!  This is incorrect. You do NOT need to use debits or credits or T accounts to prepare a company’s income statement and balance sheet.

How Will We Convince You?

To convince you that you do not need debits and credits to prepare the financial statements of a company, we will walk you through the entire accounting process from the beginning to the end in this book. We will start with identifying a transaction and end with the financial statements.

Here are some common activities a business undertakes. We will teach you how these activities can be analysed and recorded in the accounting system of a company. We will then show you how these activities are summarised and presented in the income statement and balance sheet.

1. Mark invested $20,000 to start a business in exchange for 1,000 shares on January 1^st.
2. The business borrowed $30,000 from ABC bank at an interest rate of 10% per year on January 2^nd.
3. Equipment worth $25,000 was purchased and paid for immediately on January 4^th.
4. On January 6^th, inventory worth $40,000 was purchased by the company on a 60-days credit note.
5. Three customers walked into the store to enquire about prices and products on January 12^th.
6. $10,000 worth of inventory was sold for $30,000 in revenue on 30-day credit on January 15^th.
7. $5,000 of wages were paid on January 31^st.
8. The rent for January was $2,000 and was paid on January 31^st.
9. On January 31^st, $10,000 of accounts receivable was collected from the customer related to sales made on Jan 15^th.
10. The equipment would last for 5 years. The straight-line depreciation method is used to account for depreciation expenses.

What will the company’s income statement and balance sheet look like after each of these transactions is complete? What will the company’s income statement and balance sheet look like at the end of the year? We will analyse and record all the above transactions, place them in the accounting system, and present the company’s income statement and balance sheet. We will do all this without using debits, credits or T accounts.

Note: The statement of cash flows can be prepared from the company’s income statement and balance sheet. We will keep the preparation of the Statement of Cash Flows for another lesson.

Identifying Transactions

A transaction is any activity that has a financial impact on the company. Examples of transactions include purchasing an asset, selling goods or services, collecting cash from customers, and paying expenses. We are only looking for activities that have a financial impact on the company. This need not be a payment or receipt of cash. A transaction could be creating a current or future financial obligation, such as a payable in the future. An activity that does not have a financial impact, such as the arrival of a visitor, is not a transaction that the accounting system needs to capture.

Analyzing Transactions

Once a transaction is identified, the transaction is analyzed to identify 1) if the transaction creates a benefit (asset) or an obligation (liability) to the company, 2) which specific areas (accounts) are impacted, 3) the quantity of impact, and 4) the direction (up/down) of impact.

Recording Transactions

After a transaction has been analyzed, the transaction must be recorded in the accounting system. Here is where we will deviate from the conventional accounting process. The recording of these transactions is usually done in the company’s accounting books as an entry in the general ledger, journal, and T-accounts. We will record the transactions in the Balance Sheet Equation Template on an Excel spreadsheet or on the accountingtutor.org webpage.

End of period Transactions

Sometimes a benefit (asset or income) or an obligation (liability or expense) may be created with the passage of time (as opposed to an event or transaction). These must be accounted for at the end of the accounting period.

In the traditional accounting system, these end of period transactions are called adjusting entries.

Summarizing Accounts

After the end of period transactions are recorded, all individual accounts are summed up to summarize each account. The sum of each account is often referred to as the account balance. In the traditional accounting system, this process is called preparing the trial balance.

Preparing Financial Statements

You are now ready to prepare the financial statements. The income statement and balance sheet are prepared using the above account balances. The income statement and balance sheet are nothing but the various accounts ordered in a logical manner. This is the last step in an accounting period.

Starting a New Accounting Period

This cycle is then repeated for the next accounting period.

Any activity that has a financial impact on the company is a financial transaction that needs to be recorded in the company’s accounting system. A financial impact is created by an event or activity that involves the exchange of value between two or more parties. Examples of transactions include the purchase of an asset, the sale of goods or services, the use of a service such as a recruitment service, running an advertisement, etc.

An activity that has a financial impact on the company need not be a payment or receipt of cash. An activity or transaction could be creating a current or future financial obligation such as a payable in the future even if there is no payment of cash now. An example of such a transaction is the use of a contractor’s services today for which a payment will be made a few weeks from now.

Internal Transactions Or External Transactions

Transactions could be internal transactions or external transactions: Internal transactions are transactions that occur within the organization and do not involve external parties. Examples of internal transactions include recording employee wages, depreciation expenses of the company’s assets, inventory obsolescence, etc.

External transactions are transactions that the company engages with external parties such as customers, suppliers, lenders, and investors. Examples of external transactions are sales to customers, buying inventory, borrowing money, etc.

