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Taking Nine Example Transactions through the Accounting Cycle
Accounting Cycle Step 1 – Transactions
What we’ll do now is start up a business (we’ll focus on the commercial side in this illustration)
and take its first 9 transactions through the entire Accounting Cycle. We’ll be selling jeans retail to
the public, and the name of our business will be “Jeans for Beans.” These are the transactions we
will work with.
1. Contribute $50,000 of our own personal money to our new business (note: Accounting treats
our business as completely and totally separate from our personal lives; therefore this
example deals only with the new business we’re starting and will not deal with any record
keeping for our personal affairs).
2. Borrow $50,000 cash from our bank and sign a Note Payable to the bank. The note will be
amortized (paid off) over 60 months, and the bank is charging 8.5% interest on it.
3. Purchase a building for $20,000. . . cash.
4. Purchase our first load of inventory for $10,000 (cost price to us). We will pay our supplier
$6,000 in cash and agree to pay her the remaining $4,000 next month.
5. Record our first month’s sales of $11,000 (retail price to our customers). Of the $11,000, we
took in $7,000 in cash and set up customer accounts for the various customers who
collectively owe us the remaining $4,000 (note: this $4,000 has nothing to do with the $4,000
in transaction #4; they are separate and unrelated amounts).
6. Pay our one sales person his wages of $500 for the month, in cash.
7. Take physical inventory at the end of the month and find that $6,000 (cost price to us) of
jeans is still in inventory. This represents jeans that are both on the sales floor and in our
stock room.
8. Measure and record depreciation related to our building.
9. At the end of the month, make our first payment on the note that we owe to the bank.
Let’s take each transaction one by one.
Accounting Cycle Step 2 – Journal Entries
Now, we’re ready to take our 9 transactions to the next step of the Accounting Cycle, which is to
record them in the General Journal. Remember, this is the first place where we translate the
transaction into its Debit and Credit components.
1. Contribute $50,000 of our own personal money to our new business. As far as the business
is concerned, what’s happening here? There is $50,000 worth of cash coming into it from the
owner. An asset is being increased, and the claim against it belongs to the owner. So:
Debit
Cash
Credit
$50,000
Contributed Capital
$50,000
2. Borrow $50,000 cash from our bank and sign a Note Payable. What’s happening here? As
with the first transaction, there is $50,000 worth of cash coming into the business, but this
time it is the bank who has the claim against it. An asset is being increased, but the claim
against it belongs to the bank. So:
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Debit
Cash
Credit
$50,000
Notes Payable
$50,000
3. Purchase a building for $20,000. . . cash. What’s happening here? This one is interesting
because we need to understand that not only are we buying the building, we are also buying
the land that it sits on. So, we must allocate some portion of the $20,000 purchase price to
the land. Now, probably the best way to approach this would be to call a real estate appraiser
and have him/her provide you with a professional opinion. Another approach could be just to
use your best judgment. The point here is that, within a range of acceptable approaches, we
could get different answers. In Accounting, that’s OK. On the other hand, it introduces to us
the notion that Accounting is not always precise. Many times the information that is reported
on the financial statements comes from estimates and judgments. In a case like this, there is
no single right answer but a range of acceptable ones. So, let’s say our appraiser tells us that
a fair amount for the land is $5,000. That means that the remaining $15,000 is allocated to
the building. Our Land account needs to be increased by $5,000; our Building account needs
to be increased by $15,000; and our Cash account needs to be decreased by $20,000. So:
Debit
Land
Building
Credit
$5,000
$15,000
Cash
$20,000
4. Purchase our first load of inventory for $10,000 (cost price to us); $6,000 in cash; pay $4,000
next month. What’s happening here? This transaction is also interesting. We’re buying our
first load of inventory. The wholesale (cost) price to us is $10,000. Our arrangement with our
supplier is to pay her $6,000 of the total invoice now and the remaining $4,000 later. Our
Inventory account should be increased; our Cash account should be decreased; and we need
to reflect an Account Payable to our supplier. So:
Debit
Inventory
Accounts Payable
Cash
Credit
$10,000
$4,000
$6,000
5. Record our first month’s sales of $11,000 (retail price to our customers), $7,000 in cash,
collect $4,000 from our customers next month. What’s happening here? We earned $11,000
worth of sales in our first month. Some of what we earned – $7,000 – we collected in cash.
