- Now at this point, we must bring revenues
and expenses into the picture.
Obviously, they're going to be a part
of every ongoing business.
Recall from our discussion of the income statement
that resources provide resource inflows.
They are increases in resources
from the sale of goods or services.
Expenses represent resource outflows,
they are costs incurred in generating revenues.
Note that revenues are not synonymous with cash
or other assets, but are a way of describing
where the assets came from.
For example, cash received from the sale
of a product is recorded as the asset Cash,
but the source of the asset would be considered revenue.
In contrast, cash received by borrowing
from the bank would not be revenue,
but an increase and a liability.
By the same token, expenses are a way
of describing how an asset has been used.
Thus, cash paid for interest on a loan is an expense,
but cash paid to buy a building represents
the exchange of one asset for another.
So, how do revenues and expenses fit
into the accounting equation?
Remember, revenues minus expenses equals net income,
and net income is a major source
of change in owner's equity
from one accounting period to the next.
Revenues and expenses then may be thought
of as temporary subdivisions of owner's equity.
Revenues increase owner's equity
and so like all other owner's equity accounts
are increased with credits.
Expenses reduce owner's equity,
and the owner's equity is reduced with debits.
Let me say that again, revenues increase owner's equity,
and owner's equity increases with credits.
Expenses decrease owner's equity,
and owner's equity decreases with debits.
This is sometimes confusing, so let me be clear.
As expenses go up, owner's equity goes down.
The more debits to my expenses,
the more my owner's equity decreases.
Why, because remember, owner's equity
goes down with debits.
Now, one other temporary account affects
owner's equity, the Dividends account shows
distributions of earnings to owners.
Because dividends reflect payments
to the owners, thereby reducing owner's equity,
the Dividend account is increased
with a debit and decreased by a credit.
Using the corporate form of business,
the accounting equation may be expanded
to include revenues and expenses,
and dividends, as shown here.
All we're doing with this expansion
of the accounting equation is recognizing
that when expenses go up, they are in effect decreasing
the Retained Earnings account, and Retained Earnings
is decreased with a debit.
Dividends have a similar effect on retained earnings.
Another way to think about dividends
is that they are earnings that are not retained,
they are instead returned to the owners of a business.
Earnings that are not retained would involve
decreasing my retained earnings,
and that would require a debit
to the Retained Earnings account.
Revenues on the other hand effectively increase
our Retained Earnings account, and Retained Earnings,
why it's increased with a credit.