Businesses are organized to earn a profit, and here we will discuss revenue and expense transactions.
Revenues are inflows of assets (or reductions in liabilities) in exchange for providing goods and services to customers. Suppose that during January JG&T provides services (golf lessons) to customers and charges them $600. The customers pay $200 immediately and agree to pay the remaining $400 in February. This transaction meets both aspects of the preceding definition. First, JG&T has received assets of $600. The receipt of the $200 is obviously an asset inflow. The $400 to be received next month is also an asset and is called an account receivable. Second, the services were provided by the end of January. That is, they have been earned; JG&T has done everything it has promised to do. Accordingly, revenue of $600 is recorded in January.
This transaction increases cash by $200, accounts receivable by $400, and owners’ equity by $600. Why has owners’ equity increased by $600? The assets of the business have expanded, and it must be decided who has a claim against (or an interest in) those assets. Because this transaction has not increased the creditors’claims, the owners’ interests must have increased. This conclusion makes sense. Owners are the primary risk-takers, and they do so with the hope of expanding their wealth. If the firm enters into a profitable transaction, the owners’wealth (their interest in the business) should expand.
Of course, we cannot be absolutely certain that the customers will eventually pay the additional $400. This concern will be addressed in a subsequent chapter. For now, assume we are quite confident about this future receipt.
This transaction holds an important lesson. Although revenue equals $600, only $200 of cash has been received. Thus, from an accounting perspective, revenue does not necessarily equal cash inflow. Although revenue is recorded when assets are received in exchange for goods and services, the asset received need not be cash. This underscores the need for both an income statement to summarize earnings and a statement of cash flows to identify the sources and uses of cash.
As another illustration, assume that on January 10 a customer pays $100, in advance, for golf lessons. The lessons are to be rendered during the last week in January and the first week in February. Has a revenue transaction occurred on January 10? No. A requirement for revenue recognition is that the services must be rendered. As of January 10, this has not yet occurred. The transaction increases cash, but the owners’ claim on assets has not increased. Instead, the customer now has a claim on the assets. If JG&T does not provide the lessons, the customer has the right to expect a refund; JG&T has a liability. It is obligated to either provide the lessons, which have a $100 value, or return the $100 payment. In either case, a $100 liability exists on January 10. Unearned revenue is the liability that has increased. Another appropriate name is advances from customers.
Expenses occur when resources are consumed in order to generate revenue. For example, during January, JG&T employed salespersons and golf instructors. Assume these employees earned total wages of $700, which were paid in cash by JG&T. Because JG&T used the employees’ services during January, this is an expense transaction for that month.
The transaction decreases cash and owners’ equity by $700. The decrease in cash is obvious. Why does owners’ equity decrease? An analogy can be drawn to revenue.
When assets increase because of profitable operations, the owners’ interest in the firm’s assets expands. With expenses, when assets decrease in order to generate revenue, the owners’ interest in the firm’s assets declines.
Consider another example. Assume that JG&T receives its utility bill on January 31 for electricity used during January. The bill is for $120. JG&T elects not to pay immediately. Even though cash has not been paid, an expense transaction has occurred in January. JG&T has consumed resources (electricity) in order to generate revenue.
Because JG&T is now obligated to the utility company, liabilities increase by $120, and owners’ equity decreases by $120. Owners’ equity decreases because assets have not changed, yet the creditors’ claims have increased by $120. There is no alternative but to recognize that owners’ equity has decreased by $120.
Sales of Inventory
Sales of inventory contain both revenue and expense components. Assume that JG&T makes sales on account (credit) during the month totaling $4,000. The cost of the inventory to JG&T was $2,200.
A revenue transaction exists because an asset (accounts receivable) has been obtained, and the goods have been provided to customers. An expense transaction exists because the asset inventory has been consumed to generate the revenue. That is, JG&T has fewer assets because the inventory has been transferred to its customers. This expense is called cost of goods sold (CGS). The net increase in assets and owners’ equity is $1,800.