The world of accounting revolves around, not surprisingly, accounts. The accounts listed on an income statement record a company’s income and expenses for a specified period. Income statement accounts are temporary because they are reset to zero at the end of each reporting period. Debits and credits change account balances, and they follow very specific rules.
Recording Accounting Transactions
All updates to accounts are made by transactions that are composed of debits and credits. The most basic rule for transactions is that the sum of the debits must equal the sum of the credits. This is the underlying feature of double-entry bookkeeping.
Each transaction will reference one or more accounts that receive debits and one or more accounts that receive credits. As long as the debits and credits add up to the same number, your transaction is balanced.
Normal Account Balances
An income account is said to have a normal credit balance, which means credits increase the balance and debits decrease it. Conversely, an expense account has a normal debit balance, meaning debits increase the balance and credits decrease it.
It might be helpful to think of a credit balance as a negative number, but all account balances are normally treated as positive numbers, which is why the sum of debits and credits can (and must) be the same.
Handling Income Transactions
Income increases an asset, usually cash or accounts receivable, or reduces a liability, like unearned income. An asset is something a company owns, and a liability is something owed. A company earns income when it performs work or delivers goods. Income accounts on the income statement are typically called "sales," "revenues," "income" or "gains."
In all cases, a credit increases the income account balance, and a debit decreases the balance. For example, when a writer sells an article for $100, she would enter a transaction into her accounting software that contained a debit to cash for $100 and a credit to sales for $100. The asset account and the income account both increase by $100.
Handling Expense Transactions
Expense transactions work in the opposite manner. Expenses drain a company of an asset, like cash, or add to a liability, like accounts payable. In an expense transaction, a debit increases the expense account balance, and a credit decreases the balance.
For example, if the writer spends $25 on printer ink, she would enter a transaction that debits office supplies expenses for $25 and credits cash by $25. In other words, expenses increase by $25 while cash decreases by $25.
The Income Statement
The income statement subtracts expenses from income to get net income, or net profit, for the period. At the close of the period, the net income is transferred to another account called retained earnings that resides on the balance sheet. This is accomplished by reversing all the temporary income and expense account balances so that they enter the new period with zero balances.
For example, if the sales account has a $1,000 balance, a closing transaction would credit (thereby increasing) retained earnings and debit (decrease) sales by $1,000. If the office supplies account has a $50 balance, then $50 would be credited to (decreasing) office supplies expenses and debited to (thereby decreasing) retained earnings.