Part 1, Lesson 6

Overview



We have now gone through how to create an initial balance sheet, the first month income statement, and the first month cash flow statement.  The next step in the process is to update the John’s Pizzeria balance sheet.  Think of the financial statements as following this formula:

Beginning Balance Sheet + Income Statement/Cash Flow Statement = Ending Balance Sheet

Let’s use the information from our January income statement and cash flow statement to update John’s Pizzeria’s balance sheet from December 31st to January 31st.

Below is a recap of the Dec 31st balance sheet, January income statement, and January cash flow statement:

John’s Pizzeria – Balance Sheet
As of December 31, 2018

Assets   Liabilities  
Cash $150,000 Short-Term Debt $50,000
Inventory $10,000 Accounts Payable $5,000
Supplies $5,000    
Total Short-Term Assets $165,000 Total Short-Term Liabilities $55,000
       
Furniture, Fixtures & Equipment (“FF&E”) $60,000 Long-Term Debt $70,000
Total Long-Term Assets $60,000 Total Long-Term Liabilities $70,000
       
    Total Short and Long-Term Liabilities $125,000
    Shareholders’ Equity  
    John’s Equity $100,000
Total Assets $225,000 Total Liabilities and Equity $225,000

 

John’s Pizzeria – Income Statement
For the Period Ending January 31, 2019

Revenue $16,000
– Cost of Goods Sold ($8,000)
= Gross Profit $8,000
   
– Salary Expense ($4,000)
– Rent Expense ($1,000)
– Electric Utility Expense ($500)
– Supplies Expense ($250)
– Depreciation Expense ($500)
= Operating Profit $1,750
   
– Interest Expense ($1,000)
= Earnings Before Taxes $750
– Income Tax Expense at 40% ($300)
= Net Income $450

 

John’s Pizzeria – Statement of Cash Flows
For the Period Ending January 31, 2019

Cash Flows from Operating Activities  
Net Income (1) $450
Decrease in Inventory (2) $8,000
Increase in Accounts Receivable (3) ($1,000)
Increase in Salaries Payable (4) $2,000
Increase in Prepaid Rent (5) ($1,000)
Increase in Accounts Payable (electric bill) (6) $500
Decrease in Supplies (7) $250
Depreciation and Amortization (8) $500
Increase in Prepaid Interest (9) ($11,000)
Increase in Taxes Payable (10) $300
Total Cash Flows from Operating Activities ($1,000)
   
Cash Flows from Investing Activities  
Capital Expenditures (11) ($500)
Total Cash Flows from Investing Activities ($500)
   
Cash Flows from Financing Activities  
Dividends to Equity Holders (12) ($50)
Total Cash Flows from Investing Activities ($50)
   
Total Change in Cash (13) ($1,550)

Updating the Balance Sheet 


To update the balance sheet, all the information we need is already in the cash flow statement.  If you refer to the cash flow statement, it basically reads as a set of instructions provided for our balance sheet update.  In practice, balance sheets are kept up to date through the ongoing use of the general ledger, which keeps each balance sheet account up to date.  But for this crash course in accounting, we will update the balance sheet in one fell swoop.

We have referenced in red how each balance sheet account is to be adjusted based on the corresponding entries in the cash flow statement. 

John’s Pizzeria – Balance Sheet

Assets Dec 31 Plus: Jan 31 Liabilities Dec 31 Plus: Jan 31
Cash + 13 $150,000 ($1,550) $148,450 Short-Term Debt $50,000   $50,000
Inventory + 2 $10,000 ($8,000) $2,000 Accounts Payable + 6 $5,000 $500 $5,500
Accounts Receivable + 3   $1,000 $1,000 Salaries Payable + 4   $2,000 $2,000
Prepaid Rent + 5   $1,000 $1,000 Taxes Payable + 10   $300 $300
Supplies + 7 $5,000 ($250) $4,750        
Prepaid Interest + 9   $11,000 $11,000        
Total Short-Term Assets $165,000   $168,200 Total Short-Term Liabilities $55,000   $57,800
               
Furniture, Fixtures & Equipment (“FF&E”) + 8 + 11 $60,000 ($500) + $500 $60,000 Long-Term Debt $70,000   $70,000
Total Long-Term Assets $60,000   $60,000 Total Long-Term Liabilities $70,000   $70,000
               
        Total Short and Long-Term Liabilities $125,000   $127,800
        Shareholders’ Equity      
        John’s Equity + 1 + 12 $100,000 $450 – $50 $100,400
Total Assets $225,000   $228,200 Total Liabilities and Equity $225,000   $228,200

Explanations to the changes in each account:

Cash – The new cash balance can simply be pulled from the cash flow statement.  The cash flow statement shows a total reduction in cash of $1,550.

Inventory – John’s Pizzeria sold $8,000 worth of inventory (refer to $8,000 cost of goods sold in the January income statement).  As such, we decrease the inventory balance by this amount.  Any purchases of inventory would increase this asset on the balance sheet.

Account Receivable – Since $1,000 of the January sales is still owed by a customer.  We increase accounts receivable with the expectation that John’s Pizzeria will be paid in the future.  Once payment is received from the customer, we will decrease the accounts receivable balance and increase the cash balance.