The remainder – $4,000 – is still outstanding in the form of Accounts Receivable from our
customers. Even though we have not received this $4,000 yet, the rules of Accounting allow
us to go ahead and count it as Sales now because we passed the critical test, which was to
convince our customers to enter into exchange transactions with us. We achieved a legal
meeting of the minds with them. The laws of commerce will enforce our right to collect from
our customers because we have a contract. To record this series of transactions, we will
need to increase the Cash account and the Accounts Receivable account, and we will also
need to increase the Sales account. So:
Debit
Cash
Accounts Receivable
Sales
Credit
$7,000
$4,000
$11,000
6. Pay our one sales person his wages of $500 for the month, in cash. What’s happening here?
We have a worker who helps us mind our store. He works part time a few evenings a week.
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For purposes of this explanation, we will ignore payroll taxes in order to simplify the example.
We’re paying our worker in cash. So:
Debit
Wages Expense
Cash
Credit
$500
$500
7. Take physical inventory at the end of the month; $6,000 (cost price to us). What’s happening
here? At the end of each month, we need to determine the cost (our cost) of the jeans that
we sold to our customers. We also need to get a firm fix on our inventory. Why? To get
valuable management information. This requires an analysis of the Inventory account. Any
account can be analyzed as follows:
+
–
=
Beginning balance
Additions
Subtractions
Ending Balance
When we do this analysis on our Inventory account, we see:
+
–
=
Beginning balance
$0
Additions (Purchases for month) $10,000
Subtractions (Sold for month)
$?,???
Ending Balance
$6,000
The trick, then, is to “tickle out” the mystery number, which in this case is not hard to do.
Obviously, the subtraction number that makes the analysis work is $4,000. Just to be sure,
let’s recap it:
+
–
=
Beginning balance
$0
Additions (Purchases for month) $10,000
Subtractions (Sold for month)
$4,000
Ending Balance
$6,000
We know that somehow we’ll have to do an entry that brings the Inventory account balance
from $10,000 (which was what it was after our purchase in transaction #4) down to $6,000
(what it needs to be to reflect our physical inventory that we’ve just taken. We’ll need to
decrease the Inventory account balance and reflect that against Cost of Goods Sold. So:
Debit
Cost of Goods Sold
Inventory
Credit
$4,000
$4,000
8. Measure and record depreciation related to our building. What’s happening here?
Accounting’s use of Depreciation is different than what most people are used to. In
Accounting, Depreciation is merely a mathematical process to parcel out the cost of a
depreciable asset, over its useful life, onto the Income Statement. It is a process of allocation,
not valuation. In Accounting, Depreciation does not try to make a judgment about Fair Market
Value, Salvage Value, Trade-In Value, “Blue Book” Value, or the like. Most long-lived assets
are depreciable, except for one. In Accounting, Land is not depreciable, by definition, in most
cases. That’s because Land has no moving parts and is not therefore a “wasting asset.” The
reason the Depreciation process is so important in Accounting is that it tries to achieve an
honest measurement of the period-to-period cost of the usefulness of a long-lived asset over
its useful life. To charge its entire cost to expense in the first period it is put to use would be
grossly unfair, and GAAP does not permit such a practice.
Now the question becomes, what is the useful life of our building? Here is another example of
where judgment comes into play. Estimates on a building’s useful life could range anywhere
from 5 years to 50 years, or even more. Further, the estimates have a measurement impact
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on the period-to-period (monthly, quarterly, annual) Income Statements, although no matter
what useful life we estimate, we cannot over the years Depreciate more than the asset’s cost.
