BAF3M-U2-L03 · BAF3M
Measuring profit and owner's equity
Learning goals
- Prepare a properly headed income statement for a service business.
- Calculate net income or net loss.
- Prepare a statement of owner's equity.
- Explain how net income and drawings change capital differently.
Prerequisite check
Which affect net income: revenue, expenses, owner investment, drawings? Only revenue and expenses. State why drawings must remain separate.
Vocabulary
- Income statement: reports revenue, expenses, and net income or loss for a period.
- Net loss: expenses exceed revenue.
- Statement of owner's equity: explains changes in a sole proprietor's capital during a period.
- Beginning capital: owner's capital at the start of the reporting period.
- Ending capital: beginning capital plus owner investment and net income, less drawings; a net loss reduces it.
- Heading: business name, statement title, and period or date.
Core idea
The income statement answers, “How did operations perform during this period?” The statement of owner's equity then explains how operating results and owner transactions changed the owner's claim.
Why this treatment makes sense
Putting drawings in expenses would make profit depend on the owner's personal cash needs. Putting investment in revenue would make profit depend on financing. Keeping those items out of the income statement gives users a clearer view of operations.
A repeatable method
- Write the three-line heading; use For the Month/Year Ended for period statements.
- List revenue and total it.
- List expenses in the required order and total them.
- Revenue − expenses = net income; expenses − revenue = net loss.
- Move the result to the statement of owner's equity.
- Beginning capital + investment + net income − drawings = ending capital.
- Check that ending capital will fit the balance sheet.
Worked example
Silver Birch Studio has these adjusted balances for September:
| Account | Amount |
|---|---|
| Service Revenue | $16,800 |
| Wages Expense | $6,100 |
| Rent Expense | $2,400 |
| Supplies Expense | $700 |
| Insurance Expense | $500 |
| Advertising Expense | $600 |
Total expenses = $6,100 + $2,400 + $700 + $500 + $600 = $10,300.
Net income = $16,800 − $10,300 = $6,500.
The statement would be headed with three distinct lines:
- Business: Silver Birch Studio
- Statement: Income Statement
- Period: For the Month Ended September 30, 20X1
If beginning capital was $21,000, there was no additional investment, and drawings were $1,800:
| Statement of owner's equity calculation | Amount |
|---|---|
| Beginning capital | $21,000 |
| Add: Net income | 6,500 |
| Subtotal | 27,500 |
| Less: Drawings | (1,800) |
| Ending capital | $25,700 |
Reasonableness check: positive profit increases capital, while drawings reduce it. The combined increase is $6,500 − $1,800 = $4,700; $21,000 + $4,700 = $25,700.
Journal, ledger, and statement connection
Revenue and expense ledger balances come from posted transactions and adjustments. The adjusted trial balance supplies the statement amounts. Net income is not another transaction; it is the calculated result that later closes into capital. Ending capital is then reported on the balance sheet.
Common mistakes
- Using “As at” on an income statement instead of a period heading.
- Including Accounts Receivable as revenue again. The revenue account already measures what was earned.
- Including drawings as an expense.
- Subtracting liabilities when calculating profit.
- Using unadjusted balances after adjustments are known.
- Forgetting that a net loss reduces capital.
Guided practice
Prairie Sky Editing reports revenue $12,400 and expenses: wages $4,600, rent $1,900, internet $300, insurance $250, and supplies $450. Beginning capital was $17,000, additional owner investment was $2,000, and drawings were $1,100.
Calculate net income and ending capital.
Independent practice
Moonrise Music Lessons has Fees Earned $9,700; Rent Expense $2,800; Instructor Expense $4,100; Advertising Expense $650; Insurance Expense $500; beginning capital $13,600; no additional investment; drawings $900.
- Prepare the two statement calculations.
- Write correct headings for the year ended December 31, 20X4.
- Explain the statement effect if $400 of earned revenue were omitted.
Self-check and solutions
Guided practice: Expenses = $4,600 + $1,900 + $300 + $250 + $450 = $7,500. Net income = $12,400 − $7,500 = $4,900. Ending capital = $17,000 + $2,000 + $4,900 − $1,100 = $22,800.
Independent practice: Expenses = $2,800 + $4,100 + $650 + $500 = $8,050. Net income = $9,700 − $8,050 = $1,650. Ending capital = $13,600 + $1,650 − $900 = $14,350. Both statements use “For the Year Ended December 31, 20X4.” Omitting $400 revenue understates revenue, net income, and ending capital by $400; depending on the event, Cash or Accounts Receivable is also understated.
Retrieval practice
From memory, write the order of the statements and the formula for ending capital. Explain the title/date difference between an income statement and a balance sheet.
Exam-style application
Ending capital is $34,500. Beginning capital was $29,000, the owner invested $3,000, and drawings were $2,200. Expenses were $18,400. Find net income and revenue.
Answer outline: $34,500 = $29,000 + $3,000 + Net income − $2,200, so net income = $4,700. Revenue − $18,400 = $4,700, so revenue = $23,100.
Lesson summary
The income statement isolates operating performance. The statement of owner's equity then combines that result with owner investment and drawings to calculate ending capital.