Recording Transactions using

Financial Statement Approach

Service Company Example

The current presentation will cover the basics of recording transactions using the financial statement approach.
The purpose of this approach is to concentrate on how transactions impact the financial statements specifically
the income statement and balance sheet. Although we could include the cash flow statement as well, we will
ignore it here to keep things simple.

The approach displays the financial statements horizontally in order to conserve space. In addition, we will not
keep a running total of the transactions. In fact, we could very well simply record each transaction on a normal
income statement and balance sheet. The only real problem with doing so is that things get a bit messy. You
should, however, keep in mind how each transaction would simply change the financial statements.

This presentation uses Mikes Barbershop as a running example. The important point here is that we have a
service company. This type of company often incurs fairly simple transactions though not always. The next
presentation will cover a retail business with just slightly more complicated transactions. Manufacturing
companies have a few special issues involved that well talk about later.

The lay-out of the presentation is one page for the transaction and the following page showing how the transaction
would be recorded (or, impacts the financial statements).
1. Mike transfers $500 from the shops savings account to its checking account.

Balance Sheet Income Statement

ASSETS = LIABILITIES + EQUITY REVENUE - EXPENSES = NET INCOME
1. Mike transfers $500 from the shops savings account to its checking account.

Balance Sheet Income Statement

ASSETS = LIABILITIES + EQUITY REVENUE - EXPENSES = NET INCOME

+500 Cash

- 500 Savings

Mike has merely switched one asset (savings account) for another asset (cash). Note, for our purposes a checking
account is part of cash.
2. Mike purchases $100 worth of equipment (e.g., scissors, clippers, etc.) for the shop by writing a check.

Balance Sheet Income Statement

ASSETS = LIABILITIES + EQUITY REVENUE - EXPENSES = NET INCOME
2. Mike purchases $100 worth of equipment (e.g., scissors, clippers, etc.) for the shop by writing a check.

Balance Sheet Income Statement

ASSETS = LIABILITIES + EQUITY REVENUE - EXPENSES = NET INCOME
+100
Equipment

-100 Cash

Again, we have merely transformed one asset (cash) into another asset (equipment). It will only be when the
equipment wears out that well recognize an expense. Until the equipment wears out, the scissors, clippers, etc. are
assets for the shop.
3. Mike purchases a blow dryer for the shop. The dryer costs $50. Mike has asked the seller to bill him for the
dryer.

Balance Sheet Income Statement

ASSETS = LIABILITIES + EQUITY REVENUE - EXPENSES = NET INCOME
3. Mike purchases a blow dryer for the shop. The dryer costs $50. Mike has asked the seller to bill him for the
dryer.

Balance Sheet Income Statement

ASSETS = LIABILITIES + EQUITY REVENUE - EXPENSES = NET INCOME
+ 50 Accounts
+50 Equipment Payable

Mike incurred a liability when he asked the seller to bill him for the purchase of the dryer. It is being assumed here
that Mike will pay the bill relatively soon (e.g., within one year) most likely within 30 days. Thus, the liability is
a current liability. A typical account name for such liabilities is accounts payable.
4. Mike receives the bill for the purchase of the dryer and immediately pays it by putting a check in the mail for
the full amount.

Balance Sheet Income Statement

ASSETS = LIABILITIES + EQUITY REVENUE - EXPENSES = NET INCOME
4. Mike receives the bill for the purchase of the dryer and immediately pays it by putting a check in the mail for
the full amount.

Balance Sheet Income Statement

ASSETS = LIABILITIES + EQUITY REVENUE - EXPENSES = NET INCOME
-50 Accounts
-50 Cash Payable
5. Mike provides a $15 haircut to a customer that pays cash.

Balance Sheet Income Statement

ASSETS = LIABILITIES + EQUITY REVENUE - EXPENSES = NET INCOME
5. Mike provides a $15 haircut to a customer that pays cash.

Balance Sheet Income Statement

ASSETS = LIABILITIES + EQUITY REVENUE - EXPENSES = NET INCOME
+15 Retained
+15 Cash Earnings 15 15

We have our first use of the relationship between the income statement and balance sheet. Recall that the equity
portion of the balance sheet contains a running total of profit (or, net income) generated and kept within the
business. The account that does this is the retained earnings. Here, we are merely keeping track of the following
relationship:
Ending Retained Earnings = Beginning Retained Earnings + Net Income Dividends
We see that by providing the services Mike has generated revenue that increased net income and thereby increased
the retained earnings in the equity portion of the balance sheet. The balance sheet is still in balance because assets
(cash) have increased as well. All that this says is that the net income must take a particular form in this case it
the form is cash. Finally, we should note that we might like to match the associated expenses with the hair cut but
in a service company like a barbershop this may not be possible. When we turn out attention to a retail business
well see how this works.
6. Mike provides a $20 haircut to a customer. The customer a loyal and steady one for Mike has asked Mike
to bill him for the haircut.

Balance Sheet Income Statement

ASSETS = LIABILITIES + EQUITY REVENUE - EXPENSES = NET INCOME
6. Mike provides a $20 haircut to a customer. The customer a loyal and steady one for Mike has asked Mike
to bill him for the haircut.

