 Hello and welcome to the session. This is Professor Farhad and this session we're gonna be looking at the famous accounting equation. I'm gonna cover the accounting equation as you would cover it in a financial accounting or introductory course. So you don't need any prior background. I'm gonna go ahead and break the accounting equation for you and hopefully by the time you are done you will be good to go. This topic also could be used if you're studying for your CPA exam. This is basically basic. You need to know this if you're studying for your exam. As always I would like to remind you to connect with me only then if you haven't done so. YouTube is where you would need to subscribe. I have 1,600 plus accounting, auditing, finance and tax lectures. I don't only cover financial accounting, I cover all these courses as well. Please like this recording if you like it. Share it with others. If you're benefiting from this recording it means it might benefit other people. So share the wealth. On my website farhadlectures.com you will have access to additional resources if you're an accounting student or CPA candidate. PowerPoint, true, false, multiple choice and 2,000 plus CPA questions. Check it out. It's an investment in your career, investment in your education. So let's take a look at the basic accounting equation. The basic accounting equation and here's the equation. It states that assets are equal to liabilities plus equity. That's the accounting equation, okay? Now it's very important, very powerful equation. And once you understand the accounting equation it's easier to always see the big picture and that's why that's the first thing with each in accounting. So now you're gonna learn about basic concepts that you need to have a good understanding about because it's gonna help you throughout your accounting courses throughout your accounting career. So most likely there's a good chance this is the first time you are listening to this topic or you never learned it before and this is the first time you're gonna learn it and learn it well. So let's get going. So the first term is assets. So you need to know what is an asset. Simply put asset is a resource. Asset is a resource. Asset is a resource that will provide future benefit to the business. So that's basically what is an asset and that's all you need to know for now. It's a resource or assets or resources. Resources that will provide future benefit for the business. So what does that mean? It means you have something, you have something. Now you don't have to own it. It's good if you own it, own or control. You don't have to own an asset. Let's think about the real world or think about yourself personally. What could you have that will benefit you in the future? What could you own or control? Think about the car. If you own or control a car, if you could use the car, you can go to work. Do you have a computer? Do you have a cell phone? Okay, those are all assets. Now we're not talking about personal assets. We're talking about business. Remember when we do accounting, we do accounting from a business perspective. Now, that's what assets are, but the most important asset that you could have or a company can have, and I'm hoping you are thinking about it and that is cash, cash in your pocket. If you have cash in your pocket, it's the best resource that will do anything that will provide future benefit for you in any way, shape or form. What can you do with cash? You can pay bills. You can pay your employees. You can buy supplies. You can pay dividend, which is some of the terms you may not understand now, but you can do anything. Cash is an asset. Think about land. If you own a piece of land, it's an asset. If you own or control a building, that's an asset. If you have office supplies, it's an asset. If you have car or vehicle, it's an asset. If you have truck, it's an asset. If you have a machinery, it's an asset. So notice all of those, all these that I named cash, land, building, office supplies, truck, machinery, vehicle, car, all these items, they fit the definition of providing future benefit. You can use them in the business to get benefit. So that's basically what an asset is in a nutshell. And that's all what you need to know for now. Now there are many other assets that we would learn about later. Many other assets, but for the purpose of this session, just we need to know what an asset is. So that's what's an asset. So we are done with assets. Let's talk about liabilities. If you wanna use one word for liabilities to make it easy, liabilities are debt. Now what is a debt? Hopefully we are all familiar with debt. You might have, hopefully we are not, but we are, okay? So you might have credit card debt. You might have student loan debt. You might have, hopefully not, personal loan, loan that you took out. You might have a card loan. So notice you have debt or loans. Those are all liabilities. Now what is a definition for a liability? Well, a liability is something, it's something that's gonna use up resources to settle. Simply put, liabilities, it's an obligation. Obligation that will require the future, the future sacrifice of assets, generally speaking cash, generally speaking cash. We need cash. We need to use cash to settle the obligation. So obligation that would require future sacrifice of an asset, usually cash. Liabilities, something happened in the past. Liabilities occur, liabilities occur because something happened in the past. What do I mean by this? Think about it. When do you have a liability is when you did something in the past? Like what? You borrowed money. If you borrowed money in the past, do you have a liability today that you have to pay in the future? So basically a liability is today, the liability is today. For something that happened in the past and in the future, you have to pay. So it has a past effect, a current effect, and a future effect. And once you pay it, it goes away. Once you pay the liability, it goes away. Now, we talked about personal liabilities like car loan, credit card debt, personal