5 - Chapter 5 Notes - Expanded Equity Section

(CRED) & Income Statement & Chart of

Accounts & Equity Equation
So far we have used a single account, Capital, to record changes
to equity, which represents the true value of a business.

In this chapter, we will introduce three brand new 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 and
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 - Revenue must be recorded

(recognized) in the books at the time the 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 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 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.

Finally, you should also note that the purchase of an asset (for cash or
on account) is not an expense as it does not result in a decrease to the
equity (value) of the business.

GAAP - Matching Principle - 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 corresponding revenues.

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. 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 once they become
due, e.g., weekly wages or monthly rent.

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 extraordinary sale of a company asset for a gain or a loss and 

(b) the investment of funds or other assets into the business by the owner.
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

Bank/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)
                       Bank (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)
                            Bank (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)

(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

Bank (dr $4000)

B. Gold, Capital (dr $2000)
              Automobile (cr $6000)

e.g. company equipment listed at $8000 sold at a gain for $9000

Bank (dr $9000)

      Equipment (cr $8000)
      B. Gold, Capital (cr $1000)

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 no more than one equity account is ever
used in any transaction involving equity.

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 (or sometimes earnings).

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.

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 that expenses are always listed
in alphabetical order.
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 company name, statement name, and date (period of

time over which net income is measured)
 two underlined subheadings appear: Revenues, Expenses
 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 appears between Revenues and Expenses sections only
 the term "Net Income" is used regardless of whether business earns a
profit or a loss
 double underline appears below Net Income figure
 account names are indented
 whether a net profit or a net loss is incurred, the term "net income" is
always employed on the income statement
 net loss (R - E when R < E) is indicated by placing brackets around net
income figure

Fiscal periods and Time Period Concept

Net income is measured over a specified period of time known as a fiscal period.

A fiscal period may be for any period of time that is not greater than one year. This is
because income tax laws require the preparation of an income statement at least once
a year.

A fiscal period is typically one, three, six or twelve months in duration.

A fiscal period one year in length does not have to coincide with the calendar year.
GAAP - Time Period Concept - Accounting data (financial data such as revenues,
expenses, drawings and net income) is often measured over specified periods of time
known as fiscal periods.

Fiscal periods must generally be of consistent (equal) length for each business, e.g.
three months.

That said, the length of a company’s fiscal period may occasionally be modified as a
result of relevant considerations as long as notice is provided to all stakeholders.

In any event, the maximum length of fiscal period allowable under Canadian tax and
commercial 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 as of a particular date.

The expanded ledger will reflect the expanded equity section and now contains six
types of accounts: assets, liabilities, capital, drawings, revenues and expenses.

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 is a financial statement listing all of the accounts of
a business and their current balances as of a particular date.

The expanded trial balance must reflect the expanded equity section.

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 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 is a formal, official statement listing all of the ledger

accounts and their identifying numbers (but not their balances) arranged in
numerical order. Please note that the chart of accounts is the only accounting
document that does not contain financial or 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 account in each category usually begins at -05 (e.g.,
Advertising Expense 505) and all subsequent accounts are typically numbered
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.
(Please note that the first expense on the attached income statement should
begin with a dollar sign.)

Section 5.3: Equity Relationships on the Expanded Balance Sheet (Equity

Equation)
As a result of the expanded equity section, the following must be true with
respect to the 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.

Please review the expanded equity section of the balance sheet as shown on

today's handout. Keep in mind that a 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

B. Gold, Capital
Balance, January 1............ 35,000
Net Income.......................18,000
Drawings........................... 3,000
Increase in Equity.............15,000
Balance, December 31..... 50,000
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

Bank - 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

------------------- Bank - 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

Bank - 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

------------------- Bank - 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)