Lin sees that a small company has earned $40, but its bank balance has not increased at all. She suspects a reporting error. Later, the customer pays $80, yet the company does not report another $80 of profit. Which entry went wrong?
Both can be correct. Profit records business results under the applicable accounting rules; cash records when money moves. The balance sheet captures the changes between them. Following one sale through two small tables will help you understand that connection before opening a real annual report.
What you will be able to do
- Explain why a credit sale and its cost can affect profit before cash arrives.
- Check simple changes using assets equal liabilities plus equity, distinguishing balances at a date from flows over a period.
- Give a reported number its unit, scope, period, and statement location, and distinguish company totals from per-share amounts.
Take a picture of the store before the sale
Lin'an Store and all its figures are independent synthetic teaching inputs, unrelated to Costco or earlier fictional companies. Amounts are in U.S. dollars. The store has one class of common shares. Ignore taxes, interest, rent, depreciation, returns, bad debts, and other transactions. This simplified model illustrates relationships rather than a complete set of accounting standards.
At the starting date, the store has $100 cash and $60 of merchandise inventory, giving assets of $160. It owes $40 and has book equity of $120. Assets are economic resources the company owns or controls; liabilities are obligations; book equity is the remainder after liabilities are deducted from assets. [1]
The starting picture balances: $160 equals $40 plus $120. That $120 is not profit earned today, and it is not cash immediately available for shareholders to withdraw. Only $100 of the assets is cash. Another $60 remains tied to goods awaiting sale.
A balance sheet describes a position at a particular date. Revenue, expenses, and profit describe activity over a period. Adding a year's sales to year-end inventory would mix a flow and a balance without producing a meaningful total asset figure. Ask what kind of number you are reading before combining it with another.
The goods leave before the customer pays
During the first observation period, the store sells all its inventory for $100 on credit. The customer will pay later. Assume the goods have been delivered, the exercise's revenue-recognition conditions are met, and collection is expected. Signing an order alone is not our condition for recognizing the sale.
Revenue is $100 and the cost of the goods sold is $60. With no other expenses in this model, profit is $40. Cash remains $100 because nothing has been collected. Instead, the store records a $100 account receivable: its right to collect from the customer.
The $60 inventory leaves the asset side, while the $100 receivable enters it. Assets increase by a net $40. Liabilities stay unchanged. Profit remains in the company, so equity also increases by $40. Check the resulting balances rather than assuming that a sale must increase every asset account.
| Credit sale and recognition of cost | Before | Change | After |
|---|---|---|---|
| Cash | $100 | $0 | $100 |
| Accounts receivable | $0 | +$100 | $100 |
| Inventory | $60 | −$60 | $0 |
| Total assets | $160 | +$40 | $200 |
| Liabilities | $40 | $0 | $40 |
| Equity | $120 | +$40 | $160 |
After the sale, $200 of assets equals $40 of liabilities plus $160 of equity. An unchanged bank balance does not prevent a completed sale from producing accounting profit. The asset representing the customer's obligation must be included, while still being kept distinct from cash already received.
The $60 cost is not a new $60 payment from the bank during this observation. The inventory was already present at the starting date. Selling it moves its recorded cost into the period's expenses. Subtracting another $60 from current-period cash would invent a payment the exercise never supplied.
Collection changes the asset, not the sale
In the next observation period, the customer pays $80 and still owes $20. Nothing else changes. Cash rises from $100 to $180 and receivables fall from $100 to $20. Assets have changed form, but their total remains $200.
| Later collection | Before | Change | After |
|---|---|---|---|
| Cash | $100 | +$80 | $180 |
| Accounts receivable | $100 | −$80 | $20 |
| Inventory | $0 | $0 | $0 |
| Total assets | $200 | $0 | $200 |
| Liabilities | $40 | $0 | $40 |
| Equity | $160 | $0 | $160 |
Collection creates no second sale. It adds neither $80 revenue nor $80 profit. The first period's profit was $40; this second period adds no profit in the model. Across both, cumulative profit remains $40 while cash is $80 above its starting balance. Each change has an explanation, and they need not be equal.
This is one difference between accrual accounting and cash receipts. Real statements also contain prepayments, advance receipts, depreciation, and many other accounts. You will build a cash-flow bridge in the next chapter. First, make sure this transaction balances without requiring those additional complications.
If the remaining $20 later becomes doubtful, the receivable needs reassessment under the applicable accounting policy. Recognizing revenue does not eliminate collection risk. We have not added that subsequent event here, so the tables do not establish that every receivable will eventually become cash.
More equity does not necessarily mean more profit
In this closed model, equity increases from $120 to $160 entirely because of the $40 profit. Other equity transactions were excluded. A real company's equity can also change through owner contributions, dividends, repurchases, and other items.
An increase of $40 might therefore reflect $40 of profit or a $40 contribution from shareholders. Equity could even rise during a loss-making period if new contributions were larger than the loss. The difference between opening and closing equity alone cannot identify the period's earnings.
The statement of equity tracks these changes. Retained earnings generally accumulate profits not transferred through relevant distributions and other changes, but they are not a separate container of cash. Resources may already have become inventory, equipment, or other assets. Reading a retained-earnings balance does not tell you the amount waiting in a bank account.
Comprehensive income and other comprehensive income identify further differences between net income and changes in equity. For this introduction, locate the related statements and notes and recognize that the distinction exists. Detailed classification and adjustments are outside the required task.
