All managers want to know how their entities are performing financially. The income statements give this information. The measurement of an entity's income is the most important function of accounting.
Income measures the change in equity associated with the operations of the period. Some changes in equity are obvious. If the entity pays $200 cash in January for plumbing repairs completed in January, its cash decreases by $200, and its equity decreases by $200, because of the repairs expense. You would record this transaction as follows:
|
Debit Repairs Expense |
200 |
|
|
Credit Cash |
200 |
However, some expenses are not accompanied by a decrease in cash in the same accounting period. Also, some revenues do not increase cash in the same period. Recording these non-cash transactions correctly is the most difficult problem in accounting. They are governed by the accrual principle.
The accrual principle stems from the need for maintaining the fundamental equation: Assets = Liabilities + Equity. In the previous example of the plumbing repairs, Cash decreases by $200. Therefore, to maintain the equation, there must be a debit to equity of $200. Debit equity is an expense, in this case, Repairs Expense.
For transactions like these, you should ask, "Does the transaction change equity?" If so, and the change is associated with operations for the period, there is either a credit to revenue (if equity increases) or a debit to expense (if equity decreases). Such transactions affect income.
A change in cash is not necessarily associated with a change in equity. For example, in an earlier transaction the entity used $2,000 cash to acquire equipment. In this transaction, one asset, Cash, decreases by $2,000, and another asset, Equipment, increases by $2,000. The total of assets was unchanged, so there was no change in equity and no effect on income. If, by mistake you record a $2,000 expense for this transaction in addition to the two changes in assets, debits would not equal credits.
Similarly, the payment of an amount owed to a vendor does not affect equity. It results in a decrease in cash and an equal decrease in a liability.
The initial $10,000 contribution of capital did add to equity, but it was not associated with operations, so it does not appear on an income statement.