In accounting, profit is the amount by which revenues exceed the expenses. Revenue is defined as the sales value of goods and services provided to customers and expense is defined as the cost of the assets that have been utilised by the business in order to generate those revenues.
Example
1. If we sell goods at a price of $500 to a customer, and the expenses we incur to make those goods available to the customer amount to $200, it would result in a profit of $300 ($500 - $200 = $300)
2. If we sell goods at a price of $500 to a customer, and the expenses and the expenses we incur to make those goods available to the customer amount to $700, it would result in a loss of $200 ($500 - $700 = -$200)
What is the relationship between profit and capital?
Let us assume that the assets and liabilities of a business at the start of the year are:
Assets: Office building $15,000; Stock $1,000; Cash in hand $400. Liabilities: Creditors $1,000.
The capital can be calculated using the following accounting equation:
Capital = Assets - Liabilities
The capital will be $15,000 + $1,000 + $400 - $1,000 = $15,400.
Let’s assume that the whole of the $1,000 stock is sold during the year for $3,000 cash. The assests and liabilities at the end of the year will be:
Assets: Office building $15,000; Stock Nil; Cash in hand $3,400. Liabilities: Creditors $1,000.
The capital is now $17,400:
Assets ($15.000 + $3400) - Liabilities $1,000
The capital has increased from $15,400 to $17,400. It has increased by $2,000 increase because the $1,000 stock was sold at a profit of $2,000 for $l3,000. Profit, therefore, increases capital
Therefore,
Old capital + Profit = New capital
A loss, on the other hand, would reduce the capital:
Old capital - Loss = New capital
After the profits or losses have been calculated, the balance in the capital account will either increase or decrease, depending on whether its a profit or loss. To calculate the figure of profit or loss, revenues and expenses must be entered into the appropriate accounts. All the expenses could be charged to one account, but to understand the nature of expenses better, full details of each type of expense are shown in profit calculations. The similar is true for each type of revenue. A separate account is opened for each type of expense and for each type of revenue. Try to get familiar with the following expense and revenue accounts which are commonly used:
Miscellaneous Expenses Account
Consultancy fees account
Rent receivable Account
News paper subscription account
Interest receivable Account
Rent Payable Account
Interest payable Account
Electricity bills payable Account
Motor Expenses Account
Telephone Account
Audit Fees Account
Salaries Account
Advertising expense Account
Items of expense which do not fit into any specific category and are too immaterial to to have an account of their own are usually put into a miscellaneous expense account or general expense account.
Question: Can you identify which of the above are expense accounts and which are revenue accounts?
Answer
Most organizations do not use names for their accounts that make it obvious which accounts are for revenue and which accounts are for expenses. For instance there may be an account by the name of “consultancy fee”. It is not possible to determine from this information whether the account is for expense or revenue. However, if you know that the organization is not a consultancy firm, the account cannot be a revenue account.
This brings us to the next question: Should expense accounts be debited or credited? We have studied that expenditures incurred on purchasing assets are entered as debit entries. When a business makes an expense, the principle stays the same since it involves an expenditure by the business. It should therefore be debited. An entry for expense will also involve a credit to the bank or cash account which means that the entry in the asset or expense account has to be a debit. For instance if you pay electricity bill of $300 in cash, the cash asset decreases by $300. In case the expense is incurred on credit, the credit entry will be in the supplier's (i.e. creditor's) account and debit in the expense account. When the supplier is paid off, the bank account will be credited and the supplier's account will be debited. According to the accounting equation if assets decrease, so does the capital; if liabilities increase, capital decreases or else the accounting equation will not balance.
Recall from your earlier study that you have entered sales figures as credits into the sales account. Since by nature revenue is the opposite of expenses it is treated in the opposite way.
Example '
1 Telephone bill of $50 is paid by cheque. The dual effect is:
a) The Telephone Bill expense has increased. The Telephone bill account will be debited with $50.
b)The cash at bank, which is an asset, has decreased. The cash at bank account should be credited with $50.
2 $100 cash is received for interest earned by the business on a saving account in a bank. The dual effect is:
a)The cash asset has increased. To increase the assset we need to debit $100 in the cash in hand account.
b)The Interest received account (which is a revenue account in nature), should be increased. Revenue is increased with a credit entry, so, to increase the Interest Received account, it is credited with $100.
Let’s go through some more transactions and their effect upon the accounts:
