9.1 Income and expenditure

Income and expenditure are the two basic flows of money in every business. Income is the money or value that comes into the business from its activities, and expenditure is the money or value that goes out to run it. The difference between them decides whether the business makes a profit or a loss. Understanding the two, and how to tell the different kinds apart, is the starting point for preparing the income statement and the statement of financial position. Example: a hotel in Mombasa earns income from room bookings, meals and conference hire, and spends on staff wages, food supplies, electricity and repairs, and the gap between the two is the result of the period.

9.1.1 Meaning of income

Income is the inflow of economic benefits during a period that increases the owner's equity, other than contributions from the owner. It arises from the ordinary activities of the business and from other sources. Income is recorded when it is earned, not only when cash is received. Example: a garage in Nakuru that repairs a vehicle in December earns the income in December, even if the customer pays in January.

Types of income

• Revenue (sales income): income from the main activity of the business, such as sales of goods in a shop or fees charged by a clinic.
• Other operating income: income from side activities, such as commission earned by a supermarket on airtime sales.
• Interest received: income earned on money deposited in a bank or lent to others.
• Rent received: income from letting out part of the premises, such as a shop unit rented to a tenant.
• Dividends received: income from shares held in other companies.
• Discounts received: reductions allowed by suppliers for early payment, which reduce the cost of purchases.
• Gain on disposal of non-current assets: the profit made when an asset is sold for more than its book value.
• Commission and fees received: income earned for services such as agency work.

9.1.2 Meaning of expenditure

Expenditure is the money spent or the cost incurred by a business. It is split into two kinds depending on whether the benefit is used up now or lasts for many years. This division is important because each kind is reported in a different financial statement. Example: a school that pays for stationery uses it within the term, while a school that builds a classroom block will use it for decades.

Capital expenditure

Capital expenditure is money spent to buy, improve or extend non-current assets that will be used in the business for more than one year. It is shown in the statement of financial position, not in the income statement, and its cost is spread over the asset's life through depreciation.

• Purchase of land and buildings: buying a plot or constructing a warehouse.
• Purchase of machinery and equipment: buying a tractor for a farm or an oven for a bakery.
• Purchase of motor vehicles: buying a delivery van.
• Furniture and fittings: buying desks, shelves and counters.
• Improvements that increase the value or life of an asset: adding an extra floor to a building.
• Legal and installation costs of an asset: fees for transferring land and the cost of installing a machine, which are added to the asset's cost.

Revenue expenditure

Revenue expenditure is money spent on the day-to-day running of the business, and on keeping assets in working order. The benefit is used up within the year, so it is charged in the income statement of the period.

• Wages and salaries: payments to employees.
• Rent and rates: cost of premises used in the period.
• Electricity, water and telephone: utility costs.
• Repairs and maintenance: costs of keeping assets in good condition without improving them.
• Insurance: cover for stock, buildings and vehicles.
• Advertising and marketing: costs of promoting products.
• Transport and fuel: costs of running vehicles.
• Interest paid on loans: cost of borrowing.
• Depreciation: the charge for using up non-current assets over time.
• Purchases of goods for resale: the cost of stock bought for selling.

9.1.3 Difference between capital and revenue expenditure

The two types are often confused, so a careful decision on each item is needed. Wrong classification changes profit and the value of assets. Example: if a transport company spends Ksh 600,000 on a new engine that extends the life of a lorry, the amount is capital expenditure, but Ksh 15,000 on routine servicing is revenue expenditure.

Effect of wrong classification

• Treating capital expenditure as revenue: profit is understated and assets are understated.
• Treating revenue expenditure as capital: profit is overstated and assets are overstated.
• Distorted ratios and decisions: owners, banks and tax authorities may be misled.

9.1.4 Capital receipts and revenue receipts

The same distinction applies to money received. Not all receipts are income from trading. Example: a farm that sells its tractor receives a capital receipt, while one that sells its maize receives a revenue receipt.

