 Hello, and welcome to the session in which we will discuss the accounting equation, the famous accounting equation. The most important thing in understanding the accounting equation is understanding its components. So what we're going to do, how we're going to tackle this issue is by looking at assets, understanding assets, then we're going to discuss liabilities, then we're going to discuss stockholders' equity. I will explain each one of them separately, then I'll put them in the equation to make a sense of things. This equation is the foundation for your financial accounting course, for your intermediate accounting course, for all of your accounting career. So you want to have a really strong foundation in the accounting equation before you start learning about accounting. Now before I start, I would like to remind you that if you are an accounting student or a CPA candidate, I can help you on my website, farhatlectures.com. I do have resources for your financial accounting, managerial accounting, intermediate accounting, so on and so forth. But if you are studying for your CPA exam, I do have resources that supplement your CPA review course. Now I don't replace your CPA review course, what I can do, I can supplement or I can help you with your financial accounting course on my website. I do have additional resources that's going to help you in addition to the lectures, some practice questions that's going to help you reinforce that knowledge. If not for anything, check out my website to find out how well is your university doing on the CPA exam. Please connect with me on LinkedIn, if you haven't done so, and check out my LinkedIn recommendation. Like this recording, share it, follow me on Instagram and Facebook. Let's go ahead and start to discuss the accounting equation. So this equation underlies the framework for recording and summarizing economic event, which we will see later. What we're saying is assets, all your assets must equal to your liabilities plus stockholders equity, which will prove that shortly. And if a business is liquidated, claims of creditors, liabilities, must be paid before ownership claim stockholders equity are paid. And once we use some numbers, we'll see what does that mean. So the best way to explain the accounting equation, in my opinion, is to break each component separately from the equation, explain it, then put the whole thing together and see how it all fits. So we're going to start by looking at the term asset. What is an asset? So what is an asset? So we need to know what is an asset? Assets are resources, are resources, a business own, owns or control. And they don't have to own the asset as long as they can control it. What does that mean? Let's assume, so I'm going to give you an example, although we haven't properly defined asset, I'm going to tell you a vehicle, let's a truck is an asset. I'll explain why in a moment. You can own the truck or you can control the truck. What do I mean by control? You might be using this truck, but the truck is in the name of the bank. The bank still owns the title. But as long as you can use the truck, then you're in good shape. It's an asset. So you don't have to own the asset as long as you can control it. Because you might have a building, but there's a mortgage, there's a loan against that building. So who owns the building? Really the bank owns the building because you have a loan against it. But you can use the building, therefore it's an asset. So assets are resources, things that the company own and control. For what purpose? Why do you acquire assets to provide future services or benefit to the company? So the company wants to benefit itself. They want to generate profit. They want to increase their assets more. So what they do, they utilize their assets to increase their assets. So you would use the truck to make deliveries. Just as an example. And by making the deliveries, you make profit. And by making profit, profit is cash, cash is an asset. So some examples of cash, some examples not of cash. Some examples of assets are cash, supplies, equipment, land, building, inventory. So any resource that's going to provide and the keyword is future benefit. And I'm going to underline this. I'm going to highlight this actually. I'm going to highlight the word future, because it's important. Let me highlight the word future in yellow. So notice I highlight the word future to kind of keep reminding you that it's an asset, if it's going to provide you future benefit, okay? Because sometimes you buy something and you pay for something, but it doesn't provide you future benefit. We're going to call it something else. So a fundamental aspect of asset is its future benefit. Yes, if you have supplies, you're going to use them in the future. If you have a piece of equipment, if you have a computer, if you have cash, you could use it for the future to benefit the business. Okay, so this is what assets are. Liabilities, what are liabilities? Simply put, hopefully we are all familiar with the term debt. Liabilities are debt. Simply put, it's a debt. Some, you owe someone money, debt. That's one word for liabilities. Or you can say another word is obligations. So let's take a look at the definition of a liability. The definition of liabilities are claims against asset. So someone has