In this chapter, we are going to talk about revenues, expenses, and income statements. As we have mentioned in the Introduction to Financial Accounting chapter, the income statement describes a company's revenues and expenses with resulting net income or loss over a period of time using accrual accounting. Net income is calculated by taking revenue minus expenses.
What is Revenue?
Sales of goods or services that you make to your customers. In other words, when the company has performed services and is entitled to payment.
Revenues are recognized when earned, and it is an increase in shareholder equity. In order to recognize revenue, It has to be earned, which means goods and services are provided. Additionally, It must be realized, meaning that payment for the goods and services is either received in cash or can be converted to some amount of cash.
Let's say we make a sale to a customer and deliver the goods, and we give the customer an invoice with a time period in which they have to pay us back.
In this example, we have met the first revenue recognition criteria because we delivered the goods to the customer. Also, we have something that can be converted to an amount of cash, that being the invoice. Therefore, we can recognize the revenue and create an account receivable for the amount the customer owes us.
Revenue Example
What are Expenses?
Expenses are decreases in shareholders' equity. They are recognized when they are incurred or when the related revenues are recognized. When talking about expenses, we are talking about product costs and period costs.
Product Costs
If a company makes cameras, the Product costs would be the direct costs of producing the camera. These direct costs include raw materials such as metal, glass, lens, etc. It would also include the labor that goes into producing the camera, and all the costs of the factory, which we refer to as overhead costs. When the camera sold, those costs would leave inventory and become an expense.
Period Costs
Period costs are those not directly involved in producing the camera but are costs of running the business. These costs can be the sales force, marketing staff, human resources, management, and such. These costs are recognized as an expense when they are incurred.
It's time to apply what we have learned to an example.
Expenses Example
So far, we have covered the income statement and practiced applying the revenue and expense recognition concepts to an example. We will go over more revenue and expense transactions in the next chapters.
