Fundamental Accounting Equation - Video Tutorials & Practice Problems
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concept
Fundamental Accounting Equation
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Alright. So now let's discuss the fundamental accounting equation. The foundation for everything you're going to learn in this class. You ready for the big reveal? It's already on your paper. So I guess you've seen it already. Alright, well, the equation is right here assets equal liabilities plus equity. How exciting is that? Right? That is the big equation of accounting here, assets, equal liabilities plus equity. Alright, so let's discuss what each of these are and we'll see how this is always gonna be true. Okay, So, let's start with assets, assets are gonna be anything tangible or intangible that is owned by the company. Okay. So this is anything that they own and we're gonna break this up into two categories. We're gonna call them current assets and current assets are gonna be cash or anything that can be converted into cash in less than one year. Okay, So, typical things that we see in current assets are gonna be cash, We're gonna see accounts receivable money that's owed to us by our customers inventory, right, merchandise that we're selling, things like that, right? Things that that we're going to convert into cash pretty soon within one year, compare that to our long term are fixed assets, right? These are assets that we're gonna expect to use for more than one year. So, good examples of those are gonna be things like land or machinery or if we buy a building, right? These are things that we're not just gonna use for one year. We're going to use them for a long period of time. All right. So, we make this distinction at the one year mark, That's kind of the cut off current assets less than one year. We're gonna use it for multiple years. That's a long term asset. Okay, how about liabilities? So now we're on the right hand side of the equation, right, assets are gonna equal liabilities plus equity. So liability. Well, this is money that the company owes to other people. Right? We have a liability to pay this to other people. These are our liabilities. So current liabilities. Well, these guess what what do you think is gonna be current? What's when we have to pay them in under one year? Right. Just like with our current assets and long term assets, we have the same threshold of one year. So, some common current liabilities like you see here is accounts payable. This is just general money that we owe to people. We had an invoice and we've got to pay that invoice to them. Well, that's an account payable or short term debt. If we took out a loan that we're going to pay back in less than a year, just a short term kind of keep our money flowing. Well, that would be a current liability compare that with a long term liability, which is something that's payable in over one year. Right. And these are gonna be things like long term loans when we get a bank loan or bonds, bonds is another way to raise money through loaning out through getting a loan. Okay. So those are liabilities, let's go on to equity. So, remember assets, equal liabilities plus equity. So here's equity and it has two main components. So the first one it's gonna be the money. So equity is gonna have the money that the stockholders the owners of the company put into it when they first started the company. So when they first raised capital, they put money into the company. All right, this is going to be equity, right? This isn't money that the company owes to other people. This is money that the owners put in themselves. And then there's also gonna be the earnings that accumulate over over time, the earnings that are accumulated, but they're not distributed. So you think about a company making a ton of money, but they don't just take that money that they made and then give it back to the investors, right? They don't just pay a lot of dividends. What we call the payments to investors. A lot of that money gets held by the company and reinvested to make the company grow bigger and make even more money. Right? So this is the equity, the equity is gonna have that money that you first raised and it's also gonna have all the money that you made over time. So you can imagine as the, as the company's in business years and years and its earning profits years over years. Well, the equity in the company is gonna grow, right? There's more money that's owned by the company rather than liabilities to outsiders. Okay, So I want to go back up to this equation before we keep going into equity here. And I just want to point out that assets, right? This is what's owned by the company and this is how we pay for it, how we pay for or how we finance it, okay. How we finance assets. So we're either going to finance our assets with liabilities, money that we owe to other people or equity money that is ours, part of the company already. Okay, so let's go on with a few of these details about equity and let's talk about some of the main accounts that we see in equity. Okay, the first one is paid in capital. This has to do with that first investment that the company makes, that the owners make into the company. Well, this is the amount that the owners have invested, right? So just like we said, the paid in capital and it's just like the account sounds like paid in capital, its capital, that's been paid in capital, just being money, right? Retained earnings. Well, this is income from previous years. So this is what we're just talking about above income from previous years. That has not been distributed as dividends, dividends, being payments made to the stockholders. Okay, so these retained earnings, you can imagine as we make money year over year. Well, we're gonna be retaining right? We're retaining some of that money inside of the company rather than paying it out to the stockholders. So that retained earnings, that's also going to be part of our equity. And then we're gonna have the current year, when we talk about this year, when we're making money this year, we have revenues, revenues is money coming into the company. So it's inflows of resources. So when we make a sale or