loan, student loan, so on and so forth. Now for businesses, or a mortgage for a house, for businesses, you do have also debt. Now, for the purpose of today, we're gonna only cover two types of debts, just gonna illustrate the point. The two debts that we're gonna be defining today for businesses are accounts payable. And what is accounts payable is when the company buys goods or services on account. What does that mean? It means when the company buys goods and services. When we buy inventory, when we buy supplies, when we hire someone to do some work for us. Well, we tell them, we tell them, we're gonna pay you later. We're not gonna pay you now. So the company buys those goods and services on account. On account means we don't pay now. If we don't pay now, we have a liability called accounts payable. We have another liability. It's called notes payable. And what is notes payable? Notes payable is a fancy word, is a fancy word for loan. So notes payable is a fancy word for a loan. And what is a loan is when the company is when the company borrow money. And the company always borrow money. Company borrows money, they always borrow money. Most companies, as far as I know, borrowing money is part of doing business. So those are two liabilities. Okay, that's what a liability is. Now we know what a liability is. We know what assets are. Let's see if we can determine what is an equity. So let's use some numbers to start to kind of explain equity here. Let's assume as a company, I have 200,000 worth of assets. So I have 200,000 worth of assets. And we know what assets are. We have all sorts of assets. And we have 200,000 worth of those, a list of many things. And we happen to have 80,000 of liabilities. We have 80,000 of liabilities. Now, can you complete this account and equation? If I told you we have assets of 200 liabilities of 80, well, I can kind of find out my equity is 120. Why? Because if assets equal to liabilities and equity, you're telling me I have 80,000 of liabilities. Therefore I can fairly assume my equity should be 120. Now let's rearrange this formula and make a little bit more sense of this equation. Another way to look at the equation is to say equity equal to assets assets minus liabilities. That's what equity equal to. If I rearrange the formula, simply put, if I say my equity is 120 equal to assets of 200,000 minus 80,000 of liabilities, all is fine and dandy. That's what equity is. So what does that mean? Well, another way to look at equity, we can call equity net assets. We can call equity on a personal level net worth. We can call equity residual value. All these words can be used for equity. Net asset means the difference between asset in your liabilities. Net worth means after you liquidate your asset and pay off your liabilities, you are left with 120. Residual value is what's left after you pay off your liabilities. Those are three words for equity, but that doesn't help us. So what is equity really? Well, equity is what's left in the company, the value of the company after you pay off your liabilities. The question becomes, we know how we can obtain assets or kind of we know how to obtain assets, how to obtain liabilities. If we borrow money, we have assets and liabilities, but what affects equity? So what can think about it? What can increase my net asset? What can increase my net worth? What can increase my residual value? What can increase my equity? Oh, well, let's think about it. There are four things that you need to be aware of. Four things you need to be familiar with. Four, four, four things we need to be familiar with. Those four, two of them, two of those four will increase equity, okay? And two of them, they would reduce equity. So we need to know about the account that increases equity and the account that reduces equity. So now we are working only with equity. We're only working with this part of the equation. What are those two things that increase equity and the two things that reduce equity? Well, think about it for a moment. If you want to increase your net worth, if you want to have more assets than liabilities, what would you do? Well, I need to get more assets without increasing, without increasing my liabilities. What can I do? How can I get more assets? Well, guess what? If I get a second job or a better job, or if I can generate more income for myself, I can increase my assets without increasing my liabilities. So what do we call this? We call this a new term called revenues. What is a revenue? A revenue is what the company does to generate more assets. Each company does something different. For example, your university where you are attending, generate income by tuition. So they charge you tuition and that's your revenue. If you go on amazon.com and you buy that sales for Amazon, if you go to your local shop and you buy something from your local shop, that sales revenue for your local shop. If you are, let's assume you are an engineer and someone hires you, then they pay you. That's your revenue, engineering revenue. So each individual, they'll have a different type of revenue. So revenue is what the company does to generate assets. What does on a day-to-day basis? That's what they do for a living. Basically what the company does for a living. So revenues increase equity. Now that's good. So revenues are good. So let's look at something that decrease equity. What could decrease equity? Well, think about it. If you have a business, you're gonna generate revenues. But as you're generating revenues, you're gonna have to incur expenses. Well, what are expenses? Well, expenses reduces equity. Expenses reduces equity. Revenues increases equity. So what are expenses? Expenses is the cost to run your business. Cost to run your business. So no company can generate revenues without incurring expenses. It'll be great. It will be excellent. It will be excellent if I can just generate revenues without incurring expenses. For example, when I teach at the university, I have to drive my car over there. So yes, I am generating revenue, but I also have to pay for