a claim. Claim means they can claim their asset. They can say, give me back my money. They have a claim against their asset. Why? Why do you have a claim against asset? Why someone has a claim against asset? Because in the past, they lend you money, that could be an example, they lend you money. Or in the past, you purchased from them something. You purchased on account. What does it mean you purchased on account? It means you bought something. You bought goods and services from someone that you did not pay them. You did not pay them. Therefore, what's going to happen now? They have a claim against your asset. They're saying, you need to pay me back. So you have an obligation. You have an obligation to pay them. Why? Because as a result of a past transaction. But what else you need to know about liabilities, it has a future aspect. What's the future aspect? You have to pay in the future. You have to pay. So really, if you really think about it, a liability has three time frame. As a present time frame, present means you have an obligation now because of something happened in the past that would require you to make a payment in the future. And that's what a liability is. You have an obligation now because of something happened in the past, you have to pay it in the future. And liabilities are claims. Basically someone like the bank is claiming that you owe them money or you purchased supplies from someone from staples and you did not pay them yet. So they have a claim against your asset. Usually liabilities are provided to you by creditors, party to whom money is owed. When you think about creditors, we think about bank, but also your suppliers could be your creditors because they're selling you material on account. Now, for the purpose of an introductory course and for the purpose of just looking at the first chapter, you need to be familiar with two liabilities. And those are called accounts payable and notes payable. There are many other liabilities, but those are important for you to start the course. What is accounts payable is when you purchase material goods and services on account, it means you purchase them now and you're going to pay your supplier later notes payable notes payable is a fancy word for alone notes payable means you borrowed money from someone you borrowed money from someone. When we talk about notes payable, when you borrow money, there's always interest rate involved. So we'll talk about this in later chapter, how to account for notes payable. But that's the main difference between a notes and an accounts payable notes payable involve interest because you're borrowing money. The reason it's called a note because they make you sign a note, sign a paper saying you're going to be paying us this money in the in the in the in the future, not in the past in the future. So so assets liabilities equal to stockholders. I mean, I'm going to insert a new screen and we'll talk about this. So let's talk about assets. Let's assume now we know what assets are. Let's assume assets. Let's put the account and equation first here equal to liabilities plus equity. I'm just going to call it equity, but it's stockholders equity for short. So let's assume we have $300,000 of assets. We have $200,000 in liabilities, 200,000 in liabilities. Therefore, by process of computation, equity equal to $100,000. So we can say equity equal to $100,000. If we rearrange the formula, if we want to say what equity equal to, we can rearrange the formula by saying assets. Assets minus liabilities equal to equity. So simply put, if you have assets of $300,000 minus liabilities of $200,000, you will get equity of $100,000. So basically, we're saying the same thing. I just rearranged the formula. But by rearranging the formula, I hopefully you are starting to notice few things. One is, one way to define equity is to call it net assets. So one way to define equity is net asset. And what's net asset? Net asset, same thing as equity, asset minus liabilities. Or another way to say what equity is, it's the difference. Another way to define between assets and liabilities. So I didn't really say anything new so far, because that's what it is. Net asset or the difference between asset and liabilities. What does that mean? If you have $300,000 in assets, let's assume all this asset is cash, just to illustrate the point. You have $300,000 in cash. And you have $200,000 in liabilities, which is basically a loan at the bank. What does that mean? It means you can go to the bank, pay off the loan. You have $300,000, pay off the loan. And what you're left with is $100,000, what I call free and clear, free and clear. Free and clear, it means no one has any claims against this $100,000 because you paid off your loan. Basically, I can say that's your value. If this is how much it's clear, then I would say this is your value. So your value is $100,000. Or I can say this is your net worth. Net worth means if you pay off all your liabilities, if you pay off all the people that have claims against you, how much can you walk away with? Free and clear, it's your net worth. And for a business, if we take all their assets, use them to pay off all the liabilities, whatever's left is how much is the company's worth. So this is what equity is. So hopefully, you understand what's equity from this