Changes in equity usually occur through earning revenue and incurring expenses. Less frequently changes in equity occur when the owner contributes to or draws money from the business.
A business generates revenue when it exchanges goods or services with its customers in return for money or other assets. A business incurs expenses by exchanging its assets for goods and services it needs to generate revenue. A business realizes net income or profit if its revenues exceed expenses. If its expenses exceed revenue, the business incurs a loss.
In generating revenue and expense, assets and liabilities are always effected. For example, if a business renders a service in exchange for cash, assets (cash) increase. However, to maintain the basic accounting equation, either the liability or the equity side must increase by an equal amount. But in selling services no liability is incurred so equity must increase. An increase in revenue must lead to an increase in equity.
Similarly if a business incurs a cash expense, an asset, cash, has decreased. So the other side of the accounting equation must decrease as well. Because paying cash to meet an expense is not equivalent to paying off a debt, there is no decrease in liabilities. So incurring an expense must be accompanied by a change in equity. In fact, all incurred expenses lead to reductions in equity.
Note that sometimes a business receives assets from lenders or from its owners. The receipt of such assets is not revenue. Only assets received from customers or clients in exchange for goods or services constitute revenue. Similarly, the disbursement of assets to repay loans or distributions to owners are not expenses. Only the disbursement of assets used to generate revenue are considered expenses.
Even though revenue and expense transactions change equity, the specific changes in revenue and expense account balances are reflected in a separate fundamental financialstatement called the income statement. Sometimes the income statement is referred to as the profit and loss statement or simply the “P & L”.
The income statement addresses the question of economic performance. Did the firm do well (make a profit) or do badly (incur a loss)? Earning revenue and incurring expenses is so central to the operation of a business that it requires this separate report to monitor operating results.
The income statement records the changes in the revenue and expense accounts over a certain period, usually not more than a year, or less than a month. The balance sheet, on the other hand, reports the assets, liabilities and equity at a specific point in time, usually at the end of a year, quarter or month.
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