INTRODUCTION: THE ROLE OF ACCOUNTING IN A BUSINESS
1.13 THE INCOME STATEMENT – TEMPORARY RESULT
Before going further to consolidate the operational results of the Example 1.9–1.12, let us summarize the fi nancial status of R&B Grill when it was ready to serve customers. It had $1,113,000 in its assets. Of the total asset amount, it owed $463,000 (which is the total of the liabil- ities) to its creditors. Put differently, the creditors claim $463,000 on the R&B’s total Assets. The rest of the Assets ($650,000) are claimed by the owners. The lists of assets, liabilities, and equity indicate the details of asset items the business owns, for what types of liabilities it owes, and who have invested as owners. The Balance Sheet, however, does not tell the amount of revenues generated or expenses incurred. Now, it is a good time to organize the operational result by summarizing the revenues and expenses, which also have changed the status of the assets and liabilities.
When Assets and Liabilities are affected, the Equity must be affected due to the accounting equation of A = L + E.
The summary of the revenues and expenses so far is as follows:
The fi rst revenue record in the Example 1.9 (the transaction of party service, as presented in Table 1.13) recorded three entries: $18,000 of revenues in the credit side; $10,000 of Accounts Receivable in the debit side (indicating asset increase); and fi nally, $8,000 of Unearned Revenues in the debit side indicating the decrease of the liability.
The next example (Example 1.10) recorded additional revenues of
$97,000. Of this amount, $47,000 had been collected in cash and the rest ($50,000) has been put into “Accounts Receivable” for future col- lection. With these transactions, the total revenues became $115,000 and cash was increased by $47,000 and fi nally the total balance of the
“Accounts Receivable” became $60,000. The next two transactions (Examples 1.11 and 1.12) reported two expense accounts. Because these expenses were not paid, the unpaid amounts were recorded in the “Accrued Expenses” as liabilities. The consolidated records with the balance of individual T-accounts are presented in the following Table 1.20.
The Balance Sheet After Party Contract (Example 1-08) The Balance Sheet
R&B Grill, Inc.
On January ##, 2XX1 – after a Party Contract Assets: Liabilities & Equity:
Liabilities
Cash 415,000 Accounts Payable 55,000 Inventory 80,000 Unearned Revenues 8,000 Prepaid Rent 100,000 Notes Payable 400,000 Prepaid
Insurance 18,000
Equity
Common Stock
– Rachel & Brad 450,000 FF&E 500,000
Common Stock
– Jane 200,000 Total Assets 1,113,000 Total Liabilities & Equity 1,113,000
Table 1-20 T-Accounts Balances for Intermediary Verifi cation Asset accounts Liability accounts
Cash Accounts payable
Ex 1-01 450,000 100,000 Ex 1-04 55,000 Ex 1-07
Ex 1-02 150,000 250,000 Ex 1-05 55,000 Bal.
Ex 1-03 200,000 18,000 Ex 1-06 Ex 1-08 8,000 25,000 Ex 1-07 Ex 1-10 47,000 393,000 Total Total 855,000
Bal. 462,000
Accounts receivable Accrued expenses
Ex 1-09 10,000 5,000 Ex 1-11
Ex 1-10 50,000 24,000 Ex 1-12
Bal. 60,000 29,000 Bal.
Inventory Unearned revenues
Ex 1-07 80,000 Ex 9 8,000 8,000 Ex 1-08
Bal. 80,000 – Bal.
Prepaid rent Notes payable
Ex. 1-04 100,000 150,000 Ex 1-02
Bal. 100,000 250,000 Ex 1-05
400,000 Bal.
Prepaid Insurance Ex. 1-06 18,000 Bal. 18,000 FF&E
Ex 1-05 500,000 Bal. 500,000
Table 1-20 (Continued)
Equity accounts Revenues & Expenses Common stock – Rachel & Brad Revenues
450,000 Ex 1-01 18,000 Ex 1-09
450,000 Bal. 97,000 Ex 1-10
115,000 Bal.
Common stock – Jane Labor expense 200,000 Ex 1-03 Ex 1-12 24,000
200,000 Bal. Bal. 24,000
Utility expense Ex 1-11 5,000
Bal. 5,000
Table 1.20 shows the balance of each T-account used in the recording process up to this point. It is vertically organized by the account group.
The asset account group has Cash, Accounts Receivable, Inventory, Pre- paid Rent, Prepaid Insurance, and FF&E. All these accounts have their balances on the debit side. The Cash account is the only one that has credit records showing the transactions that caused cash to decrease. The debit total (of Cash) of $855,000 is the total amount of cash the business has obtained from the beginning until now. The credit total shows the total amount of cash spent during the same time, which is $393,000. As a result, R&B Grill currently has $462,000 of cash on hand. All other asset accounts have only debit records and their balances are presented in the debit side.
The liability accounts, on the other hand, show credit records. As we know, the increase of liabilities is presented in the credit side. Their bal- ances are also recorded in the credit side. The same is true with the Own- ers’ Equity accounts. There are two separate Common Stock accounts that belong to the Owners’ Equity group for two different groups of shareholders. All records, including the balances, are shown on the credit side.
Summarizing the nature of the T-accounts and their balances, a con- clusion can be made at this point. The balance of individual T-accounts is recorded in the “increasing” side. As asset accounts increase in the debit, their balances are presented in the debit side. Liability and Equity accounts, in contrast, record their balances on the credit side because their increases are recorded on the credit side. As we proceed with more advanced concepts and techniques, a few exceptions will be introduced.
