Profit and loss account consists of two elements: one element is the inflows that result from the sale of goods and services to customers which are called as revenues.
The other element reports the outflows that were made in order to generate those revenues; these are called as expenses. Income is the amount by which revenues exceed expenses. The term ‘net income’ is used to indicate the excess of all the revenues over all the expenses. The basic equation is:
Revenue – Expenses = Net Income
This is in accordance with the matching concept.
Income And Owner’s Equity:
The net income of an accounting period increases owner’s equity because it belongs to the owner. To quote an example, goods costing rs.20,000 are sold on credit for rs.28,000. The result is that stock is reduced by rs.20,000 and a new asset namely debtor for rs.28,000 is created and the total assets increase by the difference of rs.8,000. Because of the dual aspect concept, we know that the equity side of the balance sheet would also increase by rs.8,000 and the increase would be in owner’s equity. This is because the profit on sale of goods belongs to the owner. It is clear from the above example that income increases the owner’s equity.
Income Vs. Receipts:
I) when goods costing rs.20,000 are sold on credit for rs.28,000 it results in an income of rs.8,000 but the cash balance does not increase.
Ii) when goods costing rs.18,000 are sold on credit for rs.15,000 there is a loss of rs.3,000 but there is no corresponding decrease in cash.
Iii) when a loan of rs.5,000 is borrowed the cash balance increases but there is no impact on income.
Iv) when a loan of rs.8,000 is repaid it decreases only the cash balance and not the income.
An expense is an item of cost applicable to an accounting period. It represents economic resources consumed during the current period. When expenditure is incurred the cost involved is either an asset or an expense. If the benefits of the expenditure relate to further periods, it is an asset. If not, it is an expense of the current period. Over the entire life of an enterprise, most expenditure becomes expenses. But according to accounting period concept, accounts are prepared for each accounting period. Hence, we get the following four types of transactions relating to expenditure and expenses:
Expenditures That Are Also Expenses:
This is the simplest and most common type of transaction to account for. If an item is acquired during the year, it is expenditure. If the item is consumed in the same year, then the expenditure becomes expense. E.g. Raw materials purchased are converted into saleable goods and are sold in the same year.
Assets That Become Expenses:
when expenditures incurred result in benefits for the future period they become assets. When such assets are used in subsequent years they become expenses of the year in which they are used. For e.g. Inventory of finished goods are assets at the end of a particular accounting year. When they are sold in the next accounting year they become expenses.
Expenditures That Are Not Expenses:
As already pointed, out when the benefits of the expenditure relate to future periods they become assets and not expenses. This applies not only to fixed assets but also to inventories which remain unsold at the end of the accounting year. For e.g. The expenditure incurred on inventory remaining unsold is asset until it is sold out.
Expenses Not Yet Paid:
Some expenses would have been incurred in the accounting year but payment for the same would not have been made within the accounting year. These are called accrued expenses and are shown as liabilities at the year end.