What is accounting? As defined in http://www.investopedia.com, accounting is the systematic and comprehensive recording of financial transactions pertaining to a business.
Accounting provides information on the:
– Resources available to a firm;
– The means employed to finance those resources, and
– The results achieved through their use.
We have discussed about the basic concept of accounting, which is Debit equals Credit and by following this concept, your accounting records / books will always balance. This is also referred as the double-entry book keeping system. Subsequent to the double-entry book keeping post, we discussed the accounting equation of Assets equals Liabilities and Owners’ Equity. In this post, we will be discussing about Revenue, Expenses and Profits / Losses.
Revenue is the amount of money brought in by a business as a result of its core operations. So, if you are a bakery owner, then the revenue generated by your business will be the number of bread, pastries and cakes sold multiply by the selling prices. Revenue is also known as ‘top line’ or ‘gross income’ or ’sales’ or ‘turnover’. So, if an investor asks how you are going to grow your top line, then he / she is asking how you can increase your revenue. Revenue is shown as the top item of the Profit & Loss Statement / Income Statement, which probably explains the tag ‘top line’. Revenue is important as all business expenses, charges and costs are deducted from this amount to obtain the net income.
Net revenue is derived after deducting discounts allowed and product returns. If you sold 100 widgets at $100 each, your revenue will be $10,000. Of these 100 widgets, the customer returned 10 widgets and claimed 5 widgets not to be in good working condition. As a goodwill gesture, you decided to give a $60 discount each for the 5 widgets that are not in good working conditions.
So, your net revenue for this transaction is $8,700 ($10,000 less $1,000 [10*$100] less $300 [5*$60]).
Expenses are the costs incurred to generate revenue. Expenses may be in the form of actual cash payments (e.g. payroll, rental, printing and stationery, etc.), a computed expired portion of an asset (e.g. depreciation, goodwill amortization), or an amount taken out of earnings (e.g. bad debts).
However, a point to clarify is that while all expenses are costs, not all costs (such as those incurred in acquisition of income generating assets) are expenses. For example, the cost of purchasing an equipment is $1,200,000 and its useful life is 10 years.The cost of $1,200,000 is not an expense but the monthly depreciation of $10,000 [$1,200,000 divided by (10 years * 12 months / year)] charged to the Profit & Loss Statement is.
Profits or Losses
Profit is the surplus attributable to the business owner/s after deducting total expenses from total revenue and after accounting for the taxes payable. This is perhaps the best known measure of success for a business. All entrepreneurs starting any business has the profit objective in mind unless it is a not-for-profit or non-profit organization where other objectives or goals take precedence. Pursuing the profit objective is the driver for all economic activities, providing employment and growth to the economy.
Loss, on the other hand, is the deficit attributable to the business owner/s after deducting total expenses from total revenue. Persistent losses, year after year, put the business at risk and also the going concern assumption in jeopardy. Cutting costs is one way of reversing a loss situation but remember; there is only that much to cut without hurting business operations. As an business owner, you will need to think of ways and means to increase revenue (e.g. increasing selling prices, bundled promotions and sales, leveraging on social media, reducing customers’ touch points so that it’s easier to complete a sale, etc.).
To round-up this post, we will end with an illustration.
For the month of XXX, Acme Company sold 10,000 widgets at $50 a piece. There was a return of 50 widgets. The cost of one widget is $40. Salaries paid for the month was $35,000, office rental was $20,000 and depreciation was $10,000. As Acme Company is a new start-up, no taxes will be levied.
Revenue for the month: 10,000 * $50 = $500,000.
Returns: 50 * $50 = $2,500
Cost of Goods Sold: 9,950 * $30 = $398,000
Total Expenses: $35,000 (Salaries) + $20,000 (Rental) + $10,000 (Depreciation) = $65,000
Profit & Loss Statement
For the Month ended XXX
Less: Sales Returns $2,500
Net Revenue: $497,500
Less: Cost of Goods Sold $398,000
Gross Profit: $99,500
Less: Expenses $65,000
Net Profit: $34,500
So, for the month of XXX, the business owners made a profit of $34,500 and this is available for distribution as dividends.