Notice that our sample income statement covers a period of time-namely, the month of December. A balance sheet shows the financial position of a business at a particular date. An income statement. on the other hand, shows the results of business operations over a span of time. We cannot evaluate net income unless it is associated with a specific time period. For example. if an executive says, “My business eaJ1)Sa net income of $10,000,” the profitability of the business is unclear. Does it eam $10,000 per week, per month, or per year?
The period of time covered by an income statement is termed the company’s accounting period. To provide the users of financial statements with timely information, net income is measured for relatively short accounting periods of equal . length. This concept, called the time period principle, is one ‘of the generally accepted accounting principles that guide the interpretation of financial events and the preparation of financial statements.
The length of a company’s accounting period depends on how frequently managers, investors, and other interested people require information about the company’s performance. Every business prepares annual income statements, and most businesses prepare quarterly and monthly income statements as well.·(Quarte”rly statements cover a three-month period and are prepared by all large corporations for distribution to their stockholders.) The 12-month accounting period used by an entity is called its ftscaI year. The fiscal year used by most companies coincides. with the calendar year and ends on Decemher 31. Some businesses, however, elect to use a fiscal year that ends on some other date. h may be convenient for a business to end its fiscal year during a slack season rather than during a time of peak activity.
Let us now explore the meaning of the accounting terms revenue and expenses in more detail
Revenue is the price of goods sold ana services renderedduring a given accounting period. Earning revenue causes owner’s equity to increase. When a business renders services or sells merchandise to its customers, it usually receives cash or acquires an account receivable from the customer. The inflow of cash and receivables from customers increases the total assets of the company; on the other side of the accounting equation, the liabilities do not change,
but owner’s equity increases to match the increase in total assets. Thus .revenue is the gross increase in owner’s equity resulting from operation of the business
Various account titles are -used to describe different types of revenue. For example. Overnight Auto Service records its revenue in an account entitled Repair Service Revenues. A business that sells merchandise rather than services, such as.Wal-Mart or General Motors, uses the term Sales to describe its revenue. In the professional practices of physicians, ePAs, and attorneys, revenue usually is called Fees Earned. A real estate office; however, might call its revenue Commissions Earned
A professional sports team might have separate revenue accounts for Ticket Sales, Concessions Revenue, and Revenue from Television Contracts. Another type of revenue common to most businesses is Interest Revenue (or Interest Earned), stemming from the interest earned on bank deposits, notes receivable, and interest-bearing investments.
Assume that on July 25 KGPO Radio contracts with RanchO Ford to run 200 one-minute advertisements during ~ugust. KGPO runs these ads and receives full payment from Rancho Ford on September 6. In which month sh’luld KGPO recognize the advertising revenue earned from Rancho Ford-July, August. or September?
The answer is August, the month in which KGPO rendered the services that earned the revenue.’In othir words, the revenue is recognized when it is earned. without regard to when cash payment
for goods or services is received
Expenses are the costs of the goods and services used up in the process of earning revenw. Examples include the cost of employees’ salaries, advertising, rent, utilities, and the gradual wearing-out (depreciation) of such assets as buildings, automobiles, and office equipment. All these costs are necessary to attract and serve customers and thereby earn revenue. Expenses are often called the “costs of doing business,” that is, the cost of the various activi~es necessary to carry on a business.
An expense always causes a decrease in owner’s equity. The related changes in the accounting equation can be either (1) a decrease in assets, or (2) an increase in liabilities. An expense reduces. assets if payment occurs at the time thar the expense is incurred. If the expense will not be paid until later, as, for example, the purchase of advertising services on account, the recording of the expense will be accompanied by an increase in liabilities.
Th Matching PrInciple: When to Record Expenses
A significant relationship exists between revenue and expenses. Expenses are incurred for the purpose of producing revenue. In measuring net income for a period, revenue should be offset by all the expenses incurred in producing that revenue. This concept of offsetting expenses against revenue on a basis of “cause and effect” is called the matching principle
Debit and Credit Rules for Revenue and Expenses
We have stressed that revenue increases owner’s equity and that expenses decrease owner’s equity. The debit and credit rules for recording revenue and expenses in the ledger accounts are a natural extension of the rules for recording changes in owner’s equity.The rules. previously stated for recording increases and decreases in owner’s equity are as follows:
•Increases in owner’s equity are recorded by credits.
• Decreases in owner’s equity are recorded by debits.