Revenues and Expenses

In the last chapter, I discussed how assets and liabilities of a corporation are handled. Of course, most companies are in business to make profits, not just to buy and sell assets. So, in this chapter, I will review how revenues and expenses are handled and how these accounts impact the asset, liabilities, and equity accounts.

Revenue and Expense Accounts

To start with, let's expand the chart from the previous chapter to include revenues and expenses. The updated chart is displayed below:

Debit/Credit Summary for All Account Types

I've drawn a line, breaking the chart into two groups. The first group (assets, liabilities, and equity) are referred to as permanent or balance sheet accounts. The second group (revenues and expenses) are referred to as temporary or income statement accounts. The major differences between the two are:

1. Balance sheet accounts are displayed on the balance sheet while income statement accounts are displayed on the income statement.
2. Permanent accounts keep a running balance for the life of the business while temporary accounts only keep a balance for one period. As a new period starts, these accounts get reset to zero. This process is called closing, which we will cover in more detail later. A period can be any length of time for which your accounting system wants to keep income.

Using the new chart, let's show a couple of examples that affect income statement accounts.

First, we will need to add a few new accounts to our general ledger:

New Accounts

The above accounts represent the accounts that a small design shop might use to record their revenues and the costs associated with selling designs and marketing materials to clients.

Note: Our example above is a small set of expenses; most systems will have a much more detailed expense breakdown. Since taxes are paid on net profits, systems are designed to reduce net profits by accounting for all associated expenses.

Let's Review a Few Examples

1. Bambi designs a new logo for a client who loves it and pays her $250 cash for the logo file, which Bambi sends her via e-mail.
2. Kim creates a mobile version of a website and charges the client $595, which the client pays via a check.
3. Kim purchases copier paper and blank DVDs for office use, which Kim pays via a check for $75.
4. Bambi prepares a marketing brochure and poster set, which she ships to the client. She spends $28 on shipping supplies and $12 on postage. She deposits a $400 check from a client on her way back to the office.
5. The end-of-month rent of $600 for office space is paid from the checking account.

Our journal entries for the above:

General Journal Entries for Sales Activity

If you review our rules from Chapter 1, you'll notice that the total debits and total credits are equal in each transaction recorded. Using double-entry accounting, this must be the case.

We can take the amounts from the Sales Revenue account:

• Entry A—New Logo: $250
• Entry B—Mobile website: $595
• Entry D—Brochures/Posters: $400
• TOTAL FOR PERIOD: $1,245

This gives us the money we earned in total for the month.

We can now take the amounts from the expense accounts:

• Entry C—Office Supplies: $75
• Entry D—Postage/Shipping: $40
•                     Entry E—Rent : $600
• TOTAL EXPENSES: $715

You can now take the total revenues ($1,245) and subtract out the total expenses ($715) to see that the company made $530 in profits this month.

Closing Entry

After this simple first month of business, they need to close the books and prepare for the next month’s transactions. The goal of closing is to reset the income statement accounts to zero while doing something with the profit (or loss) that occurred during the period.

Tip: In any accounting system, all of the journal entries must be preserved. You cannot simply set accounts to zero; you must create journal entries to accomplish it.

To close the month, the business generates a special entry in our journals called the closing entry. It is going to take all of the revenue and expense accounts and write an entry for the exact balance. However, the entry will be debited for revenue (remember, debits reduce revenue) and credited for expenses. So, to close the sales revenue and expense accounts, we would record the following entries:

Closing Entries for First Month

Oops!

The above entry is not in balance. Accountants really frown upon out-of-balance entries! The difference of $530 has to be recorded somewhere. This difference, if a credit, represents the net income or profit for the period. (A debit difference would represent a net loss for the period).

The net income (or net loss) is recorded in the equity section of the balance sheet. To complete the above closing entry, the net income would be recorded as:

With this final entry, the transaction is now in balance and can be posted to the general ledger.

Once the closing entry is posted, all of the temporary accounts have zero balances and are ready to receive transactions for the next period. The equity account has increased or decreased by the amount of the net income/loss.

Equity accounts

For a small business such as in our example, one equity account might be sufficient. However, they might want to expand the equity section a bit so they can fine-tune from where the business equity came. One approach to do this is to break equity into two accounts, the:

• 3000 Owner’s Equity
• 3100 Retained Earnings

By using this approach, the Owner’s Equity account represents contributions directly made by the owners and the Retained Earnings account represents accumulated profits over the life of the business.

Tip: While small businesses might be content with just a single Equity account, most corporate systems will have multiple equity accounts and will almost always have a retained earnings account.

Partnerships

If a business is run as a partnership, it might use the equity section to keep track of each partner’s contributions and earnings from the business. For example, Bambi and Kim must each have their own equity accounts and agree that 60 percent of the profits go to Bambi and 40 percent of the profits go to Kim.

• 3000 Bambi’s Equity
• 3010 Bambi’s Retained Earnings
• 3100 Kim’s Equity
• 3110 Kim’s Retained Earnings

In this type of situation, the final journal row (to post the profit/loss) would be split among the two owners according to the partnership agreement:

This approach allows each partner to see how much that (a) they’ve invested and (b) how much they’ve made over the life of the business.

Summary

Now, let us quickly define some of the accounting terms I used in this chapter:

• Revenues—Monies earned from selling a product or performing a service.
• Expenses—Monies spent for administrative overhead or direct costs of                            selling/delivering the product or service
• Permanent accounts—Accounts for assets, liabilities, and equity that are tracked for the life of the business.
• Temporary Accounts—Accounts for revenue and expenses that are used to track profits for a given period, then consolidated into a permanent equity account.
• Closing—The process of summarizing the revenue/expense accounts and moving the net profit to a permanent, balance sheet account.
• Closing Entry—the journal entry used to perform the closing operation.
• Retained Earnings—the cumulative sum of all of the profits earned over the lifetime of the business.