The ACCOUNTING EQUATION For BEGINNERS

Summary

In this first episode of 'Accounting Stuff,' James introduces the fundamental principle of the accounting equation, explaining its importance in double-entry accounting. He breaks down the equation, showing that a business's assets (what it owns) equal its liabilities and equity (what it owes). Using simple examples, like starting a popcorn business, James illustrates how transactions impact the balance sheet while maintaining the equation's balance. He also touches on topics like retained earnings and promises more videos in a series on accounting basics, recommending 'The Accounting Game' for further reading.

Takeaways

• 📊 The video introduces the Accounting Equation, which is essential to understanding double-entry accounting.
• 💼 The Accounting Equation is expressed as 'Assets = Liabilities + Equity' and must always balance.
• 🤑 'Assets' represent the stuff that the business owns, like cash, inventory, and equipment.
• 🤝 'Liabilities' are what the business owes to third parties, such as loans or accounts payable.
• 👨‍💼 'Equity' refers to what the business owes to its owner(s), such as owner's equity or retained earnings.
• 📑 A Balance Sheet is a snapshot of a business's assets, liabilities, and equity at a specific point in time.
• 💡 The speaker uses a popcorn business as an example, showing how transactions impact the accounting equation.
• 📉 Assets can change categories (e.g., cash to inventory) without affecting the balance of the equation.
• 💰 Retained Earnings are explained as profits held for future use, which increase when the business makes a profit.
• 📚 The speaker recommends the book 'The Accounting Game: Fresh from the Lemon Stand' for more intuitive learning.

Q & A

What is the Accounting Equation?

The Accounting Equation states that Assets equal Liabilities plus Equity. It represents the core principle of double-entry accounting, ensuring that what the business owns (Assets) always balances with what it owes (Liabilities and Equity).

Why is the Accounting Equation important?

The Accounting Equation is the foundation of accounting. It ensures that a company’s financial statements are accurate and balanced, reflecting that all business transactions are properly recorded.

What are Assets in the context of the Accounting Equation?

Assets are resources that the business owns, such as cash, inventory, property, equipment, and investments. They represent the value of things that the company controls and can use to generate revenue.

How are Liabilities defined in accounting?

Liabilities are obligations that the business owes to third parties. This includes accounts payable, loans payable, wages payable, and taxes payable. They represent claims against the company's assets by external parties.

What is Equity in the Accounting Equation?

Equity represents the owner’s stake in the business. It includes funds that the owner has invested and profits retained in the company (Retained Earnings). Equity reflects what the business owes to its owners.

How does the Accounting Equation relate to the Balance Sheet?

The Accounting Equation forms the basis of the Balance Sheet, which is a financial statement showing a snapshot of a company's Assets, Liabilities, and Equity at a specific point in time. It illustrates how the equation balances in practice.

What happens to the Balance Sheet when the business borrows money?

When the business borrows money, Cash (an Asset) increases, and Loans Payable (a Liability) also increases by the same amount. This keeps the Balance Sheet balanced as the increase in Assets equals the increase in Liabilities.

What is Retained Earnings, and how does it affect the Balance Sheet?

Retained Earnings represent the accumulated profits of the business that are not distributed to the owners but kept for future use. They are part of Equity and increase when the business makes a profit, thus increasing Total Assets.

What is the significance of maintaining a balanced Balance Sheet?

A balanced Balance Sheet confirms that all transactions are correctly recorded, ensuring that the company's Assets are always equal to the sum of its Liabilities and Equity. This balance is crucial for accurate financial reporting and decision-making.

Can you provide a simple example of how the Accounting Equation works?

If a business starts with $5 in cash (an Asset) from the owner, it owes $5 back to the owner (Equity). If the business buys inventory with the $5, Cash decreases, and Inventory (another Asset) increases, keeping Total Assets the same, thus maintaining balance.

Outlines

00:00

👋 Introduction to the First Episode

James introduces the very first episode of 'Accounting Stuff,' where he will explain a crucial accounting principle, the Accounting Equation. This episode is part of a series on Accounting Basics, with links to future videos provided in the description.

❓ Why the Accounting Equation Matters

James explains the significance of the Accounting Equation, calling it the foundation of the double-entry accounting system. He emphasizes that the equation must always balance and is central to understanding accounting.

💼 The Business Example Begins

James introduces an example where he starts a popcorn business with $5. He explains that the money is categorized as an Asset, while the money owed to him as the business owner is classified as Equity. He introduces the full accounting equation: Assets = Liabilities + Equity.

📊 Components of the Accounting Equation

James defines Assets, Liabilities, and Equity. Assets are things like cash and inventory, Liabilities include things the business owes to third parties, and Equity represents what the business owes to its owner. He assures the viewers that the equation always balances.

🏗️ Examples of Assets and Liabilities

James elaborates on examples of Assets and Liabilities, such as Cash, Inventory, Equipment, and Loans Payable. He also briefly introduces Stockholders’ or Owner’s Equity and Retained Earnings, promising to cover the latter in more detail in a future video.

