2.6. Financial statements for the first illustration of accrual accounting

The next step is to prepare financial statements.

The income statement looks as follows:

Illustration 8: Income statement for Candely Services for 20X6

The income statement shows changes in equity from all sources other than transactions with owners. Equity is the difference between assets and liabilities, so changes in assets and liabilities other than transactions with owners, represent revenues or expenses. In our example, the increase in assets (i.e., the Account Receivable account) from consulting services was $2,800; the increase in liabilities (i.e., the Salaries Payable account) was $1,500. Therefore, the net assets increase was $1,300 ($2,800 - $1,500).

There is one important point to be remembered. Previously we defined expenses as economic sacrifices from a decrease in assets. Now, from the income statement we can see that expenses can also be recorded with an increase in liabilities. Accordingly:

Expenses can be defined as a decrease in assets or an increase in liabilities that result from operating activities undertaken to generate revenue.

Similarly, revenue can increase by decreasing liabilities.

Revenue is an increase in assets or a decrease in liabilities resulting from the operating activities of an entity.

The statement of changes in equity is presented below:

Illustration 9: Statement of changes in equity for Candely Services for 20X6

The statement of changes in equity provides us with information about the effects of capital acquisitions and distributions (i.e., transactions with owners). In our example, the capital acquisition was $3,500. The statement also provides information about the net income which amounted to $1,300. No distributions to owners took place during 20X6 accounting period. The total equity, therein, is $4,800.

The balance sheet has such a form:

Illustration 10: Balance sheet for Candely Services at 20X6 end

The balance sheet provides information about the entity's assets, liabilities, and equity. In our example we have assets: cash in the amount of $4,500, and accounts receivable of $800; liabilities only include salaries payable amounting to $500; and, finally, equity consisting of contributed capital of $3,500 and retained earnings with a $1,300 balance.

The statement of cash flows follows:

Illustration 11: Statement of cash flows for Candely Services for 20X6

The statement of cash flows explains the movements (inflows and outflows) of cash during an accounting period. Candely Services was established in 20X6. Therefore, the beginning cash balance is zero. Due the cash received for consulting services, the cash account balance increased by $2,000. In the same period $1,000 was spent on operating the business (salary expense). This creates the net cash flow from operating activities of $1,000 ($2,000 - $1,000). In addition, the capital acquisition contributed $3,500 to the cash inflow (financing activities). The combination of these factors explains the $4,500 ($1,000 + $3,500) increase in cash during the 20X6 accounting period.

Observe that the amount of net income ($1,300) reported on the income statement is different from the amount of net cash flows from operations ($1,000) as well as from net change in cash ($4,500). This takes place because of the accrual accounting. Under the accrual accounting, as we stated earlier, cash flows do not go side-by-side with the recognition of revenue and expense.

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