Types of receipts

• Revenue receipts: money received from the normal activities of the business, such as sales, fees, interest and rent. They are shown in the income statement.
• Capital receipts: money received from the sale of non-current assets, from loans or from the owner's investment. They are not income and are shown in the statement of financial position, except for any profit or loss on disposal.

Examples

• Sales of goods: revenue receipt.
• Rent received from a tenant: revenue receipt.
• Proceeds from selling old equipment: capital receipt, with any gain or loss on sale shown as income or expense.
• Bank loan received: capital receipt, since it must be repaid.
• Owner's additional investment: capital receipt.

9.1.5 Income and expenditure and profit

The difference between income and revenue expenditure for a period gives the profit or loss. A profit increases the owner's equity, and a loss reduces it. Example: a hardware shop with sales of Ksh 5,000,000 and total expenses of Ksh 4,200,000 earns a profit of Ksh 800,000.

Worked example: profit and loss

Formula: net profit = total income − total revenue expenditure

Substitution: net profit = Ksh 5,000,000 − Ksh 4,200,000

Working: 5,000,000 − 4,200,000 = 800,000

Result: net profit is Ksh 800,000.

Formula: net profit margin (%) = (net profit ÷ income) × 100

Substitution: net profit margin = (800,000 ÷ 5,000,000) × 100

Working: 800,000 ÷ 5,000,000 = 0.16, and 0.16 × 100 = 16

Result: the net profit margin is 16 per cent.

9.1.6 Matching and the accruals concept

Income and expenditure are recorded in the period to which they relate, whether or not cash has been received or paid in that period. This is the matching concept (also called the accruals concept): expenses are matched with the income they helped to earn. Example: a bakery that buys flour in November and uses it to make bread sold in December must charge the flour cost against the December sales.

Cash basis compared with accruals basis

Worked example: income earned, but not yet received

A consultancy firm in Eldoret invoices Ksh 300,000 for work completed in December. The customer pays in January.

• Cash basis: the income appears in January.
• Accruals basis: the income of Ksh 300,000 is included in December, with a receivable shown in the statement of financial position.

The adjustments for amounts owed or paid in advance at the year end, namely accruals and prepayments, are covered under year-end adjustments in 9.3.

9.1.7 Recording income and expenditure

Income and expenditure are recorded in the books of account, starting with source documents. Accurate recording allows correct financial statements to be prepared. Example: a supermarket records each day's takings from till rolls, and each supplier's invoice as it is received.

Source documents

• Sales invoice: records goods or services sold to customers.
• Receipt and till roll: proves cash received.
• Purchase invoice: records goods or services bought from suppliers.
• Credit and debit notes: record returns and corrections.
• Bank statement and cheque stubs: support the cash book entries.
• Payroll records: support wages and salaries.
• Petty cash vouchers: record small payments.

Steps in recording

1. Collect and check source documents: confirm that each is genuine and complete.
2. Classify each item: decide whether it is income or expenditure, and whether expenditure is capital or revenue.
3. Enter in the books of original entry: record in the sales day book, purchases day book, cash book and journal.
4. Post to the ledger accounts: transfer the entries to the sales, purchases, expense and asset accounts.
5. Prepare the trial balance: check that total debits equal total credits.
6. Prepare financial statements: use the balances to prepare the income statement and statement of financial position.

9.1.8 Control of income and expenditure

Businesses must control income and expenditure so that money is not lost or wasted. Example: a county hospital issues numbered receipts for all fees and requires approval of a manager for every purchase order above a stated limit.

Control measures

• Budgets: plans that set expected income and limits on spending, against which actual results are compared.
• Authorisation of payments: only named officers may approve expenditure, with higher limits requiring senior approval.
• Segregation of duties: the person who receives money should not be the one who records or banks it.
• Numbered documents: receipts, invoices and vouchers are numbered in sequence to prevent loss or misuse.
• Regular banking: takings are deposited intact and promptly.
• Bank reconciliation: the cash book is compared with the bank statement each month.
• Review and audit: managers and auditors check records and investigate differences.