Activities That Do Not Have A Financial Impact On The Company

Some activities do not have a financial impact on the company. These activities do not need to be recorded in the accounting system. (Some of these may need to be disclosed in the notes to the financial statement.)

Examples of activities that do not have a financial impact on the company and so do not need to be recorded in the accounting system include:

• Entering a contract to supply goods at a future point in time. We do not record a transaction as we have not collected cash nor have we supplied goods (yet). No asset or liability has been created yet.
• Entering a letter of credit agreement with a bank where the bank assures our company’s client that, if our company fails to make the payment, then the bank will do so. Here, we do not record this in our accounting system as we have not created an asset or liability (yet). This becomes a liability to the bank only if our company fails to make a payment and we owe the bank money.
• Entering a credit/loan facility, where a bank agrees to lend the company on a future date if required. This transaction is not recorded on the company’s books because the company has not borrowed money (as yet).

Illustration of Identifying Transactions

Mark started a new business on January 1^st. Here is a list of activities for the month of January. Which of the activities listed below has a financial impact on the company? Which of these activities needs to be recorded in the accounting system?

1. Mark invested $20,000 to start a business in exchange for 1,000 shares on January 1^st.
2. The business borrowed $30,000 from ABC bank at an interest rate of 10% per year on January 2^nd.
3. Equipment worth $25,000 was purchased and paid for immediately on January 4^th.
4. On January 6^th, inventory worth $40,000 was purchased by the company on a 60 days credit note.
5. Three customers walked into the store to enquire about prices and products on January 12^th.
6. $10,000 worth of inventory was sold for $30,000 in revenue on 30 day credit on January 15^th.
7. $5,000 of wages were paid on January 31^st.
8. The rent for January was $2,000 and was paid on January 31^st.
9. On January 31^st, $10,000 of accounts receivable was collected from the customer related to sales made on Jan 15^th.
10. The equipment would last for 5 years. The straight-line depreciation method is used to account for depreciation expenses.

Take a few minutes to think through the above transactions. Please identify which transactions have a financial impact on your company and need to be recorded in the accounting system. Please do this before you look at the answers provided below.

1. Mark invested $20,000 to start a business in exchange for 1,000 shares on January 1^st.
   • Yes, there is a financial impact.
     • Cash received.
     • Shares issued.
2. The business borrowed $30,000 from ABC bank at an interest rate of 10% per year on January 1^st.
   • Yes, there is a financial impact.
     • Cash received.
     • Debt created.
3. Equipment worth $25,000 was purchased by the company in exchange for cash on January 4^th.
   • Yes, there is a financial impact.
     • Equipment received.
     • Cash paid.
4. Inventory worth $10,000 of inventory was purchased by the company on 60 days credit on January 6^th.
   • Yes, there is a financial impact.
     • Inventory received.
     • Payable created.
5. Three customers walked into the store to enquire about prices and products on January 12^th.
   • No Financial Impact.
6. The company sold $20,000 worth of inventory for $30,000 on 30 day credit on January 15^th.
   • Yes, there is a financial impact.
     • Inventory given.
     • Receivables created.
7. The company paid wages of $5,000 on January 31^st.
   • Yes, there is a financial impact.
     • Wages recorded.
     • Cash paid.
8. The companies rent for the month was $2,000 was paid on January 31^st.
   • Yes, there is a financial impact.
     • Rent expenses recorded.
     • Cash paid.
9. On January 31^st, $10,000 of accounts receivable was collected from the customer related to sales made on Jan 15^th.
   • Yes, there is a financial impact.
     • Cash received.
     • Accounts receivable goes down.
10. The company’s equipment would live for 5 years and used the straight-line depreciation method to account for depreciation expenses.
    • Yes, there is a financial impact.
      • Depreciation expenses recorded.
      • Accumulated depreciation increases.

What are Accounts?

An account is a page/file/place in the accounting system that is used to record, compile, sort, and summarise a specific category or type of transactions.

Let me explain what an account is using an analogy. You can think of an account as a file in your office. You use a file to keep a specific category of papers together. For example, you may have a file where you keep all your rent invoices. You may have another file where you keep all your food invoices. And a third file where you keep all your fuel expenses. Similarly, a cash account is a place in your accounting system that records all the cash-related transactions. A rent expense account is a place that records all the rent expense transactions placed in that account.

You can also think of an account as a bin in your warehouse. If the warehouse deals with clothing, you will put all shirts in one place (a bin). You will put all trousers in another bin and all socks in another bin. This way, whenever you need a shirt, you pull it out of the shirt bin. When you get a new stock of T-shirts you put it into the T-shirt bin. Similarly, you put socks into another bin, and when you need socks you take them out of that bin. Each bin will have only one category of clothing.

