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 account Motor expenses account Postages account Audit fees account Telephone account Stationery account Insurance account General expenses account Wages 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: How to calculate profit by comparing revenue with expenses That the accounting equation is central to any explanation of the effect of trading upon capital Why every different type of expense is shown in a separate expense account Why every different type of revenue is shown in a separate revenue account

Learning outcomes (Continued) Why an expense is shown as a debit entry in the appropriate expense account Why revenue is shown as a credit entry in the appropriate revenue account How to enter a series of expense and revenue transactions into the appropriate T-accounts What is meant by the term ‘drawings’

Learning outcomes (Continued) That drawings are always a reduction in capital and never an expense of a business How to record drawings of cash in the accounting books How to record drawings of goods in the accounting books