hello I'm Professor Brian B and welcome back in this video we'll take a look at the one rule of grammar in the accounting language the balance sheet equation we'll see how the balance sheet equation makes all the financial statements fit together we'll also use the balance sheet equation to solve some problems where we're missing one piece of information but we can fill in everything that we do know into the balance sheet equation and solve for what we need hope you enjoy the video so if you've ever tried to learn a foreign language you know that
one of the most difficult things is learning all the rules of grammar all the cases and declensions and the changes in verb endings and all that stuff well the good news about learning the language of accounting is that there's only one rule of grammar the balance sheet equation or the accounting identity this is that assets equal liabilities plus stockholders Equity at all points in time another way to say this as we've talked about is that the resources of the company equal the claims on those Resources by The Outsiders and by the owners can you give
me an example of when this is used in the real world a good example to think about how we use the balance sheet equation in real life is when we buy something big like a house or a car so let's say we wanted to buy a $500,000 house but we only had $50,000 of cash well we would need to go out and borrow $450,000 from the bank in a mortgage in order to buy the house then after we bought it we'd have 500,000 in assets the house which is equal to the 450,000 of liabilities the
mortgage plus 50,000 in equity which is how much cash we put in and which represents our claim on that house the most important feature of the balance sheet equation is that it must always balance and that's why we're going to talk about something called double entry book keeping if you increase something on one side of the equation you have to increase or decrease something else to stay in Balance so there has to be at least two entries anytime you Tinker with the balance sheet equation and as we'll see the changes between two balance sheets are
going to be summarized in the income statement the statement of stockholders equity and the statement of cash flows so let me show you this graphically so let's say we have a balance sheet at the end of December 31 2014 assets equal Li for stockers Equity we'll split the assets Into Cash non-cash assets and we'll split stock holders Equity into contributed capital and retained earnings which are Concepts we'll talk more about in later videos then we have a balance sheet at the end of the year so we've got one at the beginning of 2015 at the
end of 2015 the difference in the retained earnings is going to be explained in the income statement for the year ended December 31 2015 and the difference in cash is going to be explained in the statement of cash flows for the year ended December 31 2015 here you go again with a difference between income and cash remind me why are they different okay let's go back to the house example so let's say on your first balance sheet at the beginning of the year you have a $500,000 house which is your asset $450,000 mortgage which is
your liability and 50,000 of equity now let's say that during the year the value of your house increases to a million dollar now you can't actually do this in practice but for the sake of the example let's assume you could write up the value of the house from 500,000 to a million at the end of the year so your balance sheet at the end of the year would have a million doll asset the house 450,000 of liabilities because the mortgage doesn't change but your Equity would go up from 50,000 to 550,000 now if we look
at the statements that explain the changes into balance sheet none of this affects the cash flow statement because there's no cash impact of your house going up in value in fact your cash actually probably went down as you were paying the mortgage but your income statement would show a gain of $500,000 from the increase in your Equity due to your ownership claim of the house housing prices going up can you give us a more contemporary example okay so let's talk about what happened during the financial crisis of 2007 2008 2009 there were Banks out there
that had assets called mortgage back securities these are assets because they're claims on collecting cash payments from uh people that took out subprime mortgages so let's say a bank had 10 billion of these mortgage back Securities as assets and let's say they had 9.5 billion of liabilities and half a billion of equity financial crisis hits these homeowners no longer make their mortgage payments which means these assets drop in value so now they have to be written down in value from 10 billion to let's say 1 billion now the liabilities don't change in fact that's why
you need a government bailout because your liabilities don't change but what does change is the equity the equity drops by 9 billion as well and so it's another example where there's no cash flow impact of the change in these two balance sheets but we end up showing A9 billion loss on our income statement due to the drop in our Equity claims on those assets of course we also have to mention the statement of stockholders equity which explains the changes in stockholders Equity between two balance sheets which we will talk about more later in the course
what I want to do next is show you how everything that we're going to talk about fits into this balance sheet equation so we' talked about how stock holders Equity has two components contributed Capital which is the money that we raise from shareholders and retained earnings which is what we create by operating the business retained earnings is going to equal whatever retained earnings were at the beginning of the period period plus any net income earned During the period minus any dividends paid out to shareholders that's why it's called retained earnings because it's the earnings or
