Introduction to Accounting 120
Chapter 5:
The Expanded Ledger
Introduction
• Thus far, any transactions that affect
owner's equity have been recorded in the
capital account. This procedure does not
provide the details necessary to make
sound judgments regarding a company's
growth, management or potential. This
unit expands the equity section of the
ledger, introducing three new account
types:
– Revenue - proceeds from the sale of goods or
services
Introduction, Continued
• New reporting methods will also
be introduced. The new reports
are the:
–Income Statement - depicts the
profit or loss of a business for a
specified period of time.
–Report Form Balance Sheet depicts the financial position of the
business incorporating an
Exploring the Purpose of
Expansion
• Examine the trial balance for Valley
Painting & Carpentry:
Exploring the Purpose of
Expansion
• From the information, provided could the following
questions be answered?
• How much money did Valley Painting & Carpentry
make in the month of June?
• How much money was spent on advertising?
• How much money was spent
on employee wages?
• Is the rent affordable?
• How much money has
Earl Berry, the owner,
withdrawn for personal use?
Exploring the Purpose of Expansion
(Continued)
• Examine the Capital account. Does it provide
more meaningful data?
• It is fairly safe to assume the credit of $15
650 is the beginning balance for the Capital
account; however other questions cannot be
answered with any degree of certainty.
Exploring the Purpose of Expansion
(Continued)
• Can we hypothesize explanations for the other
entries found in the T-Account?
– What are the other four credits? Perhaps they represent
weekly sales.
– Which of the debits is to pay for wages, advertising and
rent?
– Did the owner withdraw money for personal use?
• If we cannot answer these questions, we
undoubtedly cannot determine the potential success
or failure of the business, nor can we suggest
changes to enhance the business' performance.
• It is not that the accounting practices
used are wrong, they simply
are not sufficient.
Expanded Ledger
• Understanding that more comprehensive information is
necessary, let's remove transactions from the capital
account and place them in accounts with more meaningful
account names.
Expanded Ledger
•
•
•
•
•
•
Now some of the questions are easily answered:
Sales to date total $12 700.
The owner withdrew $200 for personal use.
$150 was spent on advertising.
$4 800 has been paid to employees.
The rent is $1 370. Now it can be compared to other similar
locations.
• Examine the revenue account:
The Income Statement
• The Fees Earned account indicates that revenue
was generated in the month of June, but did Valley
Painting & Carpentry make a profit in the month of
June?
• To determine whether or not a business is
profitable, an accountant compares the total
revenue earned during a specific time period to the
costs of generating that revenue (expenses).
• An income statement is a formal financial
document that summarizes revenue and expense
items and displays the net income or net loss of a
business for a specific period of time.
The Income Statement
• Examine the income statement for Valley
Painting & Carpentry:
The Income Statement
• The document is simplistic but yet provides an accurate measure of
profitability for a specific period of time.
• We see that:
• This income statement is measuring profit over a one month period
(For Month Ended June 30, 200--).
• The total revenue for the month of June was $12 700.
• The cost incurred earning June's revenue was $6 420.
• The profit for the month of June was $6 280.
• The accounting practices for the individual
elements of an income statement
will be reviewed in detail.
Let's Review
• The practice of recording all transactions to the
capital account does not provide the information
necessary for sound decision-making.
• Sound decision-making requires detailed
knowledge of the profitability of the business.
• To accommodate the need for more specifics, the
owner's equity section is divided. It is now
comprised of capital, drawings, revenue and
expense accounts.
• To determine if a company is profitable over a
specific period of time, an income statement is
prepared.
Revenue
• Revenue is an increase in equity resulting from the
sale of goods or services. Equity increases with a
credit; therefore, a transaction involving the
performance of a service will be a credit to the
revenue account. Acceptable revenue account
names for a service company are Fees Earned,
Fees Revenue, Revenue, Service Revenue, etc.
Revenue
• Consider the following transaction: Earl Berry
receives
$2 300 for painting rooms within Melissa
Carter's house. Melissa pays cash.
• Analysis:
• Bank
Increase Debit $2 300
Fees Earned Increase Credit $2 300
Revenue
• If the service were sold on account, the transaction
would be recorded as:
More About Revenue
• A business owner or accountant may establish one
revenue account or it may require/prefer the use of
multiple revenue accounts. Consider the following:
• Stanley Harris has opened a ski hill. Revenue is
generated from the following sources:
–
–
–
–
–
Individual ticket sales
Memberships
Rentals
Instruction
Repairs
• Stanley may choose to use individual accounts.
This could provide better insight into the potential of
various revenue components of the business.
GAAP: The Revenue Recognition
Convention
• The revenue recognition convention states
that revenue must be recognized when the
transaction is completed.
• If the transaction is for cash, the revenue is
recorded when the sale is completed and the
cash is received.
• If the transaction is on account, the revenue
is recorded when the bill is sent to the
customer. Bills are normally issued within a
few days of the completion of the service.
GAAP: The Revenue Recognition
Convention
– The revenue recognition convention does provide
some allowance. Consider the following:
– A&L Construction has been awarded the
tender to build a new community arena.
– The project is expected to take one year to
complete. A&L Construction would develop a
contractual agreement outlining periodic
payments collectable from the community. These
payments would be recorded throughout the
year.