Similarly, an account will store only one kind of transaction. If you have a wage payables account, you will put all wage payables-related transactions into that account. All property, plant, and equipment transactions will go into another account called the property, plant, and equipment account. All inventory transactions will go into another account called the inventory account.

So, to summarise, an account is a file or a bin-like place which stores all transactions of one specified category. Here is a list of accounts that we can start with. Remember, these are just files that organize all your transactions, so you can have many more accounts and name them as you deem fit.

Note: A customer account is an account that stores all transactions related to that customer.

Types of Accounts

Now that you know what an account is, you should learn about the different types of accounts. The first classification of accounts you need to know and identify are:

1. Asset Accounts
2. Liabilities Accounts
3. Shareholders Equity Accounts
4. Revenue accounts
5. Expense accounts

There are other classifications which we will deal with when required.

Asset Accounts

An asset is anything that provides a current or future economic value to a business. All accounts that deal with assets are categorized as asset accounts.

Asset accounts include the cash and cash equivalents account, the inventories account, the accounts receivable account, the property, plant, and equipment account, the goodwill account, etc.

Liabilities Accounts

A liability is any financial obligation that a business has to anyone else. Liabilities include an obligation to pay a person, a business, or any organization at any point in the future. Liabilities are settled by paying, or transferring economic benefits such as money, goods or services.

For example, if someone has worked for the company or provided a service to the company, the company owes them an obligation to pay for the service. This is a liability to the company. If the company borrows money from a bank, the company has an obligation to return the money as per the contract.  This is a liability to the company.

There are two types of liabilities: 1) Liabilities to shareholders who are owners of the company, and 2) liabilities to others who are not shareholders. All accounts that deal with liabilities to outsiders who are not shareholders are categorized as liability accounts.

Liability accounts include accounts payable, notes payable, long-term debt, tax payables, lease obligations, etc.

Shareholders Equity Accounts

All accounts that deal with liabilities associated with shareholders are categorized as shareholders’ equity accounts.

Shareholders’ equity accounts include common stock, additional paid-in capital, treasury stock, retained earnings, minority interest, etc.

Revenue accounts

Accounts related to sales or revenues are called revenue accounts. Examples of revenue accounts include sales revenue, ancillary services revenue, etc.

Expense accounts

An expense is any cost incurred to generate revenues. This includes any expenses paid or unpaid. Accounts related to expenses are called expense accounts. Examples of expense accounts include the cost of goods sold, rent expenses, wage expenses, insurance expenses, taxes, interest expenses, marketing expenses, R&D expenses, etc.

Balance Sheet vs. Income Statement Accounts

You can categorise accounts based on where they appear in a financial statement. Accounts that refer to balance sheet-related items are called balance sheet accounts. Accounts that appear in an income statement are called income statement accounts.

Balance sheet accounts

All accounts that appear on a balance sheet are called balance sheet accounts. Since all asset accounts, liability accounts, and shareholder equity accounts appear on the balance sheets, these are balance sheet accounts. Examples of balance sheet accounts include the cash and cash equivalents account, inventories account, accounts receivable account, property, plant, and equipment account, goodwill account, accounts payable account, notes payable account, long-term debt account, stockholders’ equity account, retained earnings account, etc.

Income Statement Accounts

Revenue accounts and expense accounts go into the income statement. These accounts appear in an income statement are therefore called income statement accounts. Examples of income statement accounts include revenue account, cost of goods sold, rent expenses, wage expenses, insurance expenses, taxes, interest expenses, marketing expenses, R&D expenses, etc.

Size and Direction

We also need to understand the size of the transaction we are studying in monetary terms. That is, we need to know the dollar amounts by which our company’s financial obligations change. In addition we need to know the direction of change – is it an increase or a decrease in that specific account?

So after we identify and understand which accounts are impacted, the type of accounts these are, we observe the dollar change in the accounts and if there has been an increase or decrease.

Transaction Analysis Table

After we identify and understand which accounts are impacted, the type of accounts these are, if the impacted account increased or a decreased, and by how much, we can place this information in the transaction analysis table on our website or balance sheet equation template. Steps involved are:

Step 1: Identify all the accounts that are impacted.

Step 2: Specify the type of account the identified accounts in step 1 are (Assets/Liabilities/Shareholders’ Equity).

Step 3: Identify if the accounts increase in value or decrease in value.

Step 4: Specify the amount by which the accounts’ values increase or decrease by.

We can illustrate transaction analysis with an example. Let’s say we pay $1,000 to purchase inventory. We record this transaction in a transaction analysis template below.

