Revenue or income is the receipt of money or the inflow of economic benefits as a result of past events in operating the firm. How we define revenue in accounting has changed over the years as a result the development of conceptual frameworks and the growing importance of financial reporting. However the accounting for revenue has remained pretty much the same, even with the change in definition.
A firm, say in the machinery rental business would record as income money it received for the renting out of its equipment to customers. Other firms may receive income from selling books, earning commissions or interest earned on money lent out.
Revenue is the result of the capital invested into the firm by its owners, expenses incurred, assets employed and any debts incurred in the normal course of business.
Revenue is the main source of activity that will increase the over all net worth of a firm. It achieves this through increasing both sides of the accounting equation, that is through an increase in revenue through a credit and a corresponding debit and increasing bank or debtors. Let’s have a look at a couple of examples below.
So far we looked at how we define revenue for accounting and examples of what typical revenue items look like. Now it is time to work through how revenue works in the accounting equation and the debits and credits involved in recording revenue transactions.
Accounting Entries and the Accounting Equation
By its nature in the accounting equation revenue is a credit account. This being to reflect an increase in revenue the account is credited, while a debit, not normally applied to an income account, would reduce the balance.
The accounting equation provides us with an excellent tool to help show how revenue impacts on the firm through the double-entry accounting system. Very briefly, the accounting equation helps us understand the six ways in which money flows into and out of a business.
For the inflows there are only three ways in which economic benefits flow into a firm: liabilities, revenue and capital. And on the left side of the equation there are only three avenues for economic benefits to flow out: assets being purchased, expenses being incurred and drawings on owners capital.
On November 15 ABC Ltd carries out some earth moving works for customer XYZ and is paid $10,000 in cash at the end of the contract. In the accounting equation the the business would see and inflow of economic benefits on the right side under revenue and because it received cash would record the increase in the bank account as an increase in assets:
ABC Ltd would then make the following accounting entry:
Let us say that instead of receiving cash at the end of the day from customer XYZ, our firm ABC Ltd allows them 15 days to pay the account. ABC Ltd would make the following entry in their accounting system for the work performed (don’t worry about the accounting entry for when the cash is received, we will cover that under the debtors tutorial).
In the accounting equation the you will notice the impacts are in effect the same. The reason being cash and debtors are both assets on the left side and revenue on right side doesn’t care what asset account the $10,000 is allocated to.
ABC Ltd would then go ahead and record the the transaction in its accounts as:
And that brings us to the end of our article on how we define revenue in accounting terms, how it impacts the accounting equation and how we would record the revenue earned. We mentioned that whether cash is received or a debtor is raised at the time the revenue is earned looks pretty much the same in the accounting equation. The left side or debit is either being record under bank (for cash received) or debtors (for revenue on credit).
We trust this article helps you along your path in gaining a better understanding of accounting and how it helps us understand the world of business. We also welcome your comments, questions and feedback. Drop a comment below, ask a question over on our questions page or get in touch with the Contact Us page.