The financial statements are based on the accounting equation, i.e. assets = liabilities + equity. Every transaction has a debit and a credit, which keep the accounts balanced. For example: James buys a tablet for $645. He borrowed $300 from a relative and spent another $345 earned from a part-time job. Now his assets are worth $645, liabilities are $300, and equity $345. This transaction affects only the balance sheet.
Sandra asks James to do some research on his tablet for which James charges $50 an hour. The tasks takes 3 hours. Sandra promptly pays James. He debits cash for $150 and credits revenues for the same amount. Assuming the James’ tablet is for business, he needs to depreciate it. Let’s assume that the tablet is expected to last for 3 years, so $645/36 months equals $18. After one month and no other transactions, James has the following income statement and balance sheet.
James’ Consulting James’ Consulting
Income Statement Balance Sheet
Revenues $150 Assets
Expenses: Cash $150
Depreciation $18 Tablet (net of depreciation) 627
Total Expenses 18 Total Assets $777
Net Income $132
Short-Term Loan $300
Total Liabilities $300
Total Liabilities and Equity $777
The above financial statements are very simple, but are meant to illustrate the basic idea. The income statment is temporary in nature and closed out to equity at the end of the period. Balance sheet accounts are permanent, which means that they are continually updated.