Chapter 4

The effect of profit or loss on

capital and the double entry
system for expenses and
revenues
 Learning objectives
After you have studied this chapter, you
should be able to:
 Calculate profit by comparing revenue with
expenses
 Explain how the accounting equation is
used to show the effects of changes in
assets and liabilities upon capital after
goods or services have been traded
 Explain why separate accounts are used for
each type of expense and revenue
Learning objectives (Continued)
 Explain why an expense is entered as a
debit in the appropriate expense account
 Explain why an item of revenue is entered
as a credit in the appropriate revenue
account
 Enter a series of expense and revenue
transactions into the appropriate T-
accounts
 Explain how the use of business cash and
business goods for the owner’s own
purposes are dealt with in the accounting
records
The nature of profit or loss
 Profit means the amount by which
revenue is greater than expenses for a set
of transactions, where:
 Revenue means the sales value of goods
and services that have been supplied to
customers.
 Expenses means the cost value of all the
assets that have been used up to obtain
these revenues.
Calculating profit
If we supplied goods and services valued for
sale at £100,000 to customers, and the
expenses incurred by us in order to supply
those goods and services amounted to
£70,000, the result would be a profit of
£30,000:
Revenue £100,000
Less expenses (£70,000)
Profit £30,000
The effect of profit and loss on
capital
 The accounting equation we have used is:
Capital = Assets − Liabilities

 When profit has been earned, this

increases capital:
Old capital + Profit = New capital

 Or when a loss has been earned, the

capital figure decreases:
Old capital − Loss = New capital
Recording expenses
In order to calculate profit, expenses must
be entered into appropriate accounts. A
separate account is opened for each type
of expense:

Bank interest account Subscriptions account Rent account

Overdraft interest Motor expenses Postages
account account account
Audit fees account Telephone account Stationery
account
Insurance account General expenses Wages account
account
Debit or credit
 Assets and expenses involve expenditure
by the business and are shown as debit
entries because they must ultimately be
paid for.

 Revenue is the opposite of expenses and

therefore revenue entries appear on the
credit side of the revenue accounts.
Debit or credit (Continued)
Double entries for expenses
and revenues
Rent of £200 is paid in cash:

Debit the rent account with £200

Credit the cash account with £200
Double entries for expenses
and revenues (Continued)
Motor expenses of £355 are paid by
cheque:

Debit the motor expenses account with

£355
Credit the bank account with £355
Double entries for expenses
and revenues (Continued)
£60 cash is received for commission
earned by the business:

Debit the cash account with £60

Credit the commissions received account with
£60
Activity
June 1 – Paid for postage stamps by cash
£50

June 2 – Paid for electricity by cheque £229

June 3 – Received rent in cash £138

June 4 – Paid insurance by cheque £142

Activity (Continued)
Drawings
 Money that the owner takes from the
business for private use is called
drawings.
 Drawings reduces capital – they are
never an expense of the business.
 An increase in drawings is a debit entry
in the drawings account.
 The credit entry is against cash or bank
if money was taken from the business,
or purchases if stock was taken.
Recording drawings
On 25 August, the owner takes £50 cash
out of the business for his own use:
Recording drawings (Continued)
On 28 August, the owner takes £400 of
goods out of the business for his own use:
Learning outcomes
You should have now learnt:
1.How to calculate profit by comparing
revenue with expenses
2.That the accounting equation is central to
any explanation of the effect of trading
upon capital
3.Why every different type of expense is
shown in a separate expense account
4.Why every different type of revenue is
shown in a separate revenue account
Learning outcomes (Continued)
5. Why an expense is shown as a debit entry
in the appropriate expense account
6. Why revenue is shown as a credit entry in
the appropriate revenue account
7. How to enter a series of expense and
revenue transactions into the appropriate
T-accounts
8. What is meant by the term ‘drawings’
Learning outcomes (Continued)
9. That drawings are always a reduction in
capital and never an expense of a
business
10. How to record drawings of cash in the
accounting books
11. How to record drawings of goods in the
accounting books