Book equity also differs from the market capitalization of common shares. Accounting records determine one; share counts and market prices determine the other. Positive equity does not guarantee a safe investment or specify a fair share price. That judgment also requires an assessment of future results, risk, and the purchase price.
Find the statements in a real filing
For the book's C1-R retrospective reading, use Costco's 10-K for the fiscal year ended August 31, 2025. It concerns the same company as C1-A but is a later document, not part of the original frozen information sets. It is not described here as the latest report. [2]
Item 8 lists the statements and notes. Its printed page 37 contains the income statement, with amounts in millions except per-share data. Page 39 gives balance sheets at August 31, 2025 and September 1, 2024. A year's revenue is not revenue earned on the balance-sheet date.
The equity statement is on printed page 40, the cash-flow statement on page 41, and the notes begin on page 42. Check every column's heading; the period statements cover multiple fiscal years. The task is to identify a number's meaning and location rather than memorize a row of company figures.
“Consolidated” refers to the group reporting scope. Check which entities are included and whether that scope changes. A subsidiary's revenue should not casually be divided by the entire group's equity. Notes provide policies, account composition, and judgments needed to understand the statements; they are part of the reading task.
The store's recognition assumptions do not replace Costco's actual policies. For merchandise revenue, deferred membership fees, and other items, return to the relevant note. A teaching example helps you understand the relationship without promising an identical account in the real filing.
A correct number can still have the wrong unit
Copying a total stated in millions as though it were single dollars introduces a million-fold error. Per-share amounts can use a different unit on the same page. Preserve the heading with the number, rather than expecting its size to reveal its unit later.
Now give Lin'an another explicit condition: it has exactly ten common shares throughout the entire observation period, with no preferred shares or potential dilution. Its $40 profit gives simplified earnings per share of $4. The fixed count makes that division possible; it does not establish a rule of dividing real annual income by year-end shares.
Actual basic earnings per share generally uses income attributable to common shareholders and a weighted-average share count for the period. Diluted earnings per share considers qualifying potential shares as well. Distinguish totals from per-share amounts first. When the two reported EPS figures differ, inspect their definitions instead of assuming one is an error.
A fiscal-year label also needs dates. Two companies reporting “2025” may use different year ends, week counts, and business scopes. One company's periods can change too. A tidy spreadsheet is not evidence that the inputs are comparable.
Balance the two sides yourself
Explain how the first period can produce $40 profit without collection while the balance sheet still balances. Then find the error in recording the second period's $80 receipt as revenue and reporting cumulative profit of $120. Write the correct cumulative profit and ending cash before reading on.
Reference answers · reveal
Answer points: Receivables increase $100 and inventory decreases $60, a $40 net asset increase. Retaining profit increases equity by $40, so $200 equals $40 plus $160. The receipt was part of the sale already recognized; recording it as revenue again duplicates it. Cumulative profit is $40, cash is $180, and the remaining receivable is $20.
Try another store
A separate store begins with cash of $50, inventory of $30, liabilities of $20, and equity of $60. It sells all the merchandise on credit for $60 under the exercise's recognition conditions, with no other expenses or transactions. Later the customer pays the full $60. State assets, liabilities, equity, and profit after the sale and after collection. Does collection generate another profit? Calculate before checking the answer.
Reference answers · reveal
Answer points: After the sale, cash is $50, receivables $60, and inventory zero: assets are $110. Liabilities remain $20, equity becomes $90, and profit is $30. Collection changes cash to $110 and receivables to zero. Assets remain $110, liabilities $20, and equity $90. It adds no profit, leaving cumulative profit of $30. Check the intermediate receivable rather than only the final cash.
Then choose one total and one per-share figure in Costco's original statements. For each, record issuer, period or date, currency, unit, reporting scope, and location. Mark uncertainty for checking. Do not put the fictional store's figures in a real-company field.
Save a number-identification card
Give each extracted number six fields: company, document, period or date, currency and unit, reporting scope, and original page and line-item name. Add whether it is a flow or balance, a company total or per-share amount, and the question you intend it to answer.
Attach your own reconstruction of Lin'an's two changes. Check assets equal liabilities plus equity at each step. If they do not, find the missing or duplicated item; do not alter equity arbitrarily to force balance. A real statement balancing also does not remove estimation risk or the need to inspect notes.
For a final check, hide the values. Do the labels still tell you where to find them? Then hide the labels and explain the difference between cash and profit from the calculations. Both checks prepare you to make the more detailed cash bridge next.
Identify the event before interpreting the balance
Ask whether the business activity met recognition conditions, when its revenue and cost were recorded, and when cash arrived. The balance sheet captures positions; profit and cash flow describe changes over periods. Collection must not recognize one sale twice.
Bring headings, units, scope, and notes with every real-company extract. Then distinguish equity, profit, and per-share figures. Balancing two simple transaction tables and identifying an original statement's number is a more useful result than merely remembering the phrase “three financial statements.”
References
- SEC: Beginners' Guide to Financial Statements. Basic statement purposes and the assets/liabilities/equity relationship. The store's simplified accounting assumptions are stated separately.
- Costco: fiscal 2025 Form 10-K, Item 8, printed pages 37–42 and relevant notes. A fixed historical reading, with each statement's headings controlling its dates and units.
Editorial status
AI-assisted draft synchronized to the accepted second-round Chinese source. The author review records version, arithmetic, and source checks. A separate AI reviewer has completed an independent full-text review. Human financial review and target-reader testing remain pending.