simple computation. But we're going to talk about equity a little bit further. So what is a stockholder's equity? Again, as we said, it's the difference between assets minus liabilities equal to stockholder's equity. Ownership claim on total asset. Ownership means what? It means the person that owns the company. If you own the company, remember that example. We said 300,000 minus 200,000 equal to stockholder's equity of 100,000. This is the numbers that we use. If you are the owner of this company, let's assume also to make it simple, you are 100% owner of the company. If you own this company 100%, it means your company is worth to you $100,000, because you can walk away free and clear with this $100,000. This is also referred to another term for this value, this $100,000 value. It's also called residual equity. Whoops. Residual equity. So you have many words for equity. We said we can call this net asset. We can call it net worth. Usually net worth is for the individual, not for businesses. And we also can call it residual equity. Or we can call it another word for it. You might see it in some textbook, residual value. So the residual value means how much left of value or residual value that the owners can walk away free and clear. Now, we have to look at four things that affect equity, which is don't worry about this. We'll come back to this statement later. There are four things that affect equity, four different things. Four, and we're going to define each one of them separately and explain them. Four different, basically four different activities. Four different activities or account or whatever you want to call them. Four different things affect equity. They're listed here. One, I'm going to start this one. I'm going to say this is one. I'm going to call this is two. I did them this on purpose. Don't worry about this. So revenues, expenses, three, and four. Because this is how I'm going to explain them. This is how I'm going to explain how they affect equity. So all those investment by stockholders, revenues, dividend, and expenses, those are affect stockholders' equity. I'm going to start by talking about revenues. So what are revenues? So let's talk about revenues. So this is the first one I told you I'm going to talk about. What are revenues? Somebody asked you to define revenues. What are revenues? Revenues result from business activities enter into for the purpose of earning income or the purpose of earning how we call it income or profit, actually earning assets, earning more assets. So what is revenue really? It's what the company does on a day-to-day basis to increase their asset, to increase their profit. Now, if you really think about a company, and I always use the same company, which is I like, Wawa. It's basically, if you never heard of Wawa, that's fine. Wawa is a convenience store and a gas station. So Wawa, what do they do? They sell food, they sell gasoline. So the revenue is sales revenue. That's what they do. They make sales. And as they make sales, their assets go up. You pay the money, their assets go up. So that's what they do to increase their income, to increase their revenues, to increase their profit. They make sales. Now, certain companies, they charge you a fee. For example, LA Fitness. LA Fitness, it's a gym. And how do they generate money? They charge you a fee. Every month, if you want to join, they charge you a fee and that's their revenue. Also, a company could have a service revenue. For example, a doctor, that's what they do. A plumber, an accountant, they charge you per hour. They provide you a service. That's the revenue, their service revenue. You could also have revenues from interest and dividend. For example, banks, how do banks generate revenue? They lend you money and they generate revenue from interest. How do investment companies make money? They invest in stocks and receive dividend. How do owners of property rent? How do the owners of property make revenue? They rent the property, they make revenues. So this is what revenues are. Revenues increases a stockholder's equity. Each company will have different source of revenue. You could have more than one source of revenue, but usually it's, you have one or two main sources. Revenue increases stockholders equity. Okay, hopefully we all know what revenues are. Basically activities. For example, the college that you are attending, they charge students tuition and that's their revenue. So what's the revenue for colleges? That's the tuition. They charge you tuition and by charging you tuition, tuition, so by charging you tuition, what they do is they generate revenue, tuition revenue. Okay, that's tuition revenue. So different businesses will have different revenues. The next topic we're gonna look at is on purpose I skip and I went to expenses. So the next topic is expenses. We talked about revenues, let's talk about expenses. What are expenses? Expenses are cost of assets consumed, consumed or services used in the process of burning revenue. What does that mean? Expenses are the consumption of asset and usually what do you consume? You consume, what do you usually consume? You consume cash. You consume cash to run your business. To run your business on a day-to-day basis, you need to pay your utilities. You need to pay your employees. You need to pay your