Thus far we have used a single type of account, Capital, to record changes to equity, which represents the true value or worth of a business, e.g., B. Gold, Capital.
In this chapter, we will introduce three brand new types of equity accounts to the ledger: Revenues, Expenses and Drawings.
Section 5.1: Equity Expanded: Revenues, Expenses, Drawings, Capital
1. Revenues represent the monies earned from the sale of goods or services in the normal/ordinary course of business operations (whether paid for immediately or at a later date) measured over a specified period of time.
Revenues represent an increase in the value, or equity, of the business (formerly Capital credit) that takes place over the course of the fiscal period.
Accordingly, when revenue is earned, we always credit the appropriate revenue account.
Some common revenue account names include Sales (representing the sale of tangible goods) and Fees Earned (representing the sale of intangible services).
GAAP - Revenue Recognition Principle - This rule states that revenue must be recorded (recognized) in the books at the time the sale transaction is completed, and not necessarily when payment is finally received.
This is because Canadian companies typically employ the accrual basis of accounting wherein transactions involving revenues and expenses are always recorded when they first occur and not necessarily when payment is ultimately made or received. (Remember that, in this class, we always assume all outstanding bills will eventually be paid.)
The best evidence of a completed sale using the accrual basis of accounting is the delivery of goods or services (and the accompanying bill) to the purchaser.
In general, Canadian companies do not employ the cash basis of accounting wherein transactions involving revenues and expenses are only recorded when payment is ultimately made or received.
2. Expenses represent the routine or ordinary costs (e.g., rent, wages, advertising) of operating a business (whether paid for immediately or a later date) measured over a specified period of time.
Expenses represent a decrease in the value, or equity, of the business (formerly Capital debit) that takes place over the course of the fiscal period.
Accordingly, when expenses are incurred , we always debit the appropriate expense account.
Some common expense account names include Wages Expense and Advertising Expense. Please note that sometimes the word “Expense” appears in the name of the account and sometimes it does not, e.g., Rent Expense or Rent.
GAAP - Matching Principle - This rule states that because expenses represent the costs associated with generating revenue, expenses must be recorded in the same time period as the revenues they helped to earn, i.e., expenses must be matched to their corresponding revenues.
Put another way, expenses must be recorded (recognized) in the books at the time the expense transaction is completed, and not necessarily when payment is finally made. This is why the Matching Principle is sometimes mistakenly called the Expense Recognition Principle.
As previously stated, Canadian companies typically employ the accrual basis of accounting wherein transactions involving revenues and expenses are always recorded when they first occur and not necessarily when payment is ultimately made or received. (And remember that, in this class, we always assume all outstanding bills will eventually be paid.)
The best evidence of an incurred expense using the accrual basis of accounting is the receipt of services (and the accompanying bill) from the vendor. At other times, expenses are paid for immediately as they become due, e.g., weekly wages or monthly rent.
And again as previously stated, Canadian companies generally do not employ the cash basis of accounting wherein transactions involving revenues and expenses are only recorded when payment is ultimately made or received.
3. Drawings refers to the owner’s withdrawal of money or other assets from the business for personal use measured over a specified period of time.
Drawings is also affected when the owner uses business funds to pay for personal expenditures or when the owner collects business debts but elects to keep the funds for personal use.
(Please note that an owner's drawings from his/her business is not considered a transaction carried out in the ordinary/normal course of business operations. As a result, drawings do not appear on the income statement - see below.)
Like expenses, drawings represents a decrease in the value, or equity, of the business (formerly Capital debit) that takes place over the course of the fiscal period.
Accordingly, when drawings are made, we always debit the appropriate drawings account.
In a sole proprietorship, the name of the drawings account is always the name of the owner followed by the word Drawings, e.g., B. Pitt, Drawings.
4. Capital will now represent the beginning and ending equity positions of a business, or the value of the business at the beginning and end of the fiscal period.
Capital normally has a credit balance.
The Capital account is credited to indicate increases in company value (i.e., revenues) and debited to indicate decreases in company value (i.e., expenses and drawings).
