Notice that the year-to-date net income (bottom line of the income statement) increased Stockholders' Equity by the same amount, $180. This connection between the income statement and balance sheet is important. For one, it keeps the balance sheet and the accounting equation in balance. Secondly, it demonstrates that revenues will cause the stockholders' equity to increase and expenses will cause stockholders' equity to decrease. After the end of the year financial statements are prepared, you will see that the income statement accounts (revenue accounts and expense accounts) will be closed or zeroed out and their balances will be transferred into the Retained Earnings account. This will mean the revenue and expense accounts will start the new year with zero balances—allowing the company "to keep score" for the new year.
Marilyn suggested that perhaps this introduction was enough material for their first meeting. She wrote out the following notes, summarizing for Joe the important points of their discussion:
When a company pays cash for something, the company will credit Cash and will have to debit a second account. Assuming that a company prepares monthly financial statements—
If the amount is used up or will expire in the current month, the account to be debited will be an expense account. (Advertising Expense, Rent Expense, Wages Expense are three examples.)
If the amount is not used up or does not expire in the current month, the account to be debited will be an asset account. (Examples are Prepaid Insurance, Supplies, Prepaid Rent, Prepaid Advertising, Prepaid Association Dues, Land, Buildings, and Equipment.)
If the amount reduces a company's obligations, the account to be debited will be a liability account. (Examples include Accounts Payable, Notes Payable, Wages Payable, and Interest Payable.)
When a company receives cash, the company will debit Cash and will have to credit another account. Assuming that a company will prepare monthly financial statements—
If the amount received is from a cash sale, or for a service that has just been performed but has not yet been recorded, the account to be credited is a revenue account such as Service Revenues or Fees Earned.
If the amount received is an advance payment for a service that has not yet been performed or earned, the account to be credited is Unearned Revenue.
If the amount received is a payment from a customer for a sale or service delivered earlier and has already been recorded as revenue, the account to be credited is Accounts Receivable.
If the amount received is the proceeds from the company signing a promissory note, the account to be credited is Notes Payable.
If the amount received is an investment of additional money by the owner of the corporation, a stockholders' equity account such as Common Stock is credited.
Note: To learn more about debits and credits, go to Explanation of Debits and Credits and Quiz for Debits and Credits.
Revenues are recorded as Service Revenues or Sales when the service or sale has been performed, not when the cash is received. This reflects the basic accounting principle known as the revenue recognition principle.
Expenses are matched with revenues or with the period of time shown in the heading of the income statement, not in the period when the expenses were paid. This reflects the basic accounting principle known as the matching principle.
The financial statements also reflect the basic accounting principle known as the cost principle. This means assets are shown on the balance sheet at their original cost or less and not at their current value. The income statement expenses also reflect the cost principle. For example, the depreciation expense is based on the original cost of the asset being depreciated and not on the current replacement cost.