rent. You need to pay taxes. You need to pay tax and you need to pay insurance. So those are called expenses. It's the cost, basically expenses, cost to operate the business. And I'm gonna on day-to-day basis, on day-to-day basis. So you need to pay or to operate the business. You need to pay your employees. You need to pay your utilities, so on and so forth. So salaries, expenses, an example, rent expense, utilities, tax expense, they're all right here, insurance expense. A company could have a lot of expenses, a lot of expenses. Now, it's very important to differentiate between an asset and an expense. Why? Because both, they kind of sound, sound as if they are serving the same purpose. In what sense? In both of them, you are consuming money. You are consuming money. So why when we consume money, we call something an asset and when we consume some, consume money, we call it an expense. When we consume money and we have a future benefit from that future benefit, then it's an asset. An example will be a piece of equipment or a vehicle or a truck for the company. When we buy the truck, guess what? The truck will serve the company for several years. Therefore, it's an asset. When we pay our utilities, when we pay our utilities, think about it. When do you pay your utilities? You pay your utilities after actually you consume the utilities. So you consume electricity, you consume water, then the company will send you a bill for what you consume. So you have to pay the bill, but there's no future benefit. No future benefit. If there's no future benefit for your expenditure, for your cost, then it's an expense. It's a way to operate your business. So that's, it's very important to differentiate what is an asset and what's an expense because they both consume cash at the end of the day. They both consume resources. And that resource, I'm gonna say cash. Eventually you're gonna have to pay everything in cash. So the point to make is you are consuming asset cash, okay? So it's very important to differentiate between those two. Now we're gonna move into a new, basically we're gonna move into a new formula. So since we know revenues, we know as expenses, we need to build the formula from those two. So we said revenues, we already defined revenues. So let's go ahead and let me change the color here. Let's assume a company generated $400,000 in revenues. And they have the incurred expenses of 150,000, okay? Four, I'm just gonna put year ended and don't worry, we'll talk about this later on 2019. For year ended 2019, revenues minus expenses. When we take the revenues minus the expenses we'll get 250,000, 400,000 minus 150 equal to 250. What do we call this number? We call this number net income or net profit. So this is a computation. It's called either net income or net profit. So it's very important to know that the difference between revenues and expenses equal to net income or net profit, okay? So there's a relationship between those two. You wanna make sure you are aware of this formula because it's gonna come back and you will see it later. So simply put when we generate revenues our equity goes up, when we generate expenses our equity goes down. So revenues increase equity, expenses reduces equity. What else could affect equity? I said four things, I defined two. Let me define the third one. So I said revenues one, oops, we said revenues one. We already did this, we go back here. We said revenues, this is the first one. We defined expenses. The third one is investment by stockholders. In investment by stockholders they increase stockholders equity. They increase stockholders equity. What are investment by stockholders? Investment by stockholder represent total amount paid by stockholders for the shares they purchase. Stockholders are also called owners. They're also called shareholders. They're also called investors, okay? What does that mean? It means someone likes the company and what they do. If you like a company, if you are an investor, if you are an investor and if you like the company, if you like this company, what do you do? You give them money. You invest in the company. Now you invest in the company with the hope of the company paying you back part of the profit. But this is what you do. When you invest in the company, you give them money, they give you back something called common stock. And what is common stock? It's ownership interest. They give you shares ownership interest, okay? For example, you invest a million dollar. They'll give you just 1,000 shares. And those 1,000 shares might represent 10% of the company. It doesn't matter. All what I'm saying is you need to understand what investment by stockholder is. Investment by stockholders is when the owner contribute. It's called also contributed capital. Let me just put the word here. Contributed capital. So this is, it means capital means money. It's money coming from owners. Why do owners wants to invest? Because they like the business, okay? So this is what investment by owner is. It represents. Now, so we talked about three pieces that increase the effect equity. The fourth piece is dividend to stockholders. And remember, stockholders put money into the company. The equity goes up. Then the stockholders, what do they expect? They expect to be paid. So the stockholder expect to be paid. When