And even with the expanded equity section, the Capital account will continue to be used for at least two types of relatively common transactions:
(a) the investment of funds or other assets into the business by the owner, and
(b) the sale of a company asset for a gain or a loss in an extraordinary transaction
Transactions Affecting Equity Accounts - Capital, Revenues, Expenses, Drawings (CRED)
The Equity accounts (CRED) are only affected when one of the following transactions takes place:
(1) goods or services are sold by the business to our customers in the ordinary/normal course of operations (whether for cash or on account)
e.g. goods or services sold for cash
Cash (dr)
Revenue (Sales or Fees Earned) (cr)
e.g. goods or services sold on account
Accounts Receivable (dr)
Revenue (Sales or Fees Earned) (cr)
(2) money is paid out (or a bill is received) concerning routine/ordinary business costs/expenses (e.g., rent, wages, insurance, advertising, etc.)
e.g. paid wages to company employees
Wages Expense (dr)
Cash (cr)
e.g. received bill from Toronto Star re: September advertising *
Advertising Expense (dr)
Accounts Payable (cr)
* (the only business transaction that does not involve at least one asset)
(3) money or other assets are withdrawn from the business by the owner
e.g. owner withdraws cash from the business for personal use
B. Gold, Drawings (dr)
Cash (cr)
(4) money or other assets are invested into the business by the owner
e.g. owner invests personal vehicle into the business
Automobile (dr)
B. Gold, Capital (cr) *
* Please note that sometimes a different capital account (B. Gold, Investment) is used in the above entry instead of B. Gold, Capital.
e.g. owner invests personal vehicle into the business
Automobile (dr)
B. Gold, Investment (cr)
(5) business asset (e.g., automobile, equipment, furniture) is sold for a gain or a loss in an extraordinary transaction
e.g. company vehicle listed at $6000 sold at a loss for $4000
Cash (dr $4000)
B. Gold, Capital (dr $2000) **
Automobile (cr $6000)
e.g. company equipment listed at $8000 sold at a gain for $9000
Cash (dr $9000)
Equipment (cr $8000)
B. Gold, Capital (cr $1000) **
** Please note that sometimes a special expense account (Loss on Sale) or a special revenue account (Gain on Sale) is used in the above entries instead of Capital depending on whether the extraordinary sale creates a loss (Loss on Sale) or gain (Gain on Sale). That account will eventually be closed into Capital at the end of the period (see Closing Entries - Chapter 9).
e.g. company vehicle listed at $6000 sold at a loss for $4000
Cash (dr $4000)
Loss on Sale (dr $2000 - expense)
Automobile (cr $6000)
e.g. company equipment listed at $8000 sold at a gain for $9000
Cash (dr $9000)
Equipment (cr $8000)
Gain on Sale (cr $1000 - revenue)
Notice how each of the above transactions affects the overall value of the business - that is why one of the Equity accounts must be debited or credited in each case.
You may have also noticed that if equity is used in the transaction, no more than one equity account is ever used in the transaction.
But please note that revenue, expense and drawings accounts are not technically increased or decreased as a result of these transactions – rather it is the equity (or value) of the business that increases or decreases as a result of these business events.
Section 5.2: Income Statement
The success of a business in the normal/ordinary course of business operations is measured in terms of its profitability, known in accounting terms as net income.
Net income is calculated by subtracting expenses from revenues over a specified period of time, so that R - E = NI.
Net income can either represent a net profit or a net loss.
Net profit refers to the difference between total revenues and total expenses over a specified period of time when revenues are greater than expenses.
Net loss refers to the difference between total revenues and total expenses over a specified period of time when revenues are less than expenses.
That said, regardless of whether the business experiences a net profit or a net loss, the term "net income" is used on income statements prepared in this class.
Net income can be determined via the preparation of a formal, official financial statement known as an income statement, or Statement of Operations or Statement of Comprehensive Income under IFRS.
Notice that the only types of accounts included on the income statement are revenues and expenses.