Expense
– Expense is a decrease in equity resulting
from the costs associated with producing
revenue.
– Equity decreases with a debit; therefore, a
transaction concerning cost incurred to
generate revenue will be a debit to an
expense account.
Expense
– Some common expense account names for a service company are:
– Advertising Expense
• Paid announcements to radio, television, newspapers, etc.
– Automobile Expense
• Vehicle repairs and upkeep (may be termed Car Expense or Truck Expense)
– Donation Expense
• Sponsorship of community events, clubs, teams, etc.
– Gas & Oil Expense
• Gas purchases of travelling employees
– Miscellaneous Expense
• Transactions involving an uncommon, low expenditure (e.g. gift for an ill
employee)
– Utilities Expense
• Heat, lights, water, sewage
– Wages Expense
• Payment to employees (may be termed Salary Expense)
Expense (Continued)
• Consider the following transaction:
• Earl Berry pays the power bill of $250.
– Analysis:
– Utilities
Expense
Bank
Increase Debit $250
Decrease Credit $250
Expense (Continued)
• If the expense were received on account,
the transaction would be recorded as:
• Remember the following:
• Expense represents a decrease in equity.
• A decrease in equity requires a debit entry.
Expense-Some Exceptions
• Not all expenditures or costs represent
an expense. The purchase of a longlasting asset, such as a new automobile,
does not affect equity.
• The "rule of thumb" governing
expenses is-if the item is consumed
within a one-year period, it is an
expense; anything lasting over a year is
an asset.
Expense-Some Exceptions
• Supplies are an account often established as an
asset; however, they are consumed relatively
quickly. Therefore, there are two common methods
for accounting for the expense of supplies. The first
records the purchase of supplies as an asset and
expenses any amounts used at a fiscal period end.
The second records the purchase of supplies as an
expense and, at fiscal period end, transfers any
remaining balance to an asset account. Either
method is acceptable. During this course, supplies
will first be recorded as an asset and expensed
later.
Expense-Some Exceptions
• It is also common practice to omit the
word "expense" from the expense
account name. If it is obvious that the
account is an expense, the word is
unnecessary. For example, Salaries is
often used rather than Salary Expense.
Net Income/Net Loss
• Profitability is determined by subtracting the
total of all expenses from the total of all
revenues.
• When total revenue is greater than total
expenses, the company has a net income; if
expenses are greater than revenue, the
company has a net loss.
• Companies will compare net income/loss
month-to-month, quarter-to-quarter and/or
fiscal period-to-fiscal period.
Drawings
• Company owners begin business in the hopes of
earning a living by making a net income or profit.
When a company is successful, the owner is able to
regularly take money out of the business, similar to
an employee receiving a salary. These withdrawals
of company funds are termed drawings.
• Drawings - decrease to equity, due to owner
withdrawal of money or the taking of assets from the
company for personal use
• Although Drawings represent a decrease in equity,
it has no connection to the generation of revenue,
and therefore, it is not classified as an expense.
Drawings
• Drawings can be affected in ways other
than the straight withdrawal of funds for
personal use. For example:
– The owner may take an asset from the
company for personal use.
– The owner may purchase something for
personal use through the company and with
company funds if the business receives a
price advantage not offered to individuals.
– The owner may collect money from a
customer and keep it for personal use.
Drawing Scenario - 1
• Let's examine the accounting procedures for the
different Drawings scenarios.
• Scenario: Owner withdraws $100 for personal
use.
• Analysis:
• Drawings Increase Debit $100
Bank
Decrease Credit $100
Drawing Scenario - 1
• Scenario: The owner takes home a desk and chair,
originally recorded in the furniture account
for a combined total of $1300. The owner plans to give
them to his daughter for her use.
• Analysis:
• Drawings Increase Debit $1 300
Furniture
Decrease Credit $1 300
Drawing Scenario - 2
• Scenario:
– Maritime computer supply offers a 20%
discount on the cost of new notebook
computers to any company purchasing more
than one unit. The owner decides to purchase
two new machines; one will go to the
accounting department and one he plans to
take home for personal use. The discounted
price of the units is $3100/unit.
Drawing Scenario - 2
• Analysis:
• Drawings
Increase Debit
Equipment Increase Debit
Bank
Decrease Credit
$3 100
$3 100
$6 200
Drawing Scenario - 2
• Scenario:H. Randall, a debtor, pays the
owner $150 on an amount owing. The
owner keeps the money for personal use.
Analysis:
• Drawings
Increase
Debit $150
A/R H. Randall Decrease Credit $150
Let's Review
• There are now four types of accounts in the equity
section.
• The four types of accounts are capital, drawings,
revenue and expenses.
• Capital includes the initial net worth of the owner and
any new financial investments made by the owner.
• Capital represents an increase to equity, thus has a
credit balance.
• Capital has no effect on the net income or net loss of a
company.
• Drawings are the result of the owner taking assets from
the company for personal use.
Let's Review
• Drawings represents a decrease to equity, thus has a
debit balance.
• Drawings has no effect on the net income or net loss of
a company.
• Revenue is money generated through the sale of goods
or services.
• Revenue represents an increase to equity, thus has a
credit balance.
• Expense is money spent in order to generate revenue.
• Expense represents a decrease to equity, thus has a
debit balance.
• Subtracting expenses from revenue determines the net
income/loss of a company.