Here is what the process looks like step by step:

1. We know that the cash account and the inventory account are impacted. So we list these accounts in the accounts column.
2. We know both cash and inventory are resources that benefit the company and therefore are categorized as asset accounts. So we specify that these accounts are assets in the type column in the above table.
3. We know cash goes down because we pay cash to purchase the inventory, and therefore, cash decreases. We also know that our inventory account goes up because we have purchased inventory.
4. The amount of increase and decrease is $1,000.

A few things to point out:

Note 1: Every transaction must impact at least two accounts. This is where the term double-entry book-keeping comes from.

Note 2: A transaction can impact more than two accounts.

Note 3: At all times, the accounting equation must be true. A = L+SHE. We elaborate on this in the following section.

Note 4: The opening balances of income statement accounts at the beginning of a period always start at zero as they are temporary accounts.

Note 5: The opening balances of balance sheet accounts is carried forward from the end of the previous accounting period. They could start at zero if the company is new or the account is new.

Illustration: Analyzing Transactions

We will analyze each of the transactions of our hypothetical company in this section. Please note that we simply follow the four steps outlined in the last section.

1. Mark invested $20,000 to start a business in exchange for 1,000 shares on January 15^th.
   • Cash received.
   • Shares issued.
2. The business borrowed $30,000 from ABC bank at an interest rate of 10% per year on January 1^st.
   • Cash received.
   • Debt created.
3. Equipment worth $25,000 was purchased by the company in exchange for cash on January 4^th.
   • Equipment received.
   • Cash paid.
4. Inventory worth $40,000 of inventory was purchased by the company on 60 days credit on January 6^th.
   • Inventory received.
   • Cash paid.
5. Three customers walked into the store to enquire about prices and products on January 12^th.
   • No Financial Impact.
6. The company sold $10,000 worth of inventory for $30,000 on 30 day credit on January 15^th.
   • Inventory given.
   • Receivables created.
7. The company paid wages of $5,000 on January 31^st.
   • Wages recorded.
   • Cash paid.
8. The company’s rent for the month of January was $2,000 was paid on January 31^st.
   • Rent expenses recorded.
   • Cash paid.
9. The company’s equipment would last for 5 years and use the straight-line depreciation method to account for depreciation expenses.
   • Depreciation expenses recorded.
   • Accumulated depreciation increases.
10. The company acknowledges that interest for a month is accrued.
    • Interest Expenses
    • Interest payable

All assets must be paid for. Assets must be funded by someone. This funding comes primarily from two sources. Funding can come from the owners or from other sources. Funding from owners is referred to as shareholders’ equity. And funding from other sources is classified as liabilities.

Therefore, we can say that assets of a business are funded by liabilities and owner’s equity. The accounting equation simply represents this fact as an equation.

Assets = Liabilities + Shareholders Equity

The accounting equation is also known as the balance sheet equation (BSE) because the balance sheet is built on this equation.

BSE image

A balance sheet will balance only if the accounting equation is true.

The accounting equation is the foundation of the double-entry accounting system.

But where are the income statement accounts? Where are the revenue accounts and expenses accounts?

The Income Statement Equation or the Net Income Equation

You probably noted that the income statement accounts are missing in the accounting equation. Where are the revenue accounts and expenses accounts?

The income statement accounts are netted (Revenues – Expenses) into the retained earnings account in the balance sheet. This happens continuously at the point of every transaction. On every transaction that has income statement accounts, either revenues or expenses, we apply the income statement equation, revenues – expenses, and put the results in the retained earnings account into the balance sheet equation.

Revenues increase retained earnings because the income statement accounts are netted with the equation (Revenues – Expenses), all revenues will be positive and increase the retained earnings.

Whereas, when recording an expense, we will usually have no revenues. Therefore, applying the income statement equation (Revenues – Expenses) will result in a negative value and decrease the retained earnings.

Balance Sheet Equation (BSE) Table

The balance sheet equation can be put into a table. All the asset accounts will be placed together. Similarly, all the liabilities and shareholders’ equity accounts will be placed together. The liabilities and shareholders’ equity accounts will be summed up to check if the balance sheet equation holds true at all points in time.

More details?

(Image)

Recording the Transaction Analysis in the BSE Table

Once a transaction has been analysed, we transfer this information to the balance sheet equation. All impacted assets are either increased or decreased by the amounts they have been affected by.

Each row has the details of only one transaction. And each row must reflect the accounting equation with the sum of assets equal to the sum of liabilities and shareholders’ equity. We typically build this check in Excel on the far right of the balance sheet equation.