And please note that drawings is not included in the preparation of an income statement as drawings has nothing to do with the calculation of profit or loss in the normal/ordinary course of business operations.
An income statement is always prepared at the end of each fiscal period.
Some other observations about income statements include:
heading contains name of the company, name of financial statement, and date (specific period of time over which net income is measured)
two underlined subheadings appear: Revenues and Expenses
all account names are indented
expenses are listed in alphabetical order
account balances appear in left money column, final totals appear in right money column
five dollar signs normally appear (first revenue, first expense, three totals)
space must appear between the Revenues and Expenses sections
term "Net Income" is used regardless of whether business earns a profit or loss
double underline appears below Net Income figure
net loss (R - E when R < E) is indicated by placing brackets around the net income figure
Fiscal periods and GAAP Time Period Concept
Net income (profit or loss) is always measured over specified periods of time known as fiscal periods.
A fiscal period may be for any period of time that is not greater than one year. This is because Canadian income tax laws require businesses to prepare an income statement at least once a year.
A fiscal period is typically one, three, six or twelve months in duration.
And please note that a fiscal period one year in length does not have to coincide with the calendar year.
GAAP - Time Period Concept - Accounting data such as revenues, expenses (and therefore net income) and drawings should be measured over specified periods of time known as fiscal periods.
Fiscal periods must generally be of consistent (i.e., the same) length for each business in order to ensure consistency when comparing data from one period to the next, i.e., apples to apples comparisons.
That said, the length of a company’s fiscal period may occasionally be modified or changed as a result of relevant considerations as long as proper notice is provided to all stakeholders.
In any event and as previously stated, the maximum length of a fiscal period allowable under Canadian tax law is one year.
Debit and Credit Balances in the Expanded Ledger
As previously stated, a ledger is a collection or grouping of all of the accounts of a business and their current balances expresssed as debits or credits as of a particular date.
The expanded ledger must reflect the expanded equity section and now contains six types of accounts: assets, liabilities, capital, drawings, revenues and expenses.
The order of accounts in the newly-expanded ledger is as follows:
1) assets (order of liquidity)
2) liabilities (order of due date)
3) capital (only one)
4) drawings (only one)
5) revenues (no particular order)
6) expenses (alphabetical order)
Assets, drawings and expenses normally have debit balances in the expanded ledger.
Liabilities, capital and revenues normally have credit balances in the expanded ledger.
Debit and Credit Balances in the Expanded Trial Balance
As previously stated, a trial balance - a formal, official financial statement - is a listing of all of the accounts of a business and their current balances as of a particular date expressed as either debits or credits.
The expanded trial balance must reflect the expanded equity section and now contains six types of accounts: assets, liabilities, capital, drawings, revenues and expenses.
The format of the expanded trial balance is essentially unchanged other than the introduction of the three new equity accounts.
The total of the debits should still equal the total of the credits on the expanded trial balance.
The order of accounts in the newly-expanded trial balance is as follows:
1) assets (order of liquidity)
2) liabilities (order of due date)
3) capital
4) drawings
5) revenues (no particular order)
6) expenses (alphabetical order)
Chart of Accounts
Every business uses a unique reference and identification system with respect to its ledger accounts.
A chart of accounts - a formal, official statement - is a listing all of the ledger accounts and their identification numbers (but not their balances) as of a particular date arranged in numerical order. Please note that the chart of accounts is the only accounting document that does not contain financial/monetary information.
This system is particularly useful in computerized accounting applications. In our textbook, the numbering system is as follows:
Assets (order of liquidity) 100-199
Liabilities (order of due date) 200-299
Capital / Drawings 300-399
Revenues 400-499
Expenses (alphabetical order) 500-599
Please note that the first accounts in each category usually begin at -05 (e.g., Cash 105, Advertising Expense 505) and all subsequent accounts typically increase in increments of five (e.g., 505, 510, 515, etc.) so that brand new accounts can be added to the chart of accounts in the appropriate spaces when necessary.
Section 5.3: Equity Relationships on the Expanded Balance Sheet (Equity Equation)
You have already learned that a balance sheet contains the fundamental accounting equation, namely A = L + OE.
