How financial statements are made

The financial statements are the cap stone of a careful bookkeeping process. The key to properly recording a transaction is remembering that the accounting equation, assets equal liabilities plus equity, must always be maintained.

To illustrate the process of transaction analysis, we use a hypothetical transactions for Hannah Market. A small retail business.  During the year, Hannah entered into the following transactions.  

• One, invested $700,000 of her own cash in the business.
• Two, borrowed $300,000 cash from the bank.
• Three, purchased land, a building, and equipment, for a total of $2 million. Hannah paid $100,000 down in cash. And the remaining $1.9 million is financed with a mortgage. 
• Four, purchased inventory items for resale, for a total of $1,300,000. The entire amount was put on suppliers accounts. So no cash was paid at the time of purchase.
• Five, sold inventory costing $800,000 to retail customers, for $1.1 million. The customers paid $200,000 in cash and the remaining $900,000 was put on the customers accounts.
• Six, paid employees a total of $170,000 cash for wadges.

The impact of each of these events on Hannah's balance sheet and income statement can be illustrated in a simple spread sheet.

• One, as a result of Hannah's $700,000 investment, the business now has an increased amount of the asset cash. Hannah's having invested the cash should be reflected in an increase in the amount reported as Paid in Capital. An important equity category.
• Two, the increase of $300,000 in the asset cash is paired with an increase in the liability Bank Loan Payable. 
• Three, the asset cash is reduced because of the $100,000 down payment. We also note that a mortgage was created as part of this transaction. So we must record a liability Mortgage Payable in the amount of $1,900,000. 
• Four, the inventory account is increased by $1.3 million. Also, because the inventory was purchased entirely on account, the amount of Accounts Payable has also increased by $1.3 million.
• Five, as the result of these customer sales, Hannah has added to two asset accounts an increase in cash of $200,000, and an increase in the asset Accounts Receivable of $900,000. When assets are generated in the corse of doing business, their source is recorded as revenue. In this case, the account Sales Revenue is increased by $1,100,000. The Sales Revenue account is a sub category of Retained Earnings, and represents an increase in the equity of the business that's occurred because of conducting business operations. In exchange for the cash in Accounts Receivable, Hannah gave up inventory, costing $800,000. This is reflected by reducing the asset inventory by $800,000. This asset was consumed in the course of business operations. So, it is reflected as the expense cost of goods sold. The $800,000 amount under Cost of Goods Sold, is shown as a subtraction, because it represents a reduction in equity. As with the Sales Revenue account, the Cost of Goods Sold expense account is a sub category of Retained Earnings. Now, when put together, the $1,100,000 equity increase recorded as sales revenue. And the $800,000 equity decrease recorded as Cost of Goods Sold, means that operating transactions increase the equity of the business by $300,000. The $1,100,000 revenue, minus the $800,000 expense.
• Six, Hannah paid her employees $170,000 in wadges during the year. This amount is reported as Wadges Expense. As with the other expenses, Wage Expense is a sub category of Retained Earnings and reflects a decrease in equity. Because resources were consumed in the course of doing business.
  

Now, look at the spreadsheet. You can see that for each transaction we have made sure that assets equal liabilities plus equity. And the end result of this transaction analysis is the set of account balances at the end of the year. You can see these in the bottom row of the spread sheet. The purpose of the accounting process is to create the financial statements, which can then be used in making business decisions.