For this example, we will estimate a useful life of 40 years for our building. Our monthly
Depreciation amount will be computed as follows:
÷
=
÷
=
Cost allocated to Building
Useful life in years
Annual Depreciation
12 Months per year
Monthly Depreciation
$15,000
40
$375
12
$31.25
For purposes of this example, we’ll round our answer to $30 per month. The monthly
Depreciation entry has a prescribed form. We will increase the Depreciation Expense account
and the Accumulated Depreciation account. So:
Debit
Credit
Depreciation Expense
$30
Accumulated Depreciation
$30
9. At the end of the month, make our first Note payment. What’s happening here? It’s time we
make our first payment on the $50,000 note we signed with the bank in transaction #2. We
are to pay it off (amortize it - literally “kill” it) in 60 months (5 years), and pay the bank 8.25%
interest on the outstanding balance. The first thing we have to do is determine the exact
amount of our monthly payment, keeping in mind that each payment has two components: (1)
interest and (2) principal. With the aid of a financial calculator (such as an HP-12C or a TIBAII) all we have to do is key in 3 of 4 known amounts, and the calculator will solve for the 4 th
amount. Without going into all of the detail, here is the information we keyed in:
Present Value (PV)
$50,000
Amortization Period (n) in months
60
Annual Interest Rate (I)
8.25%
And here is the answer the financial calculator figured for us:
Monthly payment
$1,025.83
The next thing to do is to construct an amortization table so that we can easily look up the
interest and principal components of each of our 60 monthly payments. This will make our
monthly entries much easier to do. It is shown on the next page.
As we can see, the interest component of each succeeding payment decreases while the
principal component increases. This is because, with each payment, some of the principal is
being repaid, and therefore a month’s worth of interest (or rent on borrowed money) is being
computed on an ever-decreasing outstanding balance. The interest component for the first
month is computed:
X
=
Outstanding balance
$50,000
Monthly interest rate (.085 ÷ 12)
.0071
1st Month’s interest component $354.17
The principal component is then simply the $1,025.83 payment amount less the $354.17
interest component.
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Amount financed
Interest rate
Amortization period (in years)
Amortization period (in months)
Required monthly payment
Pmt #
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
Payment
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
$1,025.83
Interest
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
354.17
349.41
344.62
339.79
334.93
330.04
325.11
320.15
315.15
310.11
305.05
299.94
294.80
289.62
284.41
279.15
273.86
268.54
263.17
257.77
252.33
246.85
241.33
235.78
230.18
224.55
218.87
213.15
207.40
201.60
195.76
189.88
183.96
178.00
171.99
165.94
159.85
153.72
147.54
141.32
135.06
128.75
122.39
115.99
109.55
103.06
96.52
89.94
83.31
76.63
69.91
63.14
56.32
49.45
42.54
35.57
28.56
21.49
14.38
7.22
$ 50,000.00
8.50%
5
60
$1,025.83
Principal
$ 671.66
$ 676.42
$ 681.21
$ 686.03
$ 690.89
$ 695.79
$ 700.72
$ 705.68
$ 710.68
$ 715.71
$ 720.78
$ 725.89
$ 731.03
$ 736.21
$ 741.42
$ 746.67
$ 751.96
$ 757.29
$ 762.65
$ 768.05
$ 773.50
$ 778.97
$ 784.49
$ 790.05
$ 795.64
$ 801.28
$ 806.96
$ 812.67
$ 818.43
$ 824.23
$ 830.06
$ 835.94
$ 841.87
$ 847.83
$ 853.83
$ 859.88
$ 865.97
$ 872.11
$ 878.28
$ 884.51
$ 890.77
$ 897.08
$ 903.43
$ 909.83
$ 916.28
$ 922.77
$ 929.30
$ 935.89
$ 942.52
$ 949.19
$ 955.92
$ 962.69
$ 969.51
$ 976.37
$ 983.29
$ 990.25
$ 997.27
$ 1,004.33
$ 1,011.45
$ 1,018.61
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
Balance
50,000.00
49,328.34
48,651.92
47,970.71
47,284.68
46,593.79
45,898.00
45,197.28
44,491.60
43,780.93
43,065.21
42,344.43
41,618.55
40,887.52
40,151.31
39,409.89
38,663.22
37,911.25
37,153.97
36,391.31
35,623.26
34,849.76
34,070.79
33,286.30
32,496.25
31,700.60
30,899.32
30,092.37
29,279.70
28,461.27
27,637.04
26,806.98
25,971.03
25,129.17
24,281.34
23,427.51
22,567.62
21,701.65
20,829.54
19,951.26
19,066.76
18,175.99
17,278.91
16,375.47
15,465.64
14,549.36
13,626.59
12,697.29
11,761.40
10,818.88
9,869.69
8,913.77
7,951.08
6,981.58
6,005.20
5,021.91
4,031.66
3,034.39
2,030.06
1,018.61
0.00
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The entry will reflect an increase to our Interest Expense account, a decrease to our Notes
Payable account, and a decrease to our Cash account. For purpose of the example, we will
round the dollar amounts. So:
Debit
Notes Payable
Interest Expense
Cash
Credit
$672
$354
$1,026
Let’s summarize our Journal Entries so that we can see them all in one place, much like we would in a
real Journal.