As a result of the expanded equity section though, the following must be true with respect to the owner's equity of a business over the course of a fiscal period (keeping in mind that net income equals revenues minus expenses):
Equity Equation
beginning capital + revenue – expenses – drawings = ending capital
or
beginning capital + net income - drawings = ending capital
or
BC + NI – DR = EC
Of course, the ending capital figure at the close of one fiscal period must become the beginning capital figure at the start of the subsequent fiscal period.
The above is formally known as the equity equation.
Keep in mind that even a newly-expanded balance sheet still contains the fundamental accounting equation: A = L + OE (BC + NI - DR = EC)
And please note that net income minus drawings creates an unnecessary subtotal in the grade 11 version of the expanded balance sheet known as Increase (or Decrease) in Equity.
Sample expanded equity section of balance sheet (using equity equation)
B. Gold, Capital
Balance, January 1............ 35,000 (BC)
Net Income.......................18,000 (NI)
Drawings........................... 3,000 (DR)
Increase in Equity.............15,000 (unnecessary subtotal -> NI - DR)
Balance, December 31..... 50,000 (EC)
Sample entries for selected business transactions
1. Provided services for cash, $100
Cash - dr - 100
--- Fees Earned - cr - 100
Cash sale
2. Sold goods for cash, $100
Cash - dr - 100
--- Sales - cr - 100
Cash sale
3. Provided services on account, $100
Accounts Receivable - dr - 100
---------------------- Fees Earned - cr - 100
Sale on account
4. Sold goods on account, $100
Accounts Receivable - dr - 100
------------------------ Sales - cr 100
Sale on account
5. Received payment from debtor customer, $100
Cash - dr - 100
-- Accounts Receivable - cr - 100
Receipt on account
6. Purchased supplies on account, $100
Supplies - dr - 100
-- Accounts Payable - cr - 100
Purchase on account
7. Issued cheque to creditor supplier, $100
Accounts Payable - dr 100
------------------- Cash - cr - 100
Payment on account
8. Owner withdraws $100 for personal use
B. Gold, Drawings - dr - 100
--------------------- Cash - cr - 100
Owner withdrawal
9. Owner invests $100 into business
Cash - dr - 100
-- B. Gold, Capital - cr - 100
Owner investment
10. Sold company car valued at $5,000 for $1,000 in extraordinary transaction
Cash - dr - 1000
B. Gold, Capital - dr - 4000
--------- Automobiles - cr - 5000
Sale of company asset for a loss in extraordinary transaction
11. Paid weekly salaries, $1000
Salaries Expense - dr - 1000
------------------- Cash - cr - 1000
Paid salaries
12. Received bill from phone company demanding payment for phone usage, $100
Telephone Expense - dr - 100
------- Accounts Payable - cr - 100
Purchase on account
(Once again please note that transaction #12 above is typically the only business transaction that does not involve an asset.)
SUMMARY OF DEBIT CREDIT THEORY
1) Asset
increase - debit (more asset)
decrease - credit (less asset)
2) Liability
increase - credit (more debt/liability)
decrease - debit (less debt/liability)
3) Capital (Equity)
increase - credit (increase in company value via owner investment or sale of company asset for gain in extraordinary transaction)
decrease - debit (decrease in company value via sale of company asset for loss in extraordinary transaction)
4) Drawings (Equity)
debit (owner withdrawal of money or another company asset for personal use)
5) Revenue (Equity)
credit (sale of goods or services in ordinary course of operations, whether paid for immediately or at a later date)
6) Expense (Equity)
debit (incurrence of regular cost/expense of running business in ordinary course of operations, whether paid for immediately or at a later date)
SUMMARY OF DOUBLE ENTRY SYSTEM OF ACCOUNTING
For each business transaction:
at least one account must be debited and at least one account must be credited (one debit, one credit)
debits are always listed first and credits are always listed last (debits before credits)
the total dollar value of the debits must equal the total dollar value of the credits (debits equal credits)