something like that, we're gonna get revenue from selling right? And it's generally cash is going to be what we're getting as inflows. But there could be other things as well and we'll discuss that later when we, when we dive into revenues and expenses. So expenses is the opposite right? Revenues is the money coming in expenses. Those are gonna be our outflows. And it's generally cash again, but it could be whatever outflow, right? If the company needs something, if, if we need a service from, from an outsider, we're gonna have an expense when we have to pay for that. Right? So we've got our revenues and our expenses, these are current year items, right? Where when we think about retained earnings, these were the revenues and expenses from previous years. Okay, So now we're talking about revenues and expenses this year and then we've got dividends, right? So dividends, these are gonna be the payments to share shareholders and these come out of our retained earnings, right? So we have so much money and retained earnings and then we're gonna say, hey, let's pay some of this off to the shareholders and that comes out of the retained earnings. So here we go. All caps here. Obviously, I don't want you to miss this, dividends are not an expense. Okay, Everyone say it together. Let's all say it out loud together, dividends are not an expense. Great, isn't it great when we talk in unison, how are we talking class? We're talking in unison. It's the best way to learn. I'm just kidding. But seriously, dividends are not an expense. That's huge. And this is like one of the biggest ways they love to trick you in your first accounting classes to put, hey, how much is the dividends, expense in this situation? No such thing. Okay, dividends is just payments out of the retained earnings. Okay, this is money that the owners already own, but it's left in the company and then they pay a dividend to pay it out to the owner. Okay, Not an expense. So last is the income or the loss. So the income or the loss. Well that's gonna be a net amount income or loss. This is when we take our revenue minus our expenses, we're left with our income or our loss. Right? We would have a loss if the expenses were more than the revenue either way. So this is just the net amount and I just want to make a note that income and profit are the same thing. We use those terms interchangeably, but revenue is not the same as income. Okay. I see a lot of students when they start off in in accounting courses, they don't make a distinction between revenue and income. They just don't know the difference. So just remember that revenue is all the money coming in. But income deals with the money that came in minus the expenses during that period as well. Okay, So we've got a revenue minus expenses to get to income. Cool. So let's go ahead and pause here and we'll do a short example to just discuss the idea of equity a little more in the following video. Alright, let's do that now.
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example
Fundamental Accounting Equation
Video duration:
2m
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Alright, so let's just discuss a simple example of gaining equity when you buy a house. Okay, so let's start here on the left hand box, we say the home costs $150,000 and you make a 30,000 down payment? The remainder is a mortgage from the bank. Okay. So a lot of times when we're dealing with accounting, it's gonna be a lot about analyzing sentences like this. Okay, So the home here the $150,000. That's the asset. That's the value of the house. Right? So we'll remember our our formula is assets equal liabilities plus equity, right? That's our formula. Well, in this case the asset is the $150,000 right? That is the value of the house. And how are we financing that house? How are we getting the money to pay for it? Well, we put 30,000 down, Right? That is our equity. This is the the money that we put into it. We have equity in that house of that 30,000 and the liabilities. What we owe the bank the rest of the money, Right? The house is worth 100 and 50,000. We took a loan for the remainder which is 120,000, right, 100 and 50 minus 30 leaves us with 100 and 20,000 In liabilities. Okay, so this is how we would set up the equation when you first purchased the house. Alright. And now let's say time is going by and you pay off pay off some of the principal on the loan and you paid off 20,000. Right? So what happens when you pay off 20,000 of the loan? Well, the house in this case is still worth the same amount. Right, so the house is still worth $150,000, whoops. Let me clean that up. But how is the liabilities and equity split up? Now you no longer owe 100 and 20,000 to the bank. Right. You've paid off 20,000 of that mortgage. You only owe now 100,000 to the bank. Alright. So what's happened? Your equity has increased by 20,000? Right, it's up to now 50,000. So this is your assets liabilities and equity here, Right? And there you go. That's how it happens. So as you pay off the mortgage, your equity in the house keeps increasing. So the amount of the house that you own increases as you pay off those liabilities. And that's how we're going to see the relationship between assets liabilities and equity. We're going to see this relationship where there's gonna be transactions that happen and then we have to adjust our equation, right? Maybe our assets go up. Maybe our assets go down, right? We're gonna have to adjust. But the same is always gonna stay true that this equation is always gonna balance assets will always equal the liabilities plus equity. Alright, cool. Let's go ahead and move on to the next video
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Problem
Problem
A company has assets totaling $50,000 and equity of $20,000. What are their liabilities?
A
$0
B
$20,000
C
$30,000
D
$70,000
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Problem
Problem
A company has liabilities of $25,000 and assets of $35,000. What is the company's equity?
A
$10,000
B
$20,000
C
$30,000
D
$60,000
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Problem
Problem
If a company has liabilities of $65,000 and equity of $25,000, what are the company's assets worth?