In our illustration above, we see that the cash account has decreased by $1000. So, we will subtract $1,000 in the cash account column (negative $1,000). We know inventory has gone up by $1000 and so we put in a positive $1,000 in the inventory column.  Both cash and inventory are assets and therefore appear in the asset side of the balance sheet equation.

Illustration

We will analyze and record each transaction one by one.

Mark invested $20,000 to start a business in exchange for 1,000 shares on January 1^st.

1. This activity has a financial impact on the company. Cash is received by the company. The company issues equity or common stock. This transaction must be reflected in the accounting system.
2. The accounts impacted are:
   • Cash
   • Common Stock
3. The type of accounts impacted are:
   • Cash is classified as an Asset account.
   • Common stock is classified as a Shareholders’ Equity account.

4. The direction of the impact is listed below.
   • Cash balances increase.
   • Common Stock issued by the company increases.
5. The quantity of impact in each account is as follows:
   • Cash increases by $20,000.
   • Common Stock increases by $20,000.
6. Check if the BSE equation balances.
   • Sum of Assets : Cash $20,000.
   • Sum of Liabilities & Shareholders’ Equity : $20,000.

Balance Sheet after Issue of Equity

After Mark invested $20,000 to start a business in exchange for 1,000 shares on January 1^st, the balance sheet and income statement will look as follows. Only two accounts – cash and common stock have balances. The balance sheet balances.

There has been no revenues or expenses and so the income statement is blank.

The balance sheet equation in Excel will look as above.

Transaction 2: The business borrowed $30,000 from ABC bank at an interest rate of 10% per year on January 1^st.

1. This activity has a financial impact on the company. Cash is received by the company. The company now has a liability to the bank. This transaction must be reflected in the accounting system.
2. The accounts impacted are:
   • Cash
   • Bank Loan
3. The type of accounts impacted are:
   • Cash is classified as an Asset account.
   • Bank Loan is classified as a Liability account.

4. The direction of the impact is listed below.
   • Cash balances increase.
   • Bank Loan balance increases.
5. The quantity of impact in each account is as follows:
   • Cash increases by $30,000.
   • Bank Loan balance increases by $20,000.
6. Check if the BSE equation balances.
   • Assets : Cash $30,000
   • Liabilities & Shareholders Equity: Bank Loan $30,000

The BSE template will have a new column now – the Bank Loan column.

Transaction 3: Equipment worth $25,000 was purchased by the company in exchange for cash on January 4^th

1. This activity has a financial impact on the company. Cash is paid by the company. The company has received equipment which is an asset the company owns. This transaction must be reflected in the accounting system.
2. The accounts impacted are:
   • Cash
   • Property, Plant and Equipment (PPE)
3. The type of accounts impacted are:
   • Cash is classified as an Asset account.
   • PPE is classified as an Asset account.

4. The direction of the impact is listed below.
   • Cash balance decrease.
   • PPE balance increases.
5. The quantity of impact in each account is as follows:
   • Cash decreases by $25,000.
   • PPE increases by $25,000.
6. Check if the BSE equation balances.
   • Assets Total: Cash+PPE $-25,000 + $+25,000 = $0
   • Liabilities & Shareholders Equity Total: No accounts impacted =  $0

Note here that both the accounts impacted are asset accounts.

The BSE template will have a new column for PPE now.

Transaction 4: Inventory worth $10,000 of inventory was purchased by the company on 60 days credit on January 6^th.

1. This activity has a financial impact on the company. Inventory is received by the company. The company now has a liability to the vendor. This transaction must be reflected in the accounting system.
2. The accounts impacted are:
   • Inventory
   • Accounts Payable
3. The type of accounts impacted are:
   • Inventory is classified as an Asset account.
   • Accounts Payable is classified as a Liability account.

4. The direction of the impact is listed below.
   • Inventory balances increase.
   • Accounts Payable balance increases.
5. The quantity of impact in each account is as follows:
   • Inventory increases by $10,000.
   • Accounts Payable balance increases by $10,000.
6. Check if the BSE equation balances.
   • Assets Total: Inventory $10,000
   • Liabilities & Shareholders Equity Total: Accounts Payable $10,000

The BSE template will look as follows.

Transaction 5: Three customers walked into the store to enquire about prices and products on January 12^th.

1. No Financial Impact. No transaction needs to be recorded.

Transaction 6: The company sold $20,000 worth of inventory for $30,000 on 30 day credit on January 15^th.

