Hello this is below a quick trip to the accounting
equation so the framework in which modern-day
accounting is bases.
As noted this thing the equation is it least
500 years old in terms of organized documentation.
It's all about relationships what kind of
relationships are we talking about here?
Well first if we have an equation it must
be two-sided.
So let's try and equation in here we'll call
our world of accounting and all assume the
Flat Earth theory here.
So first of all this is the entire world that
were speaking of here.
The equation is embedded in this world of
accounting.
So let's put a line down the middle and let's
populate the pieces here.
I'm going to segment the right hand side into
two pieces this is a very important side will
come back to you shortly.
Now 1 point of caution here.
Has more is put into this world the boxes
get bigger.
Has more taking out the boxes get smaller.
Very simple Concept.
In other words these boxes breathe like the
lungs.
They’re static.
They’ll either grow or shrink.
So looking at our world of relationships here
we're looking at the left side and right side
that is segmented into two categories.
First of all let's concentrate on the left
side of the equation.
On the left side of the equation your accounting
World simply lists what a company has to operate
its business.
The right hand side is simply listing of where
those things came from.
So the fundamental relationship is whatever
increases the left side has to also increase
the right side.
What a business has and where it came from.
So for the business that has where do they
come from?
First of all they come from lenders.
Lenders can loan assets to get assets into
a business.
Secondly the owner can cause assets to come
to the business.
Now accountants called when a business has
assets.
Items that come from a lender are called liabilities.
And the owner's Contribution to business is
called equity.
The right hand side the liabilities Equity
equal the total assets of a business.
So what it has is equal to the sources of
where they came from.
Either lender or an owner.
A simple example, if an owner put a building
worth $200,000 into a business He would have
$200,000 on the left and then the business
equation on the right would show how that
building was funded.
For example, if it was funded by a $20,000
down payment by the owner that would be the
owner's equity right hand box.
If the balance of $180,000 was funded by a
loan from the bank that would be the upper
right hand corner.
So $200,000 on the left Equals $180,000 in
the upper right plus $20,000 in the lower
right.
Now these terms asset, liability, owner's
equity are so important that they form the
formal accounting equation that is assets
on the left equals liability positions and
record positions on the right.
We see our assets on the left or what a business
has set opposite of the parties responsible
for those assets.
Now those who loan assets to businesses are
known as creditors.
Creditors must be repaid.
Owner Equity is also known as owner capital.
The term owner equity and owner capital are
interchangeable.
Now back to our big picture.
What a business has in the left and the sources
of what it has on the right.
The division down the middle to great Divide
is very important.
One side equals the other side.
I can't overemphasize that Great Divide.
That line down the middle separates two completely
different worlds.
The world on the left is the real thing assets.
Items that the business uses to operate on.
The list of items on the right is the reasons
why those assets exist.
It’s essentially to keep this distinction
in mind.
The real thing or things of value things on
the right are reasons why assets came into
the business.
The listing on the right forms are initial
reporting for Financial reports that we’ll
look at later.
So quick review, what a business has on the
left are called assets.
Assets can come from lenders and we call those
liabilities.
Penny's borrowings must be paid back.
Or items come from the owner which is known
as owner's equity or owner’s capital.
Now the owner box the lower hand right has
four basic activities that we can keep track
of.
We’ll come back to those shortly.
It's very important that this area be focused
on your first orientation to accounting.
Now let's take a step back and look at that
left side versus the right side.
The left side with a business has is as indicated
what in the business.
The right hand side Two separate boxes is
the why side or why assets exist.
Specifically the reasons why assets exist.
So let's rebuild our equation from the ground
up.
The world of wealth on the left and the reasons
why that wealth exists on the right side.
Or individual assets on the left side.
Liability positions until they're paid back
in the owner Equity position.
The left side must always equal the right
hand side.
Now and any equation there's only 4 conditions
to keep it in balance.
Again what on the left and the reasons why
on the right.
First of all if we increase the on the left
we need to increase the reasons why on the
right to keep it in balance.
Likewise if we decrease the one on the left
we must decrease the reason on the right.
Another condition, if we increase somewhat
and decrease another what, A plus and a minus,
our equation stays in balance.
Similarly on the right side if we increase
the reason why and decrease another reason
why the equation stays in balance.
All transactions or economic events that were
recorded in accounting Fall into one of these
4 conditions.
Be sure that you are able to identify which
condition is affected when you look at the
transaction for recording.
Now back to our equation picture, what's think
about the things on the left, the things that
a business has that it operates on.
What kind of things does a business need?
Cash very flexible an important asset, another
thing, things to sell.
Walmart has thousands of items on it shelves
to sell.
We call that inventory by the way.
Start thinking A business would have land.
They may have buildings.
They may have equipment such as a computer.
They may have item such as a truck for delivery.
All of these things have one thing in common
they are things of value that are owned and
controlled by the business.
The only question is where do they come from?
Again we saw that they can come from lenders
or owners.
A loan by a lender or some activity that the
owner is responsible that brought the asset
into the business.
As assets on the left are used up, we will
reduce one of the boxes on the right.
Again another short recap.
On the left we have property.
On the right we have property rights.
Which party has right or claim to the property
in the business?
The property on the left that is owned or
controlled by the business is listed on the
left hand side has a party on the right who
has claims against that property because that
party help to bring assets into the business.
I want to comment on the lower right-hand
box of our equation here.
Our map of the world.
Owner Directed activities, this is traditionally
a black hole of understanding for beginning
students, I want to recap the 4 activities
that can be Recorded in that lower right hand
corner box.
First investment by owner.
it would increase the owner's equity position
for any investment that an owner would make.
Expenses, expenses are incurred that is use
of assets generated sales would reduce the
owner Equity category.
