Introduction to Accounting
3) An increase in assets resulting from rendition of goods or services to customers is called revenue.
Earning revenue can also be an asset source transaction. To illustrate the effect of a revenue transaction, assume that Friends Company received $3,000 cash for services it provided to customers (note that both assets and retained earnings increase - asset source transaction):
Illustration 1-5: Effect of revenue recognition
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Equity |
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Assets |
= |
Liabilities |
+ |
Contributed Capital |
+ |
Retained Earnings |
| Beginning balance |
$7,000 |
= |
$2,000 |
+ |
$5,000 |
+ |
$0 |
| Effect of revenue |
+3,000 |
= |
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+ |
|
+ |
+3,000 |
| Ending balance |
$10,000 |
= |
$2,000 |
+ |
$5,000 |
+ |
$3,000 |
4) As noted above, assets acquired in operating activities are called revenues. Assets used in the process of generating revenues are called expenses.
Expenses decrease retained earnings. Assume Friends Company used $1,000 in assets to earn $3,000 in revenues. This is an example asset use transaction.
Asset use transactions result in a decrease in an asset account and in one of the claim accounts (liability or equity accounts).
The affect of this asset use transaction (assets and claims decrease) on the basic accounting equation is as follows:
Illustration 1-6: Effect of expense recognition
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Equity |
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Assets |
= |
Liabilities |
+ |
Contributed Capital |
+ |
Retained Earnings |
| Beginning balance |
$10,000 |
= |
$2,000 |
+ |
$5,000 |
+ |
$3,000 |
| Effect of expenses |
(1,000) |
= |
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+ |
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+ |
(1,000) |
| Ending balance |
$9,000 |
= |
$2,000 |
+ |
$5,000 |
+ |
$2,000 |
Take a note of how decreases or negative amounts are shown in accounting records. Instead of prefixing a minus sign ("-"), a number is taken into parenthesis. This is a common way of showing a decrease in the accounting realm.
5) If a business chooses to transfer part of its assets (retained earnings in particular) to the owners, the transfer is called distribution. Assume Friends Company transfers $500 of assets to its owners. This is an asset use transaction:
Illustration 1-7: Effect of cash distribution
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Equity |
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Assets |
= |
Liabilities |
+ |
Contributed Capital |
+ |
Retained Earnings |
| Beginning balance |
$9,000 |
= |
$2,000 |
+ |
$5,000 |
+ |
$2,000 |
| Effect of distribution |
(500) |
= |
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+ |
|
+ |
(500) |
| Ending balance |
$8,500 |
= |
$2,000 |
+ |
$5,000 |
+ |
$1,500 |
Distribution and expenses both result in decreases in retained earnings and thus, in equity.
The table below is a summary of the effects of the three asset source transactions (events 1 through 3) and two asset use transactions (events 4 and 5):
Illustration 1-8: Summary of transaction effects
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Equity |
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Assets |
= |
Liabilities |
+ |
Contributed Capital |
+ |
Retained Earnings |
| Beginning balance |
$0 |
= |
$0 |
+ |
$0 |
+ |
$0 |
| Effect of contribution |
+5,000 |
= |
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+ |
+5,000 |
+ |
|
| Effect of borrowing |
+2,000 |
= |
+2,000 |
+ |
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+ |
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| Effect of revenue |
+3,000 |
= |
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+ |
|
+ |
+3,000 |
| Effect of expenses |
(1,000) |
= |
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+ |
|
+ |
(1,000) |
| Effect of distribution |
(500) |
= |
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+ |
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+ |
(500) |
| Ending balance |
$8,500 |
= |
$2,000 |
+ |
$5,000 |
+ |
$1,500 |
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