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4. Accounts Affecting Owner's Equity

Revenue and Expenses Accounts

As revenue (gains) and expenses (losses) affect the owner's equity, they can be recorded directly in the owner's equity account.

However, because of the large volume of revenue and expenses transactions, it is the practice to keep a separate account for each revenue and expense.

The revenue and expenses accounts are actually temporary owner's equity accounts because information on revenue and expenses is temporarily stored here, later matched against each other to determine the net profit or loss, which will eventually be transferred to the Capital Account.

Revenue Accounts

Revenue items generate profit that belongs to the owner and which will increase the owner's equity.

All increases to owner's equity are credits.  Likewise, all increases in revenue are credited to all revenue accounts.  It follows that all decreases in revenue are recorded as debits in all revenue accounts.

Sale of services or goods are examples of revenue items and are recorded as credits in the Sales or Sales Revenue Account.

They should be distinguished from sale of fixed assets such as motor vehicle, machinery or equipment which are purchased for use in the business and not for resale.  Such sales are recorded as credits in a particular asset account to show decreases in assets upon sale of such assets.

Returns Inwards Account or Sales Returns Account

A customer may return goods sold to him because they are defective, damaged, unsatisfactory, or the wrong brand or specification.  Returns and allowances on the sale price have the effect of reducing the amount of revenue earned by the business.

Applying the rule for recording revenue, this decrease in revenue should be debited to the Sales Account.  However, for better control and to have a clearer record of sales, a separate account called Returns Inwards Account or Sales Returns Account is opened and debited with the amount of goods returned by the customer.

Other revenue items include rent revenue, interest revenue, commission revenue or any other revenue received by the business.

Expenses Accounts

Expenses include all those items incurred in the process of earning revenue.  Expenses decrease the owner's equity and should therefore be recorded as debit entries.  It follows that any reduction in expenses is recorded as credits in all expenses accounts.

Purchases of goods for resale are expense items and an expenses account called Purchases Account is opened and debited with such purchases.

To a shop that deals in sports gods, tennis rackets and tennis balls constitute purchases.  If a motor van is purchased by this shop, the motor van cannot be termed 'purchases' as the prime intention of buying the motor van is for usage and not for resale.  The motor van is recorded in the Motor Van Account and not in the Purchases Account. 

However, an item may be termed 'goods' in the business and recorded in the Purchases Account while in another business, the same item may be recorded in an asset account, e.g. a furniture dealer's purchases of furniture will be recorded in the Purchases Account while in a provision shop, it will be recorded as an asset in the Furniture Account.

Returns Outwards Account or Purchases Returns Account

Just as his customers may return goods to him, a trader may also return goods to his supplier for similar reasons.

Any purchases that are returned are treated as decreases in expenses and are taken as credit entries.  For the same reason mentioned in the case for Returns Inwards Account, the credit entry is not made in the Purchases Account.  It is instead credited to a Returns Outwards Account or Purchases Returns Account.

In the process of generating revenue, the business may use up services like rent, transport, insurance, advertising and wages.  All these services are part of operating expenses of the business.

Like purchases, expenses are to be recorded as debit entries in their respective accounts.

Recording Withdrawals by the Owner

An owner may want to take goods, cash or other assets out for his private use.  These personal withdrawals by the owner are known as drawings.  All drawings by the owner reduce the owner's equity in the business.  Instead of debiting all drawings directly into the owner's capital account, a separate account is opened to record all drawings.

The drawings account is a temporary owner's equity account where information of all drawings is stored and eventually transferred to the owner's capital account.  This allows for better control and keeps the owner's capital account clear of unnecessary details.  Withdrawals are shown as debits in the Drawings Account.  For withdrawals of goods, the Purchases Account is credited to show reduction in the goods purchased for resale.

Summary

1.  The relationship of revenue, expenses and drawings accounts to the owner's equity account is summarized as follows:

2.  Accounting rules for the following:

  1. Revenue Accounts - Decreases are debits and increases are credits
  2. Expenses Accounts - Increases are debits and decreases are credits
  3. Drawings Accounts - Increases are debits