net income less any dividends paid out and then net income as we talked about in a prior video is revenues minus expenses so if we put all of this into the balance sheet equation we get one big complete balance sheet equation which is assets equal liabilities plus contributed Capital plus your prior retained earnings Plus plus revenues minus expenses minus dividends that you pay During the period are you going to make us do some mathematic SES why yes I am going to ask you to do some [Music] math now I'm going to give you some problems
give you a chance to try to answer the problems and then we'll talk through the answers after I read the problem you'll see a little pause icon on the screen scen if you want to try to answer the problem before I give you the answer pause the video at this point try to come up with the answer and then resume the video but if you want to just roll through and hear the answer right away then it's okay to keep the video going this is going be the procedure that we follow anytime that I give
you some questions that I want to try want you to try to answer during the video lecture okay here's the first one assets equal 100 liabilities equal 50 what is stockholders equity we can solve this one with the balance sheet equation we know that assets are 100 liabilities are 50 the only thing that's missing is stockholders equity which has to be 50 so that we have 100 on the left hand side and 100 on the right hand side next liability is increased by 100 and stockholders Equity is unchanged what is the change in assets again
we can use the balance sheet equation to answer this but now we're looking at changes in the numbers so stockhold as Equity is unchanged liabilities go up by 100 the only way for the equation to stay in balance is for assets to also go up by 100 next all non-cash assets are 70 total liabilities are 60 total stockholders Equity is 30 what is cash we can use the balance sheet equation for this one if we separate assets into cash and non-cash assets so we have liabilities of 60 and Stock's Equity of 30 that's 90 on
the right hand side non-cash assets are 70 the only thing missing is Cash which has to equal 20 so that we have 90 on each side next cash decreases by 10 and all non-cash assets increase by 15 what is the change in liabilities we can use the same equation but we have to be a little bit careful we have cash going down by 10 non-cash assets going up by 15 we're looking for liabilities but we don't know what happened with stockholders equity and because we don't know what happened with stockholders Equity we actually don't have
enough information to solve this now if we knew that stockholders Equity had not changed then liabilities would have had to go up by five so that we have an increase in five on both sides of the equation but without knowing what happened to stock holders Equity we technically don't have enough information to answer this one but come on a trick question really uh sorry about the trick question but I promise that it won't be the last next we have retained earnings increasing by 100 Dividends are 50 what is net income earlier in the video we
looked at the equation for retained earnings where retained earnings is equal to Prior retained earnings what they were at the beginning of the year plus net income during the period minus dividends so we know that the change in net income or change in retained earnings retained earnings minus prior retained earnings is 100 we know that dividends is 50 so the only thing missing is net income which has to be 150 for this to balance next next we have Revenue increasing by 100 all other categories are unchanged except assets what is the change in assets we
have to use the complete balance sheet equation to solve this one so that we break stockholders Equity into contribute to Capital prior retained earnings revenues expenses and dividends so we know that revenues are going up by 100 everything else is unchanged but assets which means that assets also have to go up by 100 so that both sides of the equation increase by 100 finally expenses increase by 60 and all other categories are unchanged except cash what's the change in [Music] cash we'll again use the complete balance sheet equation but now we'll split assets into cash
and non-cash assets so we know that expenses went up by 60 everything else is unchanged except for cash now notice on the right hand side of the equation expenses going up by 60 means the right hand side goes down by 60 which means that cash also has to go down by 60 for us to stay in Balance I think I can do this can we do more maths problems finally some positive feedback the the purpose of this exercise was to preview the type of problem that you're going to be doing a lot in this course
there's going to be a certain piece of information that you need that you're not given but you can take all the other information that you're given and a set of equations which will usually be in the form of te accounts or journal entries fill in everything you know and then solve for that one piece of information that you need but you can't find in the financial statements wow has it been 12 minutes already time sure flies when you're doing the balance sheet equation so I'm going to go ahead and wrap up this video and we'll
come back next time and talk in more detail about assets liabili and shareholders Equity I'll see you then see you next video