the company makes a profit, they expect it. They don't have to be paid. If the company decides to pay them and we'll talk about dividend way, way, much, much more later on down the road. But dividend or distribution of cash or other assets to stockholders. And we say cash or other stock or other assets because sometime you might give the shareholders something other than cash. But most of the time, and for our purposes, we say we distribute cash, cash to the shareholders. Dividend reduces retained earning, which we'll talk about this in a moment, okay? Let's go back to our example here to see how dividend work. Remember, this company makes $250,000 in profit. Let's assume this company would like to distribute from this amount, 100,000. So they would like to distribute dividend because dividend comes out of retained, out of profit, out of profit. So they're gonna, they want to distribute dividend what we call dividend of $100,000. Let me take out those two lines. They're gonna distribute dividend of 100,000. And again, what's dividend is given that money to the shareholders. Why? Because the shareholders invested in us. We made the profit as a company. The shareholder gets a cut of the profit. They're gonna get 100,000. So if we take net income minus the dividend, the company will keep 150,000. I should have used a different figure. I'm gonna use a different figure than 100,000. Give me one moment, please. Let's assume the company decided actually to distribute. We're gonna be generous here. The company decided to distribute $200,000. From the profit, they decided to distribute $200,000. What's left for the company is 50,000. We call this 50,000 retained earnings. And what is retained earnings is the earnings, the profit that the company kept. Although they made a profit of 250, they distribute 200,000. What's left is 50,000. We call this retained earnings. Okay? So retained earnings is affected by three things. Revenues, expenses, and dividend. So another way to say this, another way to say this, we can say retained earnings, retained earnings, dividend reduces retained earnings. So what is retained earnings? Retained earnings is revenues minus expenses minus dividend equal to retained earnings. So dividend reduces retained earnings because it's reducing the amount that we're keeping. Okay? So but retained earnings also, but the dividend is coming out of profits. So therefore revenues minus expenses equal to profit. Profit minus dividend equal to retained earnings. However, just bear in mind, dividend are not expenses. So we don't report dividend and expenses in the same place. Because expenses are cost to operate the business, dividend are a way to reward the shareholders. Two different things. So don't confuse expenses with dividend. Although they both reduce retained earnings, they're both part of retained earnings. So simply put, if we look at this picture, we can see that those three accounts here, revenues, expenses, and dividend, those three accounts are retained earnings account and we have common stock. So simply put, we can break equity into two component, common stock as a major component. And I'm gonna put this in a different color. And the other part is retained earnings. So equity is really composed of two things, retained earnings and common stock. However, under retained earnings, we have revenues, expenses, and dividend. Revenues increase retained earnings, which in turn increase equity. Expenses reduce retained earnings, I'm sorry, reduces retained earnings, which increases equity. And dividend reduces retained earnings, which in turn reduces equity. Now I can show you this full picture. Then I said, I will come back to it. And when I said stockholders equity, and I cross it out, stockholders equity is composed of two main component. Common stock is one and retained earnings is two. Remember retained earnings is revenues minus expenses, minus dividends. So those three account form retained earnings. And this is basically what stockholders equity. Now what we're gonna be doing in the next session is to look at transaction that put all this together. But this is the overall, what's called expanded accounting equation. Let me see if I can show you a picture of it. Before we saw a picture of it, let's look at this example. So it's very important to understand how to classify items as issuance of stocks, dividend, revenues, or expenses, and indicate whether each increase or decrease stockholders equity. So if I say you have a rent expense, what is this? Is this revenue, expense, dividend, or common stock? Hopefully you know it's an expense. How does it affect equity? It reduces equity, decreases equity. Service revenue, what type of an account? Service revenue is revenue, and it increases equity. Dividend is obviously dividend, and it reduces equity. Salaries and wages expense, it's an expense, and it reduces equity, and it reduces equity. So in the next session, what we're gonna be doing is looking at financial transaction that affect the accountant equation, that affect the accounting equation. If you have any questions, any comments, by all means, email me if you're taking the class, see me in class, complete your homework, complete your quiz, and if you're studying for your CPA exam, always, always, always study hard. It's worth it.