Notice the column headings that are in our Journal. Notice particularly the two “Ref” columns. The
Journal Reference merely provides a sequential numbering of the entries that are made in the
Journal. The Source Reference provides a trail back to the specific source document in our files
which evidences a that the transaction actually took place. . . in the nature and in the amount
recorded in the Journal. Also notice the Account Numbers. Each Account in our General Ledger
is given its own unique number. This numbering precaution is taken because some account
names can be very similar. So, an added measure of uniqueness is required. In practice,
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numbers for Asset accounts usually begin with “1,” Liability accounts with “2,” Owners Equity
accounts with “3,” Revenue accounts with “4,” and Expense accounts with “5” through “9.”
This completes the Journalizing step of the Accounting Cycle.
Accounting Cycle Step 3 – Posting to the General Ledger
Now we need to go on to the third step, which is to post the entries to our General Ledger (GL).
The postings are reflected in the exhibits that follow. Please DO take the time to trace each line of
each journal entry above to its respective account posting.
The exhibits that follow represent mini-pictures of each account. A real GL however is a book.
Each page of the book is an account. So, the first page of the GL is our Cash account, and the
last page is our Depreciation Expense account. The pages in between are our other accounts. So
the exhibits below are not exactly how a GL looks in real life. Please keep this in mind. The first
page following this one shows the Balance Sheet accounts (that is, Cash through Retained
Earnings); the second page shows the Income Statement accounts (that is, Sales through
Depreciation Expense).
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From the above exhibits, we should get a feel for what a GL looks like and what entries in GL
accounts look like. Notice the column headings in the accounts. The Source Journal column tells
us which Journal the entry came from. The only journal that we have used here is the General
Journal, therefore our only Source Journal reference here will be “GJ.” There are several other
journals though, that are beyond the scope of this discussion. We’ll just list them here: Sales
Journal, Cash Receipts Journal, Purchases Journal, and Cash Disbursements Journal. The
purpose of these journals is to make the journalizing process more efficient and less prone to
error. Do you have to have all these journals? No. Use any or all of them only if you find it helpful.
You can always use a General Journal; there is never a case where a General Journal entry
won’t serve your purpose.
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Accounting Cycle Step 4 – Run A Trial Balance
The fourth step of the Accounting Cycle is to “run” a Trial Balance (T/B). Run is just a shortcut for
“prepare.” We run our T/B by listing each account down the left side of the page and then
“plucking” information from each GL account, in the manner shown below.
The two main reasons for running a T/B are to make sure that total Debit balances equal total
Credit balances, and to scan each account’s balance for reasonableness and agreement with our
expectations and understanding of our business. We must investigate any out-of-balance or
unexpected situation before we prepare our financial statements.
The text boxes at left are teaching aids here to point out the Balance Sheet and the Income
Statement accounts. In truth, even the Income Statement accounts are Balance Sheet accounts
because they enable the entire Trial Balance – as well as the Balance Sheet – to balance. The
Income Statement accounts are really a subset of the Retained Earnings account. We are not
allowed to post our daily revenue and expense transactions to Retained Earnings because to do
so would bury valuable management information within a single account.
Notice that total debits and credits balance. Below the totals line there is a special totaling of the
Income Statement accounts and a calculation of Net Income ($6,116), which is the difference of
$11,000 in total revenues less $4,884 in total expenses.
