Revenue is the price of goods sold and services rendered during a giver accounting period. Earning revenue causes owner’s equity to increase. When a business renders services or sells merchandise to its customers, it usually receives cash or acquires ar account receivable from the customer. The inflow of cash or receivable from customers increases the total assets of the company. On the other side of the accounting equation, the liabilities do not change, but owner’s equity increases to match the increase in total assets. Thus revenue is the gross increases in owner’s equity resulting from operation of the business.
Various terms are used to describe different types of revenue; for example, the revenue earned by a real estate might be called Sales Commissions Earned, or alternatively, Commissions Revenue. In the professional practice of lawyers, physicians, dentists, and CPAs, the revenue is called Fees Earned. A business which sells merchandise rather than services (General Motors, for example) will use the term Sales to describe the revenue earned. Another type of revenue is Interest Earned, which means the amount received as interest on notes receivable, bank deposits, government bonds, or other securities.
When to Record Revenue: The Realization Principle When is revenue recorded in the accounting records? For example, assume that on May 24, a real estate company signs a contract to represent a client in selling the client’s personal residence. The contract entitles the real estate company to a commission equal to 5% of the selling price, due 30 days after the date of sale. On June 10, the real estate company sells the house at a price of $120, 000, thereby earning a $6, 000 commission ($120, 000 x 5% ), to be received on July 10. When should the company record this $6, 000 commission revenue in May, June, or July?
The company should record this revenue on June 10 the day it rendered the service of selling the client’s house. As the company will not collect this commission until July, it must also record an account receivable on June 10. In July, when this receivable is collected, the company must not record revenue a second time. Collecting an account receivable increases one asset, Cash, and decreases another assets, Accounts Receivable. Thus, collecting an account receivable does not increase owner’s equity and does not represent revenue.
Our answer illustrates a generally accepted accounting principle called the realization principle. The realization principle states that a business should record revenue at the time services are rendered to customers or goods sold are delivered to customers. In short, revenue is recorded when it is earned, without regard as to when the cash is received.
Expenses are costs of the goods and services used up in the process of earning revenue. Examples include the cost of employee’s salaries, advertising, rent, utilities, and the gradual wearing-out (depreciation) of such assets as buildings, automobiles, and office equipment. All these costs are necessary to attract and serve customers and thereby earn revenue. Expenses are called the “costs of doing business”, that is, the cost of the various activities necessary to carry on a business.
An expense always causes a decrease in owner’s equity. The related changes in the accounting equation can either (1) a decrease in assets or (2) increase in liabilities. An expense reduces assets if payment occurs at the time that the expense is incurred (or if payment has been made in advance). If the expense will not be paid until later, as, for example, the purchase of advertising services on account, the recording of the expense will be accompanied by an increase in liabilities.
When to Record Expenses: The Matching Principle. A significant relationship exists between revenue and expenses. Expenses are incurred for the purpose of producing revenue. In measuring net income for a period, revenue should be offset by all the expenses incurred in producing that revenue. This concept of offsetting expenses against revenue on a basis of “cause and effect” is called the matching principle.
Timing is an important factor in matching (offsetting) revenue with the related expenses. For example, in preparing monthly income statements, it is important to offset this month’s expenses against this month’s revenue. We should not offset this month’s expenses against last month’s revenue, because there is no cause and effect relationship between the two.