Chapter 5 Notes – The Expanded Ledger:
Revenue, Expense, and Drawings
5.1 Expanding the Ledger
- Equity now has many different accounts; each account will reflect a particular kind of transaction in equity
- In the expanded equity section, you will see accounts for:
revenues – which are related to the sales of goods and services;
expenses – which are the costs related to the revenue;
drawings – which are the owner’s withdrawal for personal use
Purpose of Expanding the System
- The purpose is to provide essential information about the progress of the business
- This info is important to managers & owners to see if the business is profitable and to make good decision
- Trial balances only show claims on assets and assets, but not what happened during the month
- A trial balance is not bad, it’s general and doesn’t answer important questions like how much profit is made
- Information found in the expanded ledger can make an income statement
income statement – a financial statement that summarizes the items of revenue and expenses, and shows the net income or net loss of a business, for a given fiscal period
- Since equity has multiple accounts, it gives efficient information on the changes within this account
Example of an Income Statement
Eve Boa, LLBIncome Statement
Month Ended January 31, 20-
Revenue
Fees Earned
Expenses
Advertising Expense
Car Expense
Rent Expense
Sundry Expense
Wages Expense
Total Expenses / $ 1 321
615
3 300
385
9 830 / $23 660
15 451
Net Income / $ 8 209
Revenue
revenue – an increase in equity resulting from the sale of goods or services in the usual course of business
1. Revenue represents an increase in equity
2. An increase in equity requires a credit entry
3. Therefore, the Fees Earned account is credited
- All transaction affecting fee revenue will be credited to the Fees Earned account; the account will have a credit balance, it will be the total fees earned in a fiscal year
- Most businesses have one revenue account depending on its services; it’s named after its form of earnings
ex. a loan company earn its revenue in the form of interests à Interest Revenue
GAAP – The Revenue Recognition Convention
The revenue recognition convention states that revenue must be recorded in the accounts (recognized) at the time the transaction is completed.
- This means that revenue is recorded at the time of the billing for the customer ex. a company is building a tower over several years, it doesn’t wait until the tower is fully build, the bill is sent periodically for the work that is done over time; revenue must be correct, or the income statement is wrong and info is misread
Expenses
- The cost associated with producing revenue – rent, wages, utilities etc. is known as expense
expense – a decrease in equity from the costs of the materials and services used to produce the revenue
1. Expense represents a decrease in equity
2. A decrease in equity requires a debit entry
3. Therefore, an expense account is debited
- In any business there are many different types of expense account representing a decrease in equity
ex. Rent Expenses, Insurance Expenses, Bank Charges, Postage
- Expenses doesn’t always have to be on the account title if it is obvious that it was an expanse account
- Not all expenditures are for expenses; long lasting buys such as a building is debited in assets
Net Income or Net Loss
- Its from the revenue and expense account that a business can tell if has earned a net income (profit)
- Net income is the differences between the total revenue and total expenses, where revenue is greater than the expenses; if expenses are greater than the revenues, they suffer a net loss (revenue – expense)
Drawings
- Owner looks to the profits of the business to provide a livelihood; owner can take funds out of the business if it is a healthy business much like a salary
drawings – a decrease in the owner’s equity from a personal withdrawal of funds/other assets by the owner
- Drawing are not expenses, they have nothing to do with determining net income or net loss
- Drawing account is affected if the owner has the business pay for something that is personal use
- Drawings are a decrease in equity with a debit entry and have a debit balance
- Some transactions that will affect the drawing account (accountant must be told about these transactions:
-the owner takes assets out other than cash for personal use; ex. a computer;
-the owner collects a debt from the customer and keeps the money for personal use
Equity Section Summary
There are four types of accounts in the equity section:
1. Capital – this account will have the equity figure as the beginning of the fiscal year; + new capital
2. Revenues – increase in equity; has a credit balance
3. Expenses – decrease in equity; has a debit balance
4. Drawings – decrease in equity; has a debit balance; not a factor in calculating net income or loss
5.2 The Income Statement
Important features of a formal income statement:
1. Heading – name of business; name of statement; accounting period for which figures were accumulated
2. Revenue – a section to show the increase in equity (first, in alpha order)
3. Expense – a section to show a decrease in equity (in alpha order)
4. Net Income or Net Loss – it isn’t cash; it is the difference between revenue and expenses
if revenue > expense = income; revenue < expenses = loss
The Income Statement Put to Use