1. This activity has a financial impact on the company. The company earns revenues. The customer owes the company the value of goods. The company’s inventory balances have declined. This transaction must be reflected in the accounting system.
2. When goods or services are sold and revenue is recognized, we need to account for two distinct ways the company is impacted. The accounts impacted are:
   • Revenue recognition:
     • Revenues need to be recorded. Receipt of payment or creation of an accounts receivable .
     • Recognition of cost of goods sold:
     • Cost of Goods Sold (COGS) expenses acknowledged.
     • Reduction of inventory balances.
3. The type of accounts impacted above are:
   • Revenue is classified an Income Statement – Revenues Account.
   • Accounts receivable is classified as an Asset account.
   • Cost of Goods Sold (COGS) expenses is classified an Income Statement – Expenses Account.
   • Inventory is classified as an Asset account.

4. The direction of the impact is listed below.
   • Revenues balance increase.
   • Accounts receivable balance increases.
   • CoGS goods balance increases.
   • Inventory balance decreases.
5. The quantity of impact in each account is as follows:
   • Revenues balance increases by $40,000.
   • Accounts receivable balance increases by $40,000.
   • CoGS goods balance increases by $10,000.
   • Inventory balance decreases by $10,000.
6. Check if the BSE equation balances.
   • Sum of Assets : Accounts receivable + Inventory $+40,000 + $-10,000 = $30,000
   • Sum of Liabilities & Shareholders’ Equity : Retained Earnings (+Revenues-CoGS)=  $+40,000+$-10,000= $30,000

Note: We see the income statement accounts active for the first time. In this transaction, you will see both revenues and CoGS expenses are added to the income statement. Note also that the revenue has increased the retained earnings and the CoGS has reduced the retained earnings. The difference between the revenues and expenses is what is added as the retained earnings in the balance sheet below.

Transaction 7: The company paid wages of $5,000 on January 31^st.

1. This activity has a financial impact on the company. Cash is paid by the company. The company has received services for which wages are being paid. Wages are an expense incurred by the company. This transaction must be reflected in the accounting system.
2. The accounts impacted are:
   • Cash
   • Wage expenses
3. The type of accounts impacted are:
   • Cash is classified as an asset account.
   • Wage expense account is classified as an income statement – expenses account.

4. The direction of the impact is listed below.
   • Cash balance decrease.
   • Wage expenses balance increases.
5. The quantity of impact in each account is as follows:
   • Cash decreases by $5,000.
   • Wage expenses account increases by $5,000.
6. Check if the BSE equation balances.
   • Assets Total: Cash $-5,000.
   • Liabilities & Shareholders Equity Total: Retained Earnings (Revenues – Expenses)  $-5,000.

Since wage expenses has been added to the income statement, the net income and consequently the retained earnings goes down bythe wage expenses of $5,000.

Transaction 8: The company’s rent for the month was $2,000 was paid on January 31^st.

1. This activity has a financial impact on the company. Cash is paid by the company. The company has received services for which rent is being paid. Rent is an expense incurred by the company. This transaction must be reflected in the accounting system.
2. The accounts impacted are:
   • Cash
   • Rent expenses
3. The type of accounts impacted are:
   • Cash is classified as an asset account.
   • Rent expense account is classified as an income statement – expenses account.

4. The direction of the impact is listed below.
   • Cash balance decrease.
   • Rent expenses balance increases.
5. The quantity of impact in each account is as follows:
   • Cash decreases by $2,000.
   • Rent expenses account increases by $2,000.
6. Check if the BSE equation balances.
   • Sum of Assets : Cash $-2,000.
   • Sum of Liabilities & Shareholders Equity : Retained Earnings (Revenues – Expenses)  $-2,000.

Since rent expenses has been added to the income statement, the net income and consequently the retained earnings goes down bythe rent expenses of $2,000. The BSE table below will have a new column for rent expenses.

Transaction 9: On January 31^st, $10,000 of accounts receivable was collected from the customer related to sales made on Jan 15^th.

1. This activity has a financial impact on the company. Cash is received by the company. The company has received cash from a customer who owed money to the company. Since he owes less money to the company, accounts receivable balance is also impacted. This transaction must be reflected in the accounting system.
2. The accounts impacted are:
   • Cash
   • Accounts receivable
3. The type of accounts impacted are:
   • Cash is classified as an Asset account.
   • Accounts receivable is classified as an Asset account.

4. The direction of the impact is listed below.
   • Cash balance increases.
   • Accounts receivable balance decreases.
5. The quantity of impact in each account is as follows:
   • Cash increases by $10,000.
   • Accounts receivable increases by $10,000.
6. Check if the BSE equation balances.
   • Sum of Assets : Cash+ Accounts receivable $10,000 + $-10,000 = $0
   • Sum of Liabilities & Shareholders Equity : No accounts impacted =  $0

Note that there seems to be no change from the previous balance sheet as the total assets of $100,000 has not changed. However, if you look carefully, you will see that the cash balance has gone up and the accounts receivable balance has come down by the cash collected $10,000.

