In the last post, I discussed the elements of the financial statement. In this post I expand on how accounts flow through the elements of the financial statement.

The very fundamental of any accounting transaction is: assets has to equal liabilities and equity as shown below:

Assets = Liabilities + Equity

Assets, liabilities and equity are the three main elements of the financial statement and every transaction flows through one of these accounts. Transactions affect this equation in four ways:

• Asset source: Asset source transactions are transactions that answer where the assets of the business come from.
• Asset exchange: Is a transaction between two asset accounts
• Asset Use: Is when a transaction decreases the assets of a business. For example: paying rent expense.
• Claims Exchange: This is a transaction between a liability and equity account. For example, accruing wages at the end of the year.

Relationship between the profit and loss statement and balance sheet

Every transaction must flow through the balance sheet in one of the four ways mentioned above. To see how this happens I will expand on the accounting equation with an example:

Expansion of accounting equation

Assets = Liabilities +Equity

Assets = liabilities + capital contribution + retained earnings* – distributions

Assets = liabilities + capital contribution + prior earnings +revenue – expenses

*Remember – retained earnings is the accumulation of prior earnings retained in the business.

Example

Your cousin Lucy, was downsized from her business and so decided to start a consulting business. She took $2,000 from her savings to buy a computer. After the first month she had one client who paid $1,000. She paid $200 for wages to a high school student who worked with her.

The first thing we need to do is identify what elements of the financial statements are affected and how:

Before starting her business Lucy acquired $2,000 capital from her savings. When this happens, her asset cash increases and her equity $2,000 increases. This is an asset source transaction and is represented in the accounting equation as follows:

Assets = Liabilities +Equity

2000 (cash) = 0 + 2000 (capital contribution)

Next she uses $2,000 to buy a computer (asset). The asset account, computer, increases by $2,000 and cash another asset declines by $2,000. This is an asset exchange transaction and is represented as follows:

Assets = Liabilities +Equity

-2000 (cash) + 2000 (computer) –no change in liabilities or equity

Next she makes $1,000 in the first month. This event increases her cash account (an asset) and her revenue account (equity). This is an asset source transaction. The accounting equation is affected as follows:

Assets = Liabilities +Equity

Assets = liabilities + capital contribution + retained earnings – distributions

Assets = liabilities + capital contribution + prior earnings +revenue – expenses

1000 (cash) = 1000 (revenue) – all other accounts are 0

Lastly she spends $200. This is an asset use transaction which decreases her cash account and increases her expense account as follows:

Assets = Liabilities +Equity

Assets = liabilities + capital contribution + retained earnings – distributions

Assets = liabilities + capital contribution + prior earnings +revenue – expenses

-200 (cash) = -200 (expense) – all other accounts are 0

As a result of these transactions, Lucy’s profit and loss statement and balance sheet look like this:

Profit and loss statement

Balance sheet statement

The profit and loss shows the wealth generated during the period. The revenue and expense elements of the financial statement are represented in the profit and loss statement while the assets, liabilities and equity are represented in the balance sheet. Lucy’s net worth is equal to her equity balance which is $800.

Next we will discuss the cash flow statement and clearly define how to identify each element of the financial statement.