gasoline. I have to pay for parking. I have to pay for other expenditure. So those are expenses. For example, a company might have to pay for their utilities. They have to pay for their cell phone. They have to pay for the internet service. They have to pay for insurance. They have to pay for rent. So what is an expense? It's the cost to run the business. So that's the second item that affect equity. And it's kind of think of it as the opposite of revenue. Now here's what we need to know about revenues and expenses. We have a formula that says if we take our revenues minus our expenses, it's gonna give us the difference between those. It's gonna give us net income or net loss for that matter, or net income. So that's the first thing I want you to learn or loss. Simply put, if we have revenues of 80,000, expenses of 30,000, we have a net income of 50,000. And that's what net income is. Net income is the difference between revenues and expenses. They are both equity account. Both revenue is equity and expenses are equity. One increases equity, the other one decreases equity. Now those are the two equity account. Now, I said there are four, so we have to look for the other two. Let's think about if you like a company, what can you do if you like a company? If you like a company, you can invest, you can contribute capital. So you can give the company money. So if you like my company, you would like, I like your company. Great, if you like my company, invest in my company. Give me money, give the company money and I'll give you shares in the company. So what we need to understand is we have something called kin-tributed capital or we're gonna see it, the account is called common stock. What is that account? Well, if you like a company and this is gonna increase equity, this is gonna increase equity. So we already identified the two accounts that increase equity, revenue and common stock. What does the common stock represent? It represent how much the investors invested in the business. What does that mean? If when the investors give you money, when the investors give you money, they invest in your business. It means they want to be owners. If they want to be owners, they have to give you money. When they give you money, your assets go up when they give you cash and your common stock goes up. So that's another way to increase your equity is to try to convince people to invest with you, to invest in your company, not invest in you, it's the company. That's what contributed capital is. Now, why would people invest in your company? So why would you like a company? Well, you like a company for one reason. It's because the company is good, good in a sense that it's making a profit and when it makes that profit, they're gonna give you part of the profit. So what's gonna happen is this. We have another account that when they make a profit, let's go back to this, actually to this example. You remember this fictitious company here, they made 80,000 of revenues, 30,000 of expenses. The company made 50,000. Well, the company might decide to give 30,000 to the owners. When they give 30,000 to the owners, this is called, the term is called dividends. So we're gonna say, we're gonna say dividend 30,000. So they pay dividend of 30,000. Well, if they pay dividend of 30,000, it means they took the cash from the business and they gave it to the owners. Well, guess what? The equity of the business will go down. The equity of the business will go down. So when the company pays out dividend, the equity of the business will go down. Now, let's go back here and expand this little bit further. Let's go back. So we made an income of 50,000. Then we paid dividend of 30,000. We paid dividend of 30,000. No reason why I put in an parentheses. What's left in the company is 20,000. Well, what's left after we pay out the dividend is called retained earnings, retained earnings. It's what the company kept after they pay out the dividend. So the company made a profit of 30,000. They pay 30,000 in dividend. What they left is 20,000. So net income minus dividend is retained earning. And but all of those, all these accounts, revenues, expenses, common stock and dividend, they're all under the umbrella of equity. Now, let's look at what we called the expanded account and equation. I'm gonna erase everything that's on the board. So let's look at the expanded account and equation. Assets equal to liabilities minus equity, common stock minus dividend. So remember, equity. So now we have the umbrella of equity. Under equity, we have contributed capital. And contributed capital is common stock. Then we have revenues minus expenses. Remember, everything under equity here. Everything under equity, revenues and expenses gives us net income. And remember what we were doing, we said revenues are 80, expenses are 30. And for the purpose of our example, we had income of 50,000. Then we paid dividend of 30. I should have had used a different number, that's fine. And what happened after we pay out the dividend, retained earning is 20. So notice dividend, revenue and expenses, they are all retained earnings account. Then we have common stock. So simply put, all in all, equity is composed of contributed capital. One, retained earnings too. Now retained earnings can be broken down further into revenues minus expenses, which is net income, net income minus dividend equal to retained earnings. So this is basically the expanded accounting equation. Now the only reason you're gonna learn how to do this is to first understand the big picture and what we're gonna do in the next session, we are going to analyze business transaction using this accounting equation. Now, as always, I would like to invite you to connect with me. Also like this video if you like it, share it. Please visit my website if you're looking for additional resources and serious about your accounting education, especially if you're studying for your CPA exam. Study hard, good luck and like the videos and share them. If they benefit you, it might mean they might benefit other people. Good luck.