The BSE equation will look as follows.

Transaction 10 is an end-of-period entry. So we will deal with it in the next chapter.

In-period transactions are transactions that happen daily in the course of the company’s business activities. You have finished recording them on a daily basis throughout the accounting period.

The end-of-period transactions are transactions that are recorded at the end of the period, usually to account for changes in revenues, expenses, assets, or liabilities due to the passage of time or usage of an asset. In the traditional accounting system, this step is called adjusting entries.

An example of revenue creation due to the passage of time is the recognition of a sale of a magazine subscription. An example of the creation of a liability due to the passage of time is the recognition of a rent payable at the end of a month/year. An example of an expense with the usage of an asset is depreciation or amortization of an asset.

Adjusting entries are journal entries made at the end of an accounting period to ensure that a company’s financial statements accurately reflect its financial position and performance. These entries are necessary because of the accrual method of accounting. The accrual method records transactions when they occur, not necessarily when the cash is exchanged.

Adjusting entries ensure that the income statement (which shows revenues and expenses) and the balance sheet (which shows assets, liabilities, and equity) are up-to-date and accurate at the end of the accounting period. This process is crucial for producing financial statements that provide a true and fair view of a company’s financial position and performance. Adjusting entries are typically made at the end of the year, but before financial statements are prepared. Common examples of adjusting entries include recording depreciation on fixed assets, recognizing bad debts, and adjusting inventory values. These entries help accountants adhere to the matching principle, which states that expenses should be recognized in the same period as the revenue they help generate, leading to a more accurate representation of a company’s financial health.

The 10th transaction in our illustration is an end-of-the-period entry. We are accounting for the value of the machine used due to the passage of time.

Transaction 10: The company’s equipment would live for 5 years and used the straight-line depreciation method to account for depreciation expenses.

1. The use of equipment reduces its value. This has a financial impact on the company as it reduces its asset value. The reduction in value is captured in an account called the accumulated depreciation account. The accumulated depreciation account offsets the PPE account which carries the gross value of the asset. Accounts that offset other accounts are called as contra asset accounts.
   
   Since the equipment is used to generate revenues, the associated value used is considered as an expense and must be recorded as a depreciation expense. This transaction must be reflected in the accounting system.
   
2. The accounts impacted are:
   • Accumulated depreciation account.
   • Depreciation expenses.

3. The type of accounts impacted are:
   • Accumulated depreciation account is classified as asset (contra) account.
   • Depreciation expense account is classified as an income statement – expenses account.
     
4. The direction of the impact is listed below.
   • Accumulated depreciation account balance increases.
   • Depreciation expenses balance increases.
     
5. The quantity of impact in each account should reflect the time that is being accounted for. Here we are talking about one month in a life of 5 years for the equipment. So the cost of the equipment $25,000 is divided by 5 for five years. This is then divided by 12 to account for 1 of twelve months. (25,000*(1/5)*(1/12)=416.7)
   • Depreciation expenses increases by $417.
   • Accumulated depreciation account increases by $417.
     
6. Check if the BSE equation
   • Sum of Assets : PPE via Accumulated depreciation $-417.
   • Sum of Liabilities & Shareholders Equity : Retained Earnings (Revenues – Expenses)  $-417.

The balance sheet equation template will be as follows.

Transaction 11: Interest on Bank Loan

The company has a bank loan on which it pays a 10% interest. Since we follow the accrual system of accounting, we need to accrue the interest expense for the month of January even if we do not pay the interest.

1. The passage of time has created an interest obligation and so there is a financial impact on the company. Interest is payable by the company. This transaction must be reflected in the accounting system.
2. The accounts impacted are:
   • Interest payable
   • Interest expense
3. The type of accounts impacted are:
   • Interest payable is classified as a liability account.
   • Interest expense account is classified as an income statement – expenses account.

4. The direction of the impact is listed below.
   • Interest payable balance increases.
   • Interest expenses balance increases.
5. The quantity of impact in each account is as follows:
   • Interest payable increases by $250.
   • Interest expenses account increases by $250.
6. Check if the BSE equation balances.
   • Assets Total: zero.
   • Liabilities & Shareholders Equity Total: Liabilities $+250 & retained Earnings (Revenues – Expenses)  $-250 so net zero.

Both the end-of-period transactions listed on this page happen to be small amounts and so are not visible on the balance sheet and income statment displayed above. These are, however, visible in the BSE template below.

Let us move to the next step which is summarizing these accounts.

In the traditional accounting process, this process is called preparing the trial balance.