This simple rule is usually introduced as “normal balance” in accounting textbooks.
Interestingly, there is at least one asset account that records its bal- ance in the credit side. This will be introduced in the next chapter with an example of Accumulated Depreciation. However, even in such an exceptional situation, the rule of balance recording in the increasing side remains the same. Even in such occasions, the meaning of the credit records of an asset account – decrease – does not change. The credit record of an asset account indicates the impact of “decreasing.” There- fore, the balance of an asset account in the credit side represents a neg- ative value.
Let’s prepare the Balance Sheet by transferring the balances of each account to appropriate groups. Because revenues and expenses, with their impacts on Assets, Liabilities, and Equity, are reported sep- arately on the Income Statement, the equation of Assets = Liabilities + Equity does not seem to work now. Take a look at the following Balance Sheet newly created in the Table 1.21. Pay attention to the bottom line for the amount of the total assets and the total liabilities + equity.
Table 1-21 The Balance Sheet for Temporarily Closing (Incomplete) The Balance Sheet
The R&B Grill, Inc.
On Jan. XX, 2XX1
Assets Liabilities & Equity
Liabilities
Cash 462,000 Accounts Payable 55,000 Accounts
receivable 60,000 Accrued Expenses 29,000 Inventory 80,000 Unearned Revenues - Prepaid Rent 100,000
Prepaid Insurance 18,000 Notes Payable 400,000 Total Liabilities 484,000 FF&E 500,000 Owners’ Equity
Common Stock – Rachel
and Brad 450,000 Common Stock –
Jane 200,000
Total Owners’ Equity 650,000 Total Assets 1,220,000 Total liabilities & Equity 1,134,000
* At this point, the Balance Sheet shows different amounts of Assets and Liabilities and Equity combined. The difference is Assets $1,220,000 – L+E $1,134,000 =
$86,000. (Review the Income Statement for this.)
The bottom line of the Balance Sheet (Table 1.21) shows that the equation of A = L + E is not working. The total asset amount is larger than the liabilities and equity combined by $86,000. The reason is, as mentioned before, that the effects of revenues and expenses have not been included in the Balance Sheet as of yet. Only with the operational results transferred from the Income Statement, the Balance Sheet can be completed. The following Table 1.22 shows the summarized records of revenues and expenses up to now.
Table 1-22 The Temporary Income Statement (refer to the comments on the bottom)
The Income Statement The R&B Grill, Inc.
For the month of January, 2XX1
Revenues 115,000
Expenses
Labor expense 24,000 Utility expense 5,000
Total expenses 29,000
Profit (Loss) 86,000
* This Income Statement shows only the records that have been covered so far.
* More expenses that have been incurred during the operations will be introduced in the next chapter to complete the Income Statement.
The bottom line on the Income Statement shows a Profi t of $86,000, which is exactly the same as the overage of the assets against the total liabilities and equity combined (as shown in the Table 1.21). As revenues increase owners’ equity and expenses decrease owners’ equity, profi ts will eventually increase the equity. In case the business suffered losses, it would decrease the equity. This is why revenues and expenses are not directly reported on the Balance Sheet and they are called temporary accounts of the owners’ equity.
The term Profi t or Loss does not belong to the balance sheet because it is the operational results. It has to transform its nature of the operating result to that of the equity when transferred to the Balance Sheet. At this transformational step, it becomes a part of the “Retained Earnings” that belongs to the owners’ equity. The term “Retained Earn- ings” indicates that the earnings from the operations have been kept by the company for the owners. When the profi t reported in the Income Statement is added to the section of the Owners’ Equity on the balance sheet under the account title of “Retained Earnings,” the discrepancy between Total Assets (A) and Liabilities and equity combined (L + E) disappears and the accounting equation of A = L + E works again as shown in Table 1.23.
Table 1-23 Revised Balance Sheet for Temporarily Closing The Balance Sheet
The R&B, Inc.
On Jan. XX, 2XX1
Assets Liabilities & Equity
Liabilities
Cash 462,000 Accounts payable 55,000
Accounts
receivable 60,000 Accrued expenses 29,000
Inventory 80,000 Unearned revenues –
Prepaid rent 100,000
Prepaid insurance 18,000 Notes payable 400,000 Total Liabilities 484,000 FF&E 500,000 Owners’ Equity
Common stock – Rachel
and Brad 450,000 Common stock –
Jane 200,000
Retained Earnings 86,000 Total Owners’ Equity 736,000 Total Assets 1,220,000 Total liabilities & Equity 1,220,000
* Now with the Profit of $86,000 added into the Retained Earnings, The equation of A = L + E works out.
There is one more fact to keep in mind regarding Retained Earnings.
As profi ts (or losses) from operations are continuously retained by the business for its owners, it accumulates whenever new profi ts (or losses) are reported. In this context, the Retained Earnings can be defi ned as
“accumulated profi ts (or losses) throughout the life of a business.” This is how the operations of a business contribute to the growth of owners’
investment.
When losses are reported, the amount of Retained Earnings is reduced. Simply, it reduces the value of the owners’ equity. For this rea- son, the Retained Earnings may become negative on the Balance Sheet.
If a business continuously reports losses from its operations for long, the accumulated negative amount of its Retained Earnings may bring down the entire value of its owners’ equity into a negative amount.