Mr. Pfahl 2015
PRINCIPLES OF ACCOUNTING 30S
Unit 2: The Income Statement
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Notes are Available online at
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PART 2: REVENUE AND EXPENSE ACCOUNTS
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Review
• In Unit 1, the purpose of accounting was expressed as a
system designed to provide the financial information
necessary to make decisions.
• We learned how daily transactions are recorded, and how
the Balance sheet is prepared.
• We learned that the balance sheet presents the assets,
liabilities, and owner’s equity at a specific date.
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Next..
We will expand our knowledge of business transactions
and learn how and why the income statement is prepared.
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The General Ledger
• To have the information necessary to prepare an income
statement, accounts must be kept for the revenue and
expense data for the accounting period.
• Therefore, the general ledger must contain all the
accounts required to prepare both financial statements:
• The Balance Sheet
• The Income Statement
Balance Sheet
• Asset
• Liability
• Owner’s Equity
Income Statement
• Revenue
• Expenses
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Income Statement Accounts
• There are two main sections in the body of the income
statement:
• The revenue section
• The expense section
Remember: Each revenue and expense item has
an account in the general ledger.
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Income Statement Accounts
• Revenue Accounts
• Review: What is revenue?
• There are many different ways a business can generate revenue
(i.e. products, services, rentals, member fees, commissions etc.)
• A separate revenue account is set up for each distinct type of revenue
earned by a company.
• Therefore, the types of revenue earned determine the number of revenue
accounts required by the business.
• Expense Accounts
• Review: What are expenses?
• There are many different ways a business can incur expenses
(i.e. Loan payments, supplies bought, equipment repairs, subscription costs,
Advertising expense etc.)
• A separate expense account is set up for each distinct type of expense
incurred by a company.
• Therefore, the types of expenses incurred determine the number of expense
accounts required by the business.
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Rules of Debit and Credit for Revenue
and Expense Accounts
• Earlier, we explained the procedure for entering transactions in the balance sheet.
Summarized in Fig. 3-2 on Pg. 77)
• Assets
• Assets are shown on the left side of the balance equation.
• Because they are shown on the left side, they increase on the left (debit) and
decrease on the right (credit)
• Liabilities and Owner’s Equity
• Liabilities and owner’s equity are shown on the right side of the balance sheet
equation.
• Because they are on the right side, they increase on the right (credit) and decrease
on the left (debit)
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Rules of Debit and Credit for Revenue
and Expense Accounts
How does the recording of transactions affect revenue
and expense accounts?
• Before a transaction can be recorded in the accounts, it is necessary to determine
whether the account will be debited or credited.
• Net Income and revenue increase owner’s equity. Owner’s Equity is increased on
the credit side. Therefore, when revenue occurs, it is recorded on the credit side of
the revenue account.
• Expenses decrease owner’s equity. Owner’s equity is decreased on the debit side.
Therefore, when expenses occur, they are recorded on the debit side of the
expense accounts.
Debits and Credits to revenue and expense accounts are determined
by the effect of each transaction on owner’s equity.
POINTS TO REMEMBER
Revenue increases equity and is recorded as a credit.
2. Expenses decrease equity and are recorded as debits.
1.
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Mr. Pfahl 2015
Rules of Debit and Credit for Revenue
and Expense Accounts
Owner’s Equity
Debit
(Decrease)
Expenses
Debit
(Increase)
Credit
(Decrease)
Credit
(Increase)
Revenue
Debit
(Decrease)
Credit
(Increase)
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Reason for Revenue and Expense
Accounts
• If revenue increases equity, expenses decrease equity,
and net income/loss is eventually added to owner’s equity
on the balance sheet…
Why are revenue and expense accounts necessary? Why
not enter transactions directly into the equity account?
• The answer is that one of the main purposes of
accounting is to provide information to management about
the operations of a business.
• At-a-glance, separate revenue and expenses accounts
show which sources are contributing most to the
company’s total revenue, and which expenses are
increasing too rapidly.
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Transaction Analysis
• As we have already learned, at least two accounts are
involved in recording every business transaction and total
debits must equal total credits for each transaction.
• In this chapter, we will see that the same principle of
double-entry accounting applies when you record
transactions that involve revenue and expense accounts.
• The transactions in this chapter will involve five types of
accounts: Asset, Liability, Owner’s Equity, Revenue,
and Expense
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Transaction Analysis
• The following six transactions are from a Lawyer, C.
Piccolo.
• Transaction #1: Asset and Revenue Transaction
• Jul. 1
Received $175 cash from a client for drawing up a new
will.
• The accounts affected are: Cash & Fees Earned
• Cash is an asset that increases on the debit side
• Because revenue increases OE, the revenue account, Fees
Earned, would be credited
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Transaction Analysis
• Transaction #2: Asset and Revenue Transaction
• Jul. 2
Billed client $1200 for legal services to close purchase
of home.
• The accounts affected are: Accounts Receivable & Fees
Earned
• A/R is an asset that increases on the debit side
• Because revenue increases OE, the revenue account, Fees
Earned, would be credited
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Transaction Analysis
• Transaction #3: Expense and Asset Transaction
• Jul. 3
Paid $95 to Telus for telephone bill received today.
• The accounts affected are: Telephone Expense & Cash
• Because expenses decrease OE, the expense account, Telephone
Expense, would be debited.
