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  • In this video, I'll give you an introduction to accounting

  • by telling you a story.

  • It's a story about Claudio,

  • and how he runs his business in Italy.

  • Before we start, let's just get clear on what accounting is.

  • Accounting makes it possible to systematically record,

  • analyze, and report important financial information,

  • and communicate the financial health of a business

  • to all interested parties.

  • It's called the language of business,

  • and it's the backbone of any company

  • because every business needs reliable data

  • to make informed decisions.

  • But what does that really mean?

  • Let's just take a moment

  • to make this a bit more transparent,

  • and understand the basics of accounting.

  • So, let me tell you about Claudio.

  • (bright music)

  • Imagine we're in Italy,

  • which is also one of my favorite places,

  • a nice beach city, where a man called Claudio

  • is selling souvenirs to tourists.

  • He only sells one item,

  • a beautiful plate made from colorful glass.

  • In the morning, he leaves his home with 100 euros,

  • and goes to the manufacturer of the souvenir.

  • Each plate costs one euro,

  • so Claudio buys 100 pieces with his 100 euros.

  • He walks to the beach and sells the plates to tourists

  • for five euros a piece, and by noon, he sold out.

  • He goes home happily,

  • and repeats the same process the next day.

  • After a month, he wants to know how much the business made.

  • What if he sold more than one item?

  • Which one was more profitable?

  • Would it make sense to expand his business,

  • like rent a fixed stand at the beach?

  • Without a way of recording

  • the daily activities of his business,

  • he's not going to be able to answer these questions.

  • Accounting makes this possible.

  • Not only will each financial transaction be recorded,

  • but Claudio will also get detailed reports,

  • summarizing his financial performance.

  • We call these reports financial statements.

  • Let's start with Claudio's profitability.

  • If you want to find out about a business's profitability,

  • you go to their income statement.

  • This is one of the main financial statements.

  • There you can find out how much sales a business had

  • in a certain period, which costs,

  • and what was the resulting profit or loss.

  • There is another name you may hear for the income statement.

  • Do you know what it is?

  • P&L, for profit and loss.

  • It's a fairly simple business model,

  • and the P&L for Claudio's business would look like this.

  • He sold 100 plates for five euros each.

  • That's what we call sales or revenue, which were 500 euros.

  • The plates he sold, he didn't get for free, right?

  • He incurred costs to buy them.

  • Each plate cost him one euro.

  • Therefore, in total, his costs were 100 euros.

  • We call this the cost of goods,

  • which we need to deduct from revenue.

  • To keep it simple,

  • we don't consider any other costs for now,

  • like fees and taxes.

  • If we add this up, we can see that Claudio made a profit,

  • or a net income of 400 euros.

  • That's how a simple income statement would look like.

  • Next, we're going to take a quick look

  • at the second main financial statement, the balance sheet.

  • The balance sheet shows which assets the company owns,

  • the liabilities it owes to others,

  • and the equity that belongs to the owners.

  • Assets are usually things of value,

  • or resources the company owns and uses.

  • For instance, land and buildings, office equipment,

  • inventory, or cash, just to name a few.

  • Liabilities are what you owe to others.

  • For example, a bank loan,

  • or what you owe to your suppliers for goods,

  • or to the IRS in taxes.

  • The third component is equity.

  • This is a bit more abstract.

  • It's the residual amount that would be left

  • if the company sold all its assets

  • and paid off all its liabilities.

  • In other words, it's the difference between total assets

  • and total liabilities.

  • This leftover money belongs to the owners of the company.

  • In the balance sheet, the assets are on one side,

  • and equity and liabilities are on the other side.

  • If you draw a line between the two, and one on top,

  • it looks like a T.

  • This is what accountants use to

  • visualize accounting transactions.

  • It's a very helpful tool,

  • and we're going to come back to these T accounts all the time.

  • You can see that the left side of the T

  • is just as big as the right side.

  • That's because everything the company owns, so its assets,

  • was purchased either from debt, so somebody else's money,

  • or its own money, meaning equity.

  • For money to go to one account,

  • it has to come out of another.

  • We call this a flow of economic benefit

  • from a source to a destination.

  • We already said that assets minus liabilities equals equity.

  • If we rearrange this, like this,

  • we we get assets equal liabilities plus equity.

  • Both sides are always in balance,

  • hence the name balance sheet.

  • And that is the foundation for any accounting system,

  • the accounting equation.

  • The total amount of assets equals

  • total liabilities plus equity.

  • Both sides are in balance.

  • With that in mind,

  • let's see how the balance sheet looks like for Claudio.

  • A balance sheet is always created

  • at a certain point in time,

  • like at the end of the business year,

  • or at the end of a quarter.

  • In our example, it's the end of Claudio's business day.

  • Claudio started out with 100 euros in cash,

  • which is also the money, or equity,

  • he put into the business.

  • The cash on the left side equals equity on the right side.

  • The balance sheet, at this point, is in balance.

  • Then, he spent the cash in the morning,

  • to buy the colorful plates.

  • The plates are what we call his inventory.

  • In the process, his cash got reduced to zero,

  • but in exchange, he received another asset, inventory.

  • He didn't get richer or poorer by that, right?

  • The total amount of assets is still 100,

  • but of course, his equities too.

  • After he sold the plates five euros each,

  • he ended up with 500 euros in his pocket

  • at the end of the day.

  • His inventory is gone

  • because he sold all the plates to the tourists.

  • At the end of the day, his inventory value,

  • therefore, is zero.

  • He doesn't have any more plates.

  • If we look at Claudio's balance sheet at the end of the day,

  • we can see that the total value of assets,

  • the left side, is 500 euros.

  • That's the cash he came home with.

  • On the credit side, we only have 100 euros.

  • The balance sheet is out of balance.

  • As we know, this can't be.

  • Both sides always need to be in balance.

  • So, what's wrong here?

  • The missing component is the profit he made during the day.

  • If you go back to the income statement,

  • we see that Claudio's net income was 400 euros.

  • This will be added to equity, why?

  • Because due to his successful business,

  • he made the business more valuable.

  • When he started out the day, it was worth only 100 euros,

  • which was the money he put into the business

  • when he walked out the door.

  • When he came home, he had sold all his plates

  • with a profit of 400 euros.

  • So, his business is now worth more,

  • which is reflected in a higher equity.

  • Net income is the link

  • between the income statement and the balance sheet.

  • So, when we add the profit of 400 euros he achieved

  • to equity, also the right side gets to a total of 500 euros,

  • and the balance sheet balances like it should.

  • So, that's how it would look like for Claudio

  • at the end of his successful day at the beach.

  • I hope this video was helpful for you

  • to get familiar with accounting basics.

  • I'm planning to add more videos for accounting

  • in the coming weeks.

  • Let me know in the comments below

  • if you want me to cover a specific topic.

  • Now, the videos that are coming,

  • just to give you a heads up,

  • what they're about is going to be on debits and credits,

  • and more details on the balance sheet.

  • If you enjoyed this video, give it a thumbs up,

  • and if you want to improve your skills, consider subscribing.

  • And don't forget to hit that bell

  • so you don't miss out any new videos.

  • Thank you for watching, see you in the next video.

  • (upbeat music)

In this video, I'll give you an introduction to accounting

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A2 US claudio balance sheet equity balance accounting sheet

Accounting Basics Explained Through a Story

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    Teach posted on 2020/07/19
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