Balance Sheet Income Statement

ASSETS = LIABILITIES + EQUITY REVENUE - EXPENSES = NET INCOME
+20 Accounts +20 Retained
Receivable Earnings 20 20

Notice how similar this transaction is to the customer that paid cash. Even though Mike has not received the cash
for the haircut, we will still recognize that he has in fact earned the revenue. The term accounts receivable
signifies an asset for Mike, which will be turned into cash relatively soon (thus, it is a current asset). It simply
means that someone owes Mike. What will happen when the customer finally pays for the haircut?
7. Mike receives a $20 check from the customer in question 6.

Balance Sheet Income Statement

ASSETS = LIABILITIES + EQUITY REVENUE - EXPENSES = NET INCOME
7. Mike receives a $20 check from the customer in question 6.

Balance Sheet Income Statement

ASSETS = LIABILITIES + EQUITY REVENUE - EXPENSES = NET INCOME

+20 Cash

-20 Accounts
Receivable

The payment means that we merely switch one asset (accounts receivable) for another (cash). Notice, we have
already recognized and recorded the revenue earned by providing the haircut.
8. Mike pays $400 in rent to the owner of his building.

Balance Sheet Income Statement

ASSETS = LIABILITIES + EQUITY REVENUE - EXPENSES = NET INCOME
8. Mike pays $400 in rent to the owner of his building.

Balance Sheet Income Statement

ASSETS = LIABILITIES + EQUITY REVENUE - EXPENSES = NET INCOME
- 400 Retained
-400 Cash Earnings 400 - 400

Again, we are utilizing the relationship between the balance sheet and income statement.

Ending Retained Earnings = Beginning Retained Earnings + Net Income Dividends

In this case, the rent represents an expense for Mike that decreases net income and therefore decreases retained
earnings and, ultimately decreases the equity (or, net worth). Notice also that the balance sheet still balances
because of the decrease in cash.
9. Mike receives his $200 utility bill. However, he does not plan to actually pay this until next month (after he
constructs this periods financial statements).

Balance Sheet Income Statement

ASSETS = LIABILITIES + EQUITY REVENUE - EXPENSES = NET INCOME
9. Mike receives his $200 utility bill. However, he does not plan to actually pay this until next month (after he
constructs this periods financial statements).

Balance Sheet Income Statement

ASSETS = LIABILITIES + EQUITY REVENUE - EXPENSES = NET INCOME
+200 Accounts -200 Retained
Payable Earnings 200 -200

The only difference between this transaction and the payment of rent is that Mike has decided to wait to pay it.
However, if he plans on constructing his financial statement prior to payment, then he will want to recognize the
utilities as an expense on the income statement and to show that he does owe (i.e., liability) the amount.
Otherwise, the net income on the income statement would be overstated by $200 and the balance sheet would not
show the $200 liability.
10. Mike receives a $5,000 small business loan from his bank.

Balance Sheet Income Statement

ASSETS = LIABILITIES + EQUITY REVENUE - EXPENSES = NET INCOME
10. Mike receives a $5,000 small business loan from his bank.

Balance Sheet Income Statement

ASSETS = LIABILITIES + EQUITY REVENUE - EXPENSES = NET INCOME
+5,000 Bank
+5,000 Cash Loan

If the bank loan will last longer than one year, then it will be placed in the non-current liability of the balance sheet,
probably with the label Long Term Debt.
11. Mike makes the first payment of $300 on his bank loan. Of the entire payment, $200 will go towards the
principal of the loan and $100 towards interest on the loan.

Balance Sheet Income Statement

ASSETS = LIABILITIES + EQUITY REVENUE - EXPENSES = NET INCOME
11. Mike makes the first payment of $300 on his bank loan. Of the entire payment, $200 will go towards the
principal of the loan and $100 towards interest on the loan.

Balance Sheet Income Statement

ASSETS = LIABILITIES + EQUITY REVENUE - EXPENSES = NET INCOME
- 200 Bank -100 Retained
-300 Cash Loan Earnings 100 - 100

Since $200 went towards the loan outstanding (originally, $5,000) we will want to bring down the liability by that amount. Thus, we
decrease the Bank Loan by 200 (the balance now is $4,800). The interest portion of the payment represents an expense for Mike.
Thus, this will be put on the income statement and decrease net income. But we know that when we decrease net income, then we are
also decrease equity (specifically, the retained earnings account). Is the balance sheet in balance? YES!!!
12. The $50 blow dryer that Mike purchased way back in question 3 has worn out completely (it is now worthless
with no salvage value at all).

Balance Sheet Income Statement

ASSETS = LIABILITIES + EQUITY REVENUE - EXPENSES = NET INCOME
12. The $50 blow dryer that Mike purchased way back in question 3 has worn out completely (it is now worthless
with no salvage value at all).

Balance Sheet Income Statement

ASSETS = LIABILITIES + EQUITY REVENUE - EXPENSES = NET INCOME
-50 Retained
- 50 Equipment Earnings 50 - 50

Recall, when we purchased the blow dryer we recorded it as an addition to assets, and not as an expense. At the
time, it was something of value for the shop. Now that it has worn out, we recognize the wearing out of the asset
as an expense. We will see that for some assets specifically, those long-lived assets we will show them
wearing out (i.e., depreciating) slowly over time.