📈 Adding Totals to the Equation

James adds totals to the equation, demonstrating how it still balances. He introduces the Balance Sheet, explaining that it provides a snapshot of a business’s financial position at a specific point in time by listing its Assets, Liabilities, and Equity.

🛒 Buying Inventory Example

James walks through an example where he spends $5 on corn for his popcorn business, resulting in a change from Cash to Inventory in the Asset category. He emphasizes that despite the change in asset type, the Total Assets remain the same, ensuring the Balance Sheet is still balanced.

💸 Borrowing Money Example

James describes a scenario where he borrows $10 from a friend to buy a pot for the business. This increases both Cash and Loans Payable. He highlights that both sides of the equation still balance at $15.

🍿 Selling Popcorn Example

James sells his first batch of popcorn at a 60% markup. He explains how Sales and Profit are calculated, with Profit being the difference between the selling price and the cost of corn. The profit is added to Retained Earnings, increasing the business’s Total Assets.

📊 Recap of the Accounting Equation

James recaps the video, reiterating that the Accounting Equation (Assets = Liabilities + Equity) always balances. He also reminds viewers that the Balance Sheet reflects this equation and is a critical financial statement.

📚 Conclusion and Further Resources

James thanks viewers for watching and encourages them to check out his upcoming videos in the Accounting Basics series. He also recommends the book 'The Accounting Game: Fresh from the Lemonade Stand' for further reading on accounting concepts, with a link in the description.

Keywords

💡Accounting Equation

The accounting equation is the foundational principle of double-entry accounting, stating that Assets = Liabilities + Equity. This equation ensures that everything a business owns (assets) is funded either by what it owes to others (liabilities) or to its owner (equity). In the video, the host emphasizes how this equation balances at all times, using simple business examples like starting a popcorn business.

💡Assets

Assets are the 'stuff the business owns,' including cash, inventory, equipment, and more. They represent valuable resources that the business controls. In the video, James explains how the $5 in cash the business receives is considered an asset, and how different assets like inventory and equipment come into play in a business.

💡Liabilities

Liabilities represent what the business owes to third parties. Examples include loans, accounts payable, and taxes payable. The video highlights how borrowing $10 from a friend increases liabilities through loans payable, showing how liabilities balance with assets and equity in the accounting equation.

💡Equity

Equity is what the business owes to its owner. It represents the owner's financial interest in the business. The video demonstrates this concept by explaining how the $5 James lends to his own business becomes equity, balancing the equation alongside liabilities and assets.

💡Double-entry accounting

Double-entry accounting is a system where every transaction affects at least two accounts, ensuring that the accounting equation stays balanced. The host doesn't explicitly mention the term, but the entire video centers around this principle by illustrating how changes in one part of the equation (like an increase in assets) are balanced by changes in another (like liabilities or equity).

💡Balance Sheet

A Balance Sheet is a financial statement that provides a snapshot of a business's assets, liabilities, and equity at a specific point in time. The video explains that the balance sheet is derived from the accounting equation, and James shows how his popcorn business's balance sheet reflects its financial position as the business grows.

💡Inventory

Inventory refers to goods that a business holds for sale or use in production. In the video, James uses the example of buying corn for $5, turning the cash asset into inventory. This demonstrates how assets change form but remain balanced within the accounting equation.

💡Profit

Profit is the financial gain a business makes when its revenue exceeds its costs. In the video, James makes a $3 profit by selling popcorn at a markup. This profit increases the business's retained earnings, which is part of equity, reinforcing the balance in the accounting equation.

💡Retained Earnings

Retained earnings are profits that a business holds onto for future use rather than distributing to owners or shareholders. In the video, James briefly introduces the concept, using the $3 profit from popcorn sales to increase retained earnings, which impacts the equity side of the accounting equation.

💡Loans Payable

Loans payable are a form of liability, representing money borrowed by the business that needs to be repaid. In the video, James borrows $10 from a friend, which increases his business’s loans payable. This loan is crucial for demonstrating how liabilities work within the accounting equation.

Highlights

Introduction of the accounting equation, a core concept in accounting.

Assets equal Liabilities plus Equity, the foundation of the double-entry accounting system.

Explanation of the terms 'Assets' and 'Liabilities' in the context of a business.

'Equity' describes what the business owes to its owner, adding depth to understanding the equation.

Illustration of the accounting equation through a popcorn business example.

A Balance Sheet is a snapshot of a business’s Assets, Liabilities, and Equity at a given time.

How business transactions, like buying inventory and borrowing money, impact the Balance Sheet.

The importance of balancing the equation in accounting for any business activity.

Profit and Retained Earnings explained through the popcorn business sales example.

Inventory and equipment as components of Assets and their impact on the accounting equation.

Liabilities increase when borrowing money from external parties.

The relationship between Sales, Costs, and Profit, and how this affects Retained Earnings.

The expanded Accounting Equation forms the foundation of the Balance Sheet.

Balance Sheets as critical financial statements that provide insights into a business's financial health.

Recommendation of the book 'The Accounting Game' for further understanding of accounting concepts.

Transcripts

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!

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