Prepaid Rent – Since John paid rent one month in advance, we record this as an asset on the balance sheet.  In February, John will recognize a February rent expense of $1,000 and reduce the prepaid rent asset by $1,000 (instead of reducing cash).

Supplies – John’s Pizzeria recognized $250 in supplies expense in January, so we reduce the supplies asset by a corresponding amount.  Remember – a purchase of supplies does not necessarily count as an expense until these items are consumed.

Prepaid Interest – John’s Pizzeria prepaid 11 months of interest, which has been recorded as prepaid interest with a balance of $11,000.  In February, John will recognize $1,000 of interest expense and reduce the prepaid interest asset by $1,000.

FF&E – John’s Pizzeria had a starting balance of $60,000 for FF&E.  For FF&E, we will always follow this formula: Beginning FF&E + Capital Expenditures – Depreciation = Ending FF&E.  In other words, John’s Pizzeria FF&E will increase by purchases of FF&E (capital expenditures) and will decrease by the amount we “consume” of the FF&E (depreciation).

Accounts Payable – Since John’s Pizzeria owes $500 towards the January electric bill, we will increase accounts payable by $500.  Once John pays the electric bill, we will reduce the accounts payable by $500 and reduce the cash balance as well.

Salaries Payable – John’s Pizzeria has not paid out $2,000 of salaries, so we create a salaries payable liability.  Once John’s Pizzeria pays out this salary, we will reduce the salaries payable balance and reduce the cash balance as well.

Taxes Payable – John’s Pizzeria accrued $300 of income tax liability from January, which it has not paid yet.  Once the taxes are paid, John will reduce the income tax liability and reduce the cash balance as well.

Shareholders’ Equity – Shareholder’s Equity will always follow this formula: Beginning Equity + Net Income – Dividends = Ending Equity.  In other words, John’s Equity increases by how much the company earns (net income) but is reduced by how much of the net income he distributes back to himself (dividends).

If it was tough to follow the changes to each account by running down the balance sheet, let’s review updating the balance sheet by going down the cash flow statement in order:

Item 1 – Net income is an addition to shareholders’ equity (and dividends are a reduction to equity).  We should add the $450 to the John’s Equity account.

Item 2 – The decrease in inventory of $8,000 is taken out of the beginning inventory account of $10,000 to end up at a new total of $2,000.

Item 3 – We need to increase accounts receivable by $1,000 to account for the $1,000 that is owed to the company.  The previous balance of the accounts receivable was $0, so the new total is $1,000.

Item 4 – We need to increase a salaries payable account on the liability side of the balance sheet since John’s Pizzeria still owes $2,000 in salary to its employees.  The new total of the salaries payable liability is $2,000.

Item 5 – By pre-paying rent of $1,000, we will increase a prepaid rent asset of $1,000 on the balance sheet.

Item 6 – In January, we increased the balance of John’s Pizzeria’s accounts payable liability by $500.  Adding this to the existing balance of $5,000 in accounts payable yields an updated balance of $5,500 in accounts payable.

Item 7 – John’s Pizzeria consumed $250 of supplies in January, so we decrease the supply asset by $250, resulting in an updated balance of $4,750 in supplies.

Item 8 – Depreciation is a reduction in FF&E, so we will reduce the FF&E asset account by the $500 depreciation expense.  Remember, we will also add the capital expenditure amount of $500 as an increase in FF&E to represent the new purchase of FF&E (item 11).

Item 9 – Since John’s Pizzeria prepaid 11 months of interest, we are increasing the prepaid interest asset by $11,000.

Item 10 – John’s Pizzeria has not paid the $300 in tax expense, so we increase the taxes payable liability account by $300.

Item 11 – Capital expenditures are always accounted for as increases to the FF&E asset account.  Beginning FF&E + Capital Expenditures – Depreciation = Ending FF&E.

Item 12 – The dividend payment of $50 is accounted for as a reduction in the John’s Equity account.  Beginning Equity + Net Income – Dividends = Ending Equity.

Item 13 – The final item is to update the cash account (which is the addition of items 1-12).  The cash account has gone down by $1,550 in January, yielding an updated balance of $148,450.

And there we have it.  Our balance sheet has now been updated for January 31st:

John’s Pizzeria – Balance Sheet
As of January 31, 2019

Assets   Liabilities  
Cash $148,450 Short-Term Debt $50,000
Inventory $2,000 Accounts Payable $5,500
Accounts Receivable $1,000 Salaries Payable $2,000
Prepaid Rent $1,000 Taxes Payable $300
Supplies $4,750    
Prepaid Interest $11,000    
Total Short-Term Assets $168,200 Total Short-Term Liabilities $57,800
       
Furniture, Fixtures & Equipment (“FF&E”) $60,000 Long-Term Debt $70,000
Total Long-Term Assets $60,000 Total Long-Term Liabilities $70,000
       
    Total Short and Long-Term Liabilities $127,800
    Shareholders’ Equity  
    John’s Equity $100,400
Total Assets $228,200 Total Liabilities and Equity $228,200