Hey guys, I'm James and welcome to the very first episode of Accounting Stuff. In this video I'm going to talk through one of the most important principles of accounting, explain what it means, and run through how it is used. This episode is all about the Accounting Equation and is going to be part of a playlist that I'm creating on Accounting Basics.
I will add links to the rest of the videos in the series to the description below. So, why the Accounting Equation? This equation lies at the heart of accounting and is the foundation of the double-entry accounting system.
I hope you find it informative. Let's do this! The key principle behind the accounting equation is that Stuff the Business Owns is equal to the Stuff that the Business Owes, and it is vitally important that you remember that this equation balances.
Always, always, always! Now let's say I come up with this amazing idea for a business. I want to make popcorn and sell it I've got five dollars in my pocket, and I decide to lend it to the business.
Now there is a word to describe the stuff that the Business Owns and that is called Assets. On the other side of the accounting equation we actually have two different words to describe what the Business Owes and that depends on who the lender is. We use liabilities to describe what the business owes to third parties, and we use equity to describe what the business owes to its owner.
. . in this case me.
So Assets equal Liabilities plus Equity. There we have it, the full accounting equation. Simple, hey?
So that five dollars that my popcorn business now has is called an Asset and that five dollars that my business owes back to me is called Equity. See it balances! Assets can include things like Cash, Accounts Receivable, Inventory, Plant Property and Equipment, Land and Buildings, Investments and Goodwill.
Whereas Liabilities can be made up of Accounts Payable, Loans Payable, Wages Payable and Taxes Payable. Amongst other things. The most common forms of Equity are Stockholders or Owner's Equity and Retained Earnings.
I will cover Retained Earnings in detail in a further video. But for now you can just think of it as Profit Held for Future Use. Now let's add some totals to the above and see if this thing still balances.
Of course it does, the accounting equation always balances! And a Balance Sheet is basically a snapshot of our different Assets, Liabilities and Equity at a single point in time. A Balance Sheet is one of the most important Financial Statements.
There is a lot you can tell about a business by looking at its Balance Sheet. Right so at the beginning of this video I promised you a couple of examples so here we go! If I head down to the shop and spend five dollars on corn then I no longer have five dollars in cash but I now have five dollars of inventory.
The categories have now changed but my Total Assets stay the same. My Balance Sheet is in balance. Now I need to pop this corn.
But I don't have enough money to go and buy a pot. So I go to one of my friends, and I ask them if I can borrow ten dollars. The businesses Cash increases by ten dollars, and Loans Payable go up by ten dollars as well.
Total Assets are now fifteen dollars, and my Liabilities plus my Equity are now also fifteen dollars. We're still in balance. I then go and spend this ten dollars on a pot.
My Cash goes down by ten dollars and my Equipment goes up by ten dollars. Let's say I go and sell this first batch of popcorn at a sixty percent markup on cost. So I've made sales of eight dollars.
All my inventory has now gone, however I now have eight dollars in Cash, and have made a small Profit of three dollars. My Profit is three dollars because my Sales were eight dollars and my corn cost me five dollars to buy. Eight less five is three dollars.
Remember I said that we can think of Retained Earnings as Profit Held for Future Use? So my Retained Earnings are going to increase by three dollars. Because my business has made a Profit of three dollars, my Total Assets have now increased from $15 to $18.
So to recap, in this video we have learned that Stuff that the Business Has is equal to the Stuff that the Business Owes. This can be re-worded to form the Accounting Equation. Assets equal Liabilities plus Equity.
This equation ALWAYS balances. The expanded Accounting Equation forms the Balance Sheet. And a Balance Sheet is a snapshot of a business's Assets, Liabilities and Equity at a single point in time.
Phew! If you have made it this far. .
. Thank You for watching! As I said at the start of the video, I'm making a playlist on Accounting Basics, so soon there going to be a bunch more videos just like this one.
If you have any suggestions for topics you'd like me to cover, let me know in the comments and I'll see what I can do. If you're really keen and would like to do some extra reading on the subject, I can recommend this book by Darrell Mullis and Judith Orloff. It's called "The Accounting Game: Fresh from the Lemon Stand".
I think Darrell and Judith do a really good job of explaining some of these accounting concepts in an intuitive way that is easy to follow. I'll throw a link to it in the description below. That's all for today, thank you for watching, see you next time!