If I don't have obtained all of the benefits
or fruits of business that is revenues or
sales they also get Fund the expenses.
So expenses reduce the owner's equity with
revenues or sales increasing the owner's equity.
Lastly, takeaways an owner has the right to
remove assets from the business.
If it does it will reduce its owner's equity
section as assets on the left are also reduced.
These 4 owner directed activities investment
expenses revenues and takeaways are the most
complex area to study as you begin your accounting.
That lower right-hand box is the most complex.
Now let's bring our three basic elements,
our accounting equation back into focus, let’s
bring into Focus the basic elements about
equation.
Assets come into a business on the left maybe
they got there because we borrowed money from
a bank.
That is we incurred a lot of liability.
If additional assets come in they may come
in from owner Equity activity such as investment.
So assets would increase again in this case
we then increase the owner's equity category
If it was an owner activity that was responsible
for that increased asset.
Nothing of value comes into a business without
reflecting or recording the reason for it.
It is a liability or a creditor loaning an
asset or the action of an owner.
It’s the owner Equity area as I mentioned
earlier, that's usually the most challenging
to understand.
Let’s look at that further.
Again our basic map the lower right-hand side
we call that the reasons an owner can invest
money increase in assets on the left increasing
owner equity on the right.
An owner can incur an expense meaning assets
go down on the left end reducing owner equity
on the right.
Revenues, which are sales activity increase
assets on the left and they increase owner's
equity on the right for that sale activity.
Or an owner can take assets out reducing assets
on the left and reducing owner's equity on
the right.
These are all 4 reporting activities that
mirror changes in assets on the right side.
Everything recorded on the right side mirrors
or reflect the changes made on the left hand
side.
Whether it be the liabilities on the top right
side or the owners’ equity on the bottom
right.
Let's talk about basic transactions that affect
assets and the owners’ Equity area in the
bottom right.
For example, and the owner invests cash into
a business Cash on the left goes up.
Due to an investment by the owner on the right.
Left side increases the right side owner Equity
increase.
Or if an owner takes away assets they decrease
on the left and we would record that decrease
in a takeaway count on the right hand side.
Every change to an asset on the left must
be reflected by the reason on the right hand
side.
This dual relationship is called double-entry
accounting.
Items created on the left, reasons explaining
that on the right.
If the assets decrease on the left we show
a corresponding reason on the right hand side
that explains the decrease in assets.
So as assets change on the left so does reasons
for accountability on the right.
This precise relationship Kama so it was previously
documented 500 years ago buy an Italian Monk
named Luca.
It was the basis for all our accounting even
today.
Again the basic equation, assets on the left
are set equal to liability positions or owner's
equity positions, sometimes called honor capital
on the right.
And if we expand the basic equation on the
right leave 4 activities of the owner Investments,
expensive, revenues, and takeaways Form the
detail of the owner's equity area.
Keep these relationships simple.
The left hand side equals the right hand side
of the equation.
Assets on the left and where they came from.
Lenders or borrowed and owner directed activity
are also recorded on the right.
Now let's shift to financial reporting.
Onto the equation, all of our reporting is
going to come out of one of these three boxes.
Will start in the lower right-hand side, the
owner's equity side.
The first two reports come from this box the
owner's equity box.
The income statement, which is a subset report.
It comes out of activity Recorded Revenue
expenses in the right-hand bottom corner.
We also have an equity statement in the bottom
right-hand corner.
This is a larger but more condensed report
this is called a net worth.
Income is part of the owner’s net worth,
for this financial report our focus is on
the owner of the business.
The income statement explains why assets change
due to the Profit-seeking activity of the
business and the owner's equity statement
reflects the total Net worth of the owner.
They're either increasing or decreasing do
to 4 activities Investments, expenses, the
revenues expenses which are the income statement
and any takeaways reduce it.
A primary focus of the owner is to build equity
in business that is to grow assets and to
grow the bottom right-hand side known as building
equity.
Now income statements can record profits or
they can record losses.
If they record losses that means the assets
on the left have shrunk and the income statement
would show a loss on the right hand side.
Now the third financial report that we will
study in this course is known as the balance
sheet.
This will focus on all three boxes.
Ending balances.
Ending balances of what?
Ending balances of individual asset amounts.
Ending balances of individual liability amounts
and various payables I know payables accountable
to the bank and accounts payable to a general
vendor etc.
Liability accounts are primarily noted by
the use of the word payable.
The business owns it.
Now the balance sheet reports all of the individual
assets, all individual liabilities it needs
one more number to balance.
That 1 pounds and number is the total owner
net worth or Equity of the business from the
perspective of the owner.
Even though there are four activities that
reflect that bottom right-hand box we want
one balancing number.
One owner Equity or owner Capital position
to balance against individual assets individual
liabilities.
In fact, if our individual assets are accurately
known we can balance our balance sheet by
plugging in the number to balance the right
hand side to left hand side.
Now In proper form we will develop that number,
but I also want to point out that it can be
plugged in if you know individual assets and
liability amounts.
The ending owner Capital is what's necessary
to balance the balance sheet.
This balance she is the total accounting equation.
All 3 of our reports are related.
All three boxes are used.
Lower hand corner box, the first subset income
statement and the first owner Equity statement
Are the first reports And in the third report
is all three boxes.
Assets on the left, liabilities on the right,
and one owner Equity position ending balance
on the right.
All reporting is cut from the same cloth that
is the accounting equation.
So in a few moments here we've gone from the
accounting equation to all the basic financial
reports that we'll cover in the next Accounting
course.
Be sure you understand what's in this equation,
the world of accounting.
Assets on the left and where those assets
came from on the right.
Please review this equation to make sure you
understand the concepts.
