Two of the most important words in accounting are income and expenses. Almost everything in the income statement comes down to these two ideas, so getting them clear early makes the whole subject easier. This guide explains what each means, shows them in a small imaginary business, and shows how they lead to profit.
What income is
Income is the value a business earns from its activities. For most businesses the main income is sales: the value of goods or services sold to customers. A business can also earn other income, such as rent received for letting out a spare room, or commission for arranging a sale for someone else.
Income makes the owner’s investment in the business grow. Income is recorded when it is earned, not necessarily when the cash arrives.
If a shop sells goods on credit, the sale is income now, even though the customer pays later. That is why a business can be profitable on paper yet short of cash, a point we return to in later topics.
What an expense is
An expense is a cost the business incurs to earn its income. Rent paid, wages, electricity, insurance, telephone charges and delivery costs are all expenses. Whenever the business uses up something of value while trading, that is an expense.
Expenses reduce the owner’s investment. A useful test is to ask: did this cost help the business earn income during the period, and is the value now used up? If yes, it is almost always an expense.
The cost of the goods a shop actually sold, its cost of sales, is an expense too. It is set against the income those goods produced.
A short worked example
Picture a small stationery shop over one month (all figures are invented). It sells goods for RM8,000 and earns another RM300 in commission for displaying a supplier’s leaflets. Total income is RM8,300.
In the same month it pays RM2,500 for the goods it sold, RM1,200 in rent, RM900 in wages and RM200 for electricity. Expenses total RM4,800.
Profit for the month is income less expenses: RM8,300 − RM4,800 = RM3,500. A real income statement follows the same structure: list the income, list the expenses, and let the difference show the result.
Income and expenses are not assets and liabilities
Beginners often mix these up. Income and expenses are about performance over a period: how much was earned and spent. Assets and liabilities are about position at one point in time: what is owned and owed.
Buying a delivery van is not an expense. It is an asset the business will use for years. Paying for fuel to run the van is an expense, because the fuel is used up as the business trades.
In our shop, a RM6,000 delivery van is an asset, while the RM150 of fuel used that month is an expense. Getting this boundary right keeps the income statement and the statement of financial position from getting tangled.
Where drawings and capital fit
Two items look like income or expenses but are neither. When the owner puts money into the business, that is capital, not income. The business has not earned it.
When the owner takes money or goods out for personal use, that is drawings, not an expense. The business did not use it up to earn income. Keeping these two out of the profit calculation is a common place for beginners to slip, so learn it early.
The difference is profit
Profit is income less expenses. If a business earns more than it spends in a period, it makes a profit.
If it spends more than it earns, it makes a loss. This one comparison is the heart of the income statement, which is why keeping income and expenses separate and complete matters.
Miss one expense and profit is too high. Count an asset as an expense and profit is too low. Careful sorting leads to an accurate result.
The matching concept
Accounting sets the expenses of a period against the income of the same period, so the profit is fair. It would be misleading to count a whole year’s rent against one month’s sales. This idea is the matching concept, and it is why year-end adjustments exist, for prepayments, accruals and similar items.
For now, remember that income and the expenses that helped earn it belong to the same period. In our shop, the RM1,200 rent covered the same month as the RM8,300 income, so the two sit together naturally.
Spotting income and expenses in a question
When you read a question, sort each item in turn. Is it something the business earned (income), a cost it incurred (expense), an asset it owns, an amount it owes, capital put in or drawings taken out? Working through the list one item at a time turns a confusing block of figures into an orderly set.
Watch especially for drawings and for purchases of assets, since those are the traps most often set for beginners. Correct sorting is the first step to a correct income statement.
Why this matters
Every profit calculation, from a single trader to a large company, rests on telling income and expenses apart and adding each up correctly. The same two ideas return in the trial balance, in adjustments and in the final accounts. Master the difference now and the income statement, and much of what follows, will feel straightforward.
Are you unsure how to tell income from expenses, or from assets and liabilities? One of our teachers can sort a page of items with you in a one-to-one lesson.
They will explain each choice. Book a trial class.