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Accounting Cycle Step 4A – Adjustments (Adjusting Journal Entries) – Accruals and Deferrals
Somewhere in the process of Step 4 – when we “run” the Trial Balance – we’ll need to deal with
adjustments.
Adjustments are accounting measurements that must be recorded and reported so that our
financials are fairly stated, in accordance with GAAP. In this process we make decisions about
“closing the books.” In a later chapter, we discuss closing in more detail. For now, however,
closing involves deciding what should be reported in this month’s financials versus next month’s.
Usually, as we get to the step of running the Trial Balance, we have – or will - become aware of
transactions or measurements that must be dealt with, either in the current month or in the next,
or perhaps even later. Much of the time, we will already know about them…but there are times
when things will pop up and surprise us.
Example: You’re ready to prepare the financials when your assistant brings you the electric bill for
the month (it came late in the mail and has not been dealt with yet). You know that, in accordance
with GAAP, you should run this transaction through this month’s accounting cycle and report its
effect on this month’s financials. So, you have no choice but to delay the preparation of the
financials until you can journalize and post this bill. (But…what if you’d already prepared and
distributed the financials to your bosses? Do you pull them back, correct, and reissue? Again, we
will discuss this in a later chapter.)
We label this particular phase of the Accounting Cycle as “Adjustments,” or “Adjusting Journal
Entries,” or “AJEs.” Occasionally, Adjustments may deal with corrections to transactions that were
previously handled incorrectly. But, for the most part Adjustments deal with Accruals and
Deferrals. So…we need to talk about them.
GAAP declares that it is the earning of revenue and the incurring of expenses that govern when
they are to be “booked” (that is, run through the Accounting Cycle). When the cash changes
hands is NOT the determining factor.
If the cash exchange is at a point in time other than the earning or the incurring, then that will give
rise either to a Deferral or an Accrual. On the next page is a diagram that may help us understand
which is which.
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Extremely important point: Our reference point here is the time when we earned the revenue or
incurred the expense. Obviously, if the cash changes hands (settlement or payment) at the same
time, then there is no deferral or accrual involved.
If payment occurs before the earning or incurring, it sets up a deferral situation.
Debit
Cash
Credit
$XXX
Unearned Revenue
$XXX
-- or -Debit
Prepaid Expense
Cash
Credit
$XXX
$XXX
“Unearned Revenue” is a Liability type account, while “Prepaid Expense” is an Asset type
account. Later, when the earning or incurring takes place (catches up), we need to make the
following respective entries:
Debit
Unearned Revenue
Revenue
Credit
$XXX
$XXX
-- or -Debit
Expense
Prepaid Expense
Credit
$XXX
$XXX
If payment occurs after the earning or incurring, it sets up an accrual situation.
Debit
Accounts Receivable
Revenue
Credit
$XXX
$XXX
-- or -Debit
Credit
Expense
$XXX
Accrued Expenses Payable
$XXX
“Accounts Receivable” is an Asset type account, while “Accrued Expenses Payable is a Liability
type account (another account that could have been affected is “Accounts Payable”). Later, when
settlement takes place, we need to make the following respective entries:
Debit
Cash
$XXX
Accounts Receivable
-- or --
Credit
$XXX
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Debit
Accrued Expenses Payable
Cash
Credit
$XXX
$XXX
Back to our example: To book the electric bill so that it is correctly reflected in this month’s
financials, we’ll make the following Journal Entry.
Debit
Credit
Utilities Expense
$XXX
Accrued Expenses Payable
$XXX
Later, when we prepare the check and send it to the electric company (settle the bill), we’ll make
the following Journal Entry.
Debit
Accrued Expenses Payable
Cash
Credit
$XXX
$XXX
Either way, we’ll have to deal with them. In fact, as your accounting staff gets more experienced
with the monthly reporting tasks,
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Accounting Cycle Step 5 – Prepare the Financials
In the fifth step of the Accounting Cycle we prepare the financial statements. Our shortcut term is
“the Financials.” A key point is that all amounts on the financials come from the T/B. So, please
make that observation as we discuss each of them. We’ll start with the Balance Sheet.