What an income statement means to certain people such as:
Owners and Managers – tells them if business is earning a profit and how much; help form company goals and policies and make business decisions; all figures can be put into an income statement; figures can be compared by year; problems can be spotted and fixed; success is making good use on the info given
Bankers – bankers want to know if they can repay the loan or if they want to give a loan out; financial statements tell bankers the conditions of a business
Income Tax Authorities – businesses, by law, need to have an income statement each year; net income of a proprietorship has to be included on the owner’s income tax return; they must be sent to the government
The Fiscal Period
- Net income is measured of a time called a fiscal period or accounting period; all the same length
- Earning figures mean nothing if they don’t know how long it will take to produce them
- Fiscal periods are usually a year; doesn’t have to be the same as the calendar year; must run 12 consecutive months
- They can be half-yearly, quarterly, and monthly; helps owners keep a close watch on the business
- They still must produce an annual income statement for tax purposes
GAAP – The Time Period Concept
The time period concepts provides that accounting will take place over time specific time periods known as fiscal years [fiscal years are equal lengths; measures financial progress of a year]
GAAP – The Matching Principle
The matching principle states that each expense item related to revenue earned must be recorded in the same period as the revenue it helped to earn
There are 2 steps to separate revenue and expenses to specific fiscal years:
Step 1 – record the proper amount of revenue for the proper period
Step 2 – must subtract only those expenses that helped earned the revenue in step 1
- Recording the proper revenue is not difficult (Revenue Recognition Convention); expenses are harder
- Ex. an agreement was made in one year, but the payment was made in the following year, the expenses will be kept in the same year as the day the contract was made
- If an agreement overlaps fiscal years, it will just need to be split accordingly
Charts of Accounts
- To expand ledger, you need to number them; this is used for identification & reference mainly in computers
Assets / 100 - 199Liabilities / 200 - 299
Owner’s Equity / Capital
Drawing / 300 – 399
Revenues / 400 – 499
Expenses / 500 - 599
Chart of accounts – a list of the ledger accounts and their numbers arranged in ledger order
- In a chart, gaps are left to insert new accounts
- For greater flexibility, software programs use a four digit system
- The first number will always identify the account type
Debits and Credits in an Expanded Ledger
Type Of Account / To Increase / To DecreaseAssets / Debit / Credit
Liabilities / Credit / Debit
Equity Capital
Revenue
Expenses
Drawings / Credit
Credit
Debit
Debit / Debit
Debit
Credit
Credit
Debit and Credit Balances
- Accountants need to understand the account balances; it will not always be easy, just remember:
1. Accounts with debit balances are normally assets, expenses, or drawings
2. Accounts with credit balances are normally liabilities, capital, or revenue
Trial Balance Procedures Unchanged
- These new accounts do not change the trial balance procedures
- Total accounts that are credits; then total accounts that are debits, see if the two totals agree
5.3 Equity Relationships and the Balance Sheet
Understanding Equity Relationships
- It is important to fully understand the equity section of a ledger
1. There are 4 types of accounts in the equity section of the ledger – capital, revenue, expenses, drawings
2. The capital account represents the beginning equity figure
3. Changes in equity are recorded in revenue, expenses, or drawing accounts
revenue – increase in equity, recorded as credits
expenses – decrease in equity, recorded as debits
drawings – decrease in equity, recorded as debits
4. The fundamental accounting equation is show at the bottom to show that the ledger is balanced
5. Difference between revenue and expenses is net income or net loss; drawing has nothing to do with this
6. The net income (loss) figure, with the drawing figure shows the increase or decrease in equity (net income or loss – drawing = equity increase or lost)
7. The following is the equity equation that can be used:
Beginning Capital + Net Income – Net Loss – Drawings = Ending Capital
Showing Equity on a Balance Sheet
- Once you understand everything on the ledger, you can prepare a balance sheet (ex is only of the equity)
Eve Boa, LLBBalance Sheet
January 31, 20-
Owner’s Equity
Eve Boa, Capital
Balance January 1 / $ 21 878
Net Income / $ 8 209
Drawings / 3 905
Increase in Capital / 4 259
Balance January 1 / 26 137
Total Liabilities and Equity / $ 32 677
- Report form balance sheet has the assets, above the liabilities above the equity (ex p.138)
- More information is shown and it clearly describes what happens during the month
- Before expanding the ledger, all of this info was hidden under capital
Other Possible Changes to Equity
- Here are a few examples of possible changes within the equity section:
1. Net income was greater than drawings; causes an increase in equity
2. Drawing are greater than net income; causes a decrease in Capital
3. Net loss decreases the capital