The ending balances in each account is listed below.

Now that you have the account balances for each account, you are ready to prepare the income statement and balance sheet.

Ordering the Income Statement Accounts

The income statement shows revenues first, followed by expenses.

Revenues

The primary source of revenue is listed first in the revenue section of the income statement. Other streams of revenue are also listed separately if significant.

Expenses

The expenses side of the income statement starts with the cost of goods sold and any other direct expenses incurred to produce revenue. This gives you the gross margin from the business.

Operating Expenses

Other operating expenses, such as research and development expenses, sales and general administrative expenses, etc., are then listed in the income statement. These are deducted from the gross profits to give you the operating profits from the business.

Non-operating Income & Expenses

We then list the non-operating expenses and non-operating income, such as interest income, interest expenses, and gains or losses on the sale of assets. The sum of these, deducted from operating profits, gets you the total income before taxes.

Taxes & Net Income

We then deduct income taxes from total income before taxes to arrive at the net income. You have prepared a completed income statement when you have ordered the revenue and expenses, computed and deducted taxes to arrive at the net income. Remember that the income statement accounts are temporary accounts. All these accounts are reset to zero at the end of the period. However, if you have followed the process correctly, the final result of the income statement, the net income of the period, would have been carried over to the balance sheet and will be reflected in the retained earnings account.

Income Statement Ordered

The income statement ordered with revenues on top followed by expenses is presented below. The net income from the income statement is transferred to the retained earnings account in the balance sheet.

The income statement accounts are ‘temporary accounts’ and the balance are transferred to the retained earnings. So at the end of an accounting period the balances are rest to zero and start at zero at the beginning of each accounting period.

Three Lists that Form the Balance Sheet: Assets, Liabilities and Shareholders’ Equity

The accounts and their balances are categorized into three categories: assets, liabilities, and shareholders’ equity.

The sum of the asset accounts forms the total assets of the balance sheet. The sum of the asset accounts must equal the sum of the liabilities and shareholders’ equity accounts in the balance sheet.

Ordering the Assets in the Balance Sheet

The asset accounts are listed in order of their liquidity by convention. Current assets are usually assets that can be converted into cash within 12 months. Assets that have a longer life are categorised as long-term assets. Current assets are listed first. Within the current accounts, we order the assets according to liquidity, with the most liquid assets listed first, followed by less liquid accounts. Cash and cash equivalents account is right on top of the current assets accounts because cash and cash equivalents are the most liquid assets. Cash and cash equivalents are followed by accounts receivable, inventory, and other short-term assets, which are the current assets in a balance sheet. Current assets are totaled first before long-term assets are listed on the assets side of the balance sheet.

Long-term assets are listed after the current assets are sub-totalled. Long-term assets are also listed in order of their liquidity. Some companies have a subtotal for long term assets. Others do not. However, all companies sum the current assets and long-term assets, to get the total assets which ends the assets side of the balance sheet.

Ordering the Liabilities in the Balance Sheet

The liability accounts are also ordered by their liquidity by convention. Current liabilities are usually liabilities that need to be paid in 12 months or less. Liabilities that have a longer life, such as bank loans and lease liabilities, are categorised as long-term liabilities.

Current liabilities are listed first. And followed by long-term liabilities. The current liabilities accounts are also ordered in order of their liquidity, with the most liquid liabilities listed first. The accounts payable account is right on top of the current liabilities accounts list because it is considered the most liquid current liability given it is usually paid in a matter of days. Accounts payable is followed by notes payable, taxes payable, and other short-term liabilities. These current liabilities are summed up to get the total current liabilities section in a balance sheet.

Long-term liabilities are listed after the current liabilities section. These are also listed in order of their liquidity. Current liabilities and long-term liabilities are summed up to get the total liabilities section in a balance sheet.

Ordering the Shareholders’ Equity in the Balance Sheet

The shareholders’ equity section of the balance sheet is less governed by liquidity. By convention, the shareholders’ equity section of the balance sheet starts with common stock. Common stock is followed by its sister account, the additional paid-in-capital account. The additional paid-in-capital account is followed by treasury stock and retained earnings.

You have prepared a completed balance sheet when you have ordered the three components of the balance sheet and put them together. Notice that the sum of total assets is equal to the sum of total liabilities and total shareholders’ equity.

Ordered Balance Sheet

The ordered balance sheet of our illustrative company is presented below.

Note that the retained earnings matches the net income from the income statement because the net income is transferred to the retained earnings. The net income matches the retained earnings only because this is the first year of operations. In subsequent years the net income is added to the retained earnings balance and so the retained earnings will not match the net income of each year.