All amounts on the Balance Sheet come from the T/B. Notice that we show the Net Income
amount of $6,116 as “Retained Earnings.” This is consistent with our discussion above that the
Income Statement accounts really make up a subset of the Retained Earnings account. Even
though we have not yet “closed” (we’ll discuss the Closing Entry in detail later) the Income
Statement accounts to Retained Earnings yet, we show it this way for presentation purposes only
on the Balance Sheet.
Notice that the $30 Accumulated Depreciation credit balance is shown as a subtraction number
up in the Asset portion of the Balance Sheet. This reinforces our previous discussion that it is a
contra-account, whose balance goes “against” the debit balance of the related Building account.
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Now let’s go to the Income Statement.
Here we see the $6,116 net income number again. The fact that net income appears here as well
as on the Balance Sheet, wrapped into Retained Earnings, gives rise to the notion of
“Articulation.”
In Accounting, we use the term “Articulation” to describe the connection between financial
statements. In medicine a fully articulated skeleton is one that is put together and resembles a
person but without the flesh and organs. It is fully connected. In Accounting, articulation is similar.
The articulation between the Income Statement and the Balance Sheet happens through the Net
Income amount. That amount is needed in both statements. And, again, it reinforces the fact that
the Income Statement accounts are merely subsets of the Retained Earnings account (or the Net
Assets account in the case of NPOs).
The percentages provide additional management information. Each percentage above is based
upon the Sales amount of $11,000. So, for example, our Cost of Goods Sold of $4,000
represents 36.36% of $11,000. This particular usage of percentages on the Income Statement is
common and helps us get a feeling for the productiveness of our sales dollar. The Income
Statement above demonstrates that every sales dollar we earn produces 55.6¢ in net income. We
can compare this against how other retail jeans stores in the industry are doing to tell whether our
management of our store measures up.
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Now let’s look at the Statement of Changes in Owners Equity.
This is a minor statement, but one that is required by Generally Accepted Accounting Principles
(GAAP) nonetheless. The purpose of this statement is to show ALL the changes in owners equity,
including those not driven by net income (or net loss if that is the case). So, in our statement
above, not only do we see the net income amount again, but we also see the $50,000 capital
contribution that we made to start up the store.
A major use of this statement is to compare how much of our equity growth is being fueled by net
income through our customers and suppliers, versus how much we are having to put in from our
own personal pockets. Since this is only our first month in operation, we need not be too
concerned that our equity came mainly from our capital contribution. However, as time goes on
we will want to see that our growth in ownership is being provided by net income via the daily
business we do with our customers and suppliers.
For NPOs, there is no separate statement like this. For NPOs, there is no distinction between
Contributed Capital and Retained Earnings, mainly because there is no ownership asserted by
private individuals in search of increased wealth. There is only the Net Assets account.
Accordingly, NPOs do not need to prepare this separate statement. For NPOs, GAAP requires
only a Balance Sheet, an Income Statement (called the Statement of Activity), and a Statement of
Cash Flows.
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Finally, let’s look at the Cash Flow Statement.
Once again, we see the familiar net income amount of $6,116, which is further evidence of
articulation. This statement contains three sections:
1. Cash Flows from Operating Activities
2. Cash Flows from Investing Activities
3. Cash Flows from Financing Activities
Later, we will discuss the “trick” behind how this statement is constructed.
Looking back at our T/B, we see that our Cash account balance went from $0 to $79,474 in
March. This statement shows how that happened.
A more important purpose is to help us compare our Net Income with our Cash Flow from
Operating Activities. For March, we made net income of $6,116, but we generated only $146 in
cash from our operating activities. Usually, there are two main reasons for a situation like this.
First, some of our net income is “locked” in Accounts Receivable (see our transaction #5) and will be
“released” once we collect on those accounts. Second, we have cash “locked” in Inventory (see our
transaction #4), suspended as an asset on the Balance Sheet, and that cash usage won’t be
reflected on the Income Statement until we sell that inventory (see our transactions #5 and #7).
The statement also reflects the cash we either generated or used in our investments, as well as
the cash we either generated of used in our efforts to finance the start-up and operation of our
business.