4 Revenue and Expenses
Income Statement Fundamentals
Maybe it’s helpful to think about the income statement this way—let’s create a simple income statement for Lawncare Expert, a small entity specializing in lawn mowing. Lawncare Expert provided services to clients valued at $12,000 in June 20X1. This $12,000 is revenue, but that’s not the end of the story because it costs money to provide lawncare. For example, a lawnmower takes gas and needs periodic repairs and maintenance, and Lawncare Expert has to pay someone to push the lawnmower! If the costs of providing the service is $9,000, Lawncare Expert’s net profit will be $3,000. The income statement might look something like this:
| Lawncare Expert Income Statement For the Month Ended 30 June 20X1 |
||
|---|---|---|
| Lawnmowing Income | 12,000 | |
| Expenses: | ||
| Fuel Expense | (2,500) | |
| Repair and Maintenance Expense | (1,000) | |
| Salaries and Wages Expense | (5,500) | (9,000) |
| Net Income | 3,000 | |
Now that we have been introduced to the income statement, we can start using income statement accounts. In fact, you can open T-accounts and post the journal entries to T-accounts just like in chapter 3! The main difference, as you see in the table below, is that we replace the Retained Earnings account with revenue and expense accounts. If you get confused about which type of account to use, keep this in mind: revenues increase Retained Earnings (credit), and expenses decrease Retained Earnings (debit). To compare, the table below shows journal entries for Lawncare Expert first as we did in the last chapter when we only knew assets, liabilities and equity accounts, and second revised to use revenue and expense accounts. Take a look:
Learned in Chapter 3
| DR | Cash | 12,000 | ||
| CR | Retained Earnings | 12,000 |
| DR | Retained Earnings | 2,500 | ||
| CR | Cash | 2,500 |
| DR | Retained Earnings | 1,000 | ||
| CR | Cash | 1,000 |
| DR | Retained Earnings | 5,500 | ||
| CR | Cash | 5,500 |
We Will Journalize:
| DR | Cash | 12,000 | ||
| CR | Lawnmowing Revenue | 12,000 |
| DR | Fuel Expense | 2,500 | ||
| CR | Cash | 2,500 |
| DR | Repair Expense | 1,000 | ||
| CR | Cash | 1,000 |
| DR | Salaries and Wages Expense | 5,500 | ||
| CR | Cash | 5,500 |
Tell Me More
Take a look at the formal definitions here. Strangely, the income statement accounts are defined by assets and liabilities! This is called balance sheet primacy or the Asset/Liability Approach, and it is an important outcome of the fundamental accounting equation (A = L + E). We have been using the asset/liability approach without even knowing it. 😊 Basically, we need to identify all assets and liabilities that may be affected when an event happens. Once we have identified all assets and liabilities affected, if we need another debit or credit to balance the journal entry, we’ll look to equity items. After all, equity is the residual: Assets—Liabilities = Equity! And because income and expenses are really just a part of equity (Retained Earnings), they are defined the same way: as the residual! Isn’t it interesting how the financial statements work together?!
Now you may be wondering how the $3,000 in net profit gets added to Retained Earnings. This topic will be covered at the end of this chapter. There is a journal entry to make this change, but we’re getting ahead of ourselves.
In our simple lawncare example, we saw that revenue and expenses are the building blocks of the Income Statement. Perhaps it would be helpful to clarify these terms. You can use the table below as a reference when you prepare journal entries later in this chapter.
| Income / Revenue | Expense | |
|---|---|---|
| Journal Entry | Credit | Debit |
| Examples |
|
|
| Informal Definition | Makes profit go up | Makes profit go down |
| Formal Definition | An increase in assets (or a decrease in liabilities) | A decrease in assets (or an increase in liabilities) |
Now that you have a basic understanding of income and expenses, let’s try to prepare an Income Statement. First, we will tackle the single-step income statementSingle-step Income Statement:
All income and revenue accounts are grouped, followed by expense accounts. Net income is simply the difference between the two groups: income less expenses. To contrast, see Multi-step Income Statement.. This is the simplest way to create an Income Statement, though it isn’t terribly informative. The single-step method groups all income/revenue accounts together, then groups expense accounts. Net income is simply the difference between the two groups: income less expenses. Alright, let’s have a try…