• Cash is an asset that decreases on the credit side.
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Transaction Analysis
• Transaction #4: Expense and Liability Transaction
• Jul. 4
Received a bill from Calgary Herald for $150 for
advertising the new location of the practice. The terms
of payment allow for 30 days to pay. The bill will be
paid later.
• The accounts affected are: Advertising Expense &
Accounts Payable
• Because expenses decrease OE, the expense account, Advertising
Expense, would be debited.
• Accounts Payable is a liability that increases on the credit side.
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Transaction Analysis
• Now try a few on your own!
Remember!
Received
$600 from the client as partial
What accounts
were affected?
payment
of the $1200 billed on July 2.
equity,
revenue,
or
•Were
Jul. 6they asset,
Paidliability,
$100 toowner’s
the Calgary
Herald
as partial
expense accounts?
payment of their bill for $150 received on July
Did the accounts
4. increase / decrease?
Were the accounts debited / credited?
• Jul. 5
1.
2.
3.
4.
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Summary of Debit and Credit Theory
• Balance Sheet Accounts
• Assets are on the left side of the balance sheet
equation.
• Assets increase on the left or debit side.
• Liabilities and OE are on the right side of the balance
sheet equation.
• Liabilities and OE increase on the right side or credit
side.
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Summary of Debit and Credit Theory
• Income Statement Accounts
• OE increases on the right or credit side.
• Revenues increase OE, and therefore are recorded on
the credit side.
• Expenses decrease OE, and therefore are recorded on
the debit side.
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Introducing the Owner’s Drawings
Account
• One of the reasons people start a business is to earn a profit
and increase the value of their equity.
• The owner of a business may make regular withdrawings of
money or other assets for personal use.
• This practice reduces Owner’s Equity, and is similar to an expense
transaction.
• The difference is expenses are recognized only if the cost was
incurred to produce revenue.
• A withdrawal of assets is recorded in an account called
drawings.
• The drawings account is an OE account, and appears on the
OE side of the General Ledger, and decreases OE on the
Balance Sheet.
• Therefore, the Owner’s Drawings account has a normal debit balance.
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Introducing the Owner’s Drawings
Account
• The Owner’s Drawings account is debited whenever
assets are withdrawn by the owner for personal use.
• Some examples of this are;
• Withdrawing cash
• Removing merchandise for personal use
• Taking equipment from the business for personal use, and
• Using company funds for personal
• Owner’s Salary
• A salary may be paid by a business to the owner of that business.
• For income tax purposes, the business may not record the payment of
salaries as an expense.
• Therefore the payment of salaries must be recorded in the Drawings
account.
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Drawings Account in the General Ledger
• As we already know, the General Ledger is a group of
accounts.
• There is one account for each asset, liability and for owner’s equity.
(Balance Sheet)
• There is also an account for each type of revenue, expense, and
for Drawings (Income Statement)
• At the end of an accounting period, a trial balance is
prepared.
• The balances of each account are used to prepare the Balance
Sheet, and Income Statement.
• Observe the General Ledger on Pg. 84
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Equity Accounts on the Balance Sheet
• The Income Statement is always prepared first because
the net income or net loss, affects the balance sheet.
• Both the Owner’s Capital account and Drawings account
appear in the Owner’s Equity section of the balance
sheet.
• The Capital account is a record of the Owner’s claim against the
assets.
• Capital increases if; there is a net income earned, or if the owner
increase the assets of the business through investments.
• Capital decreases if; there is a net loss, or if the owner withdraws assets
from the business for personal use.
• Observe Fig 3-6, 3-7, and 3-8 on Pg. 85 & 86
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Report Form of Balance Sheet
• Up to this point, the account form of balance sheet has
been used.
• The account form balance sheet lists the assets on the left, and
the Liabilities and OE on the right
• The balance sheet does not always appear in account
form. Another form of balance sheet is the report form.
• The report form balance sheet lists the assets, liabilities, and OE
vertically
• Although the concept of left side = right side no longer
applies (because the accounts are now listed vertically)
• Remember that the balance sheet equation still applies (A=L+OE)
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Report Form of Balance Sheet
• Facts to Remember!
• A slight modification of the rule given in Unit 1 for the placement of
$ signs on the balance sheet is now required.
• For the report form balance sheet, $ signs should be placed as follows;
• Beside the first figure in each column in both sections of the statement; and
• Beside the final total in both sections of the statement.
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Preparing Financial Statements from Trial
Balance
Trial
Balance
Income
Statement
Balance
Sheet
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Review: GAAPs and Key Ideas
• The Time-Period Principle requires that each company
sets and defines an accounting period. The period may be
a month, three months, a year etc. The company
consistently uses the same time period when it prepares
its financial statements.
• The Matching Principle requires that the costs recorded
in the expense accounts be matched with the revenue of
the same accounting period to determine net income.
• The accrual basis of accounting records revenue when
it is earned, whether that revenue is in the form of cash or
credit granted. Expenses are recorded when incurred,
whether those expenses are paid for in cash or credit
granted by the supplier.
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Homework
• IN CLASS DEMO: Pg. 94 #15
• Pg. 90 – 96 #8, 12, 13, 14
Workbook available on Shared Drive or
online @ www.mrpfahl.weebly.com
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