Accounting Basics Explained Through a Story — Transcript

Full transcript

1. 0:00In this video, I'll give you an introduction to accounting
2. 0:02by telling you a story.
3. 0:04It's a story about Claudio,
4. 0:06and how he runs his business in Italy.
5. 0:09Before we start, let's just get clear on what accounting is.
6. 0:14Accounting makes it possible to systematically record,
7. 0:18analyze, and report important financial information,
8. 0:22and communicate the financial health of a business
9. 0:25to all interested parties.
10. 0:27It's called the language of business,
11. 0:30and it's the backbone of any company
12. 0:32because every business needs reliable data
13. 0:35to make informed decisions.
14. 0:37But what does that really mean?
15. 0:40Let's just take a moment
16. 0:42to make this a bit more transparent,
17. 0:44and understand the basics of accounting.
18. 0:47So, let me tell you about Claudio.
19. 0:50(bright music)
20. 0:54Imagine we're in Italy,
21. 0:55which is also one of my favorite places,
22. 0:58a nice beach city, where a man called Claudio
23. 1:02is selling souvenirs to tourists.
24. 1:04He only sells one item,
25. 1:07a beautiful plate made from colorful glass.
26. 1:10In the morning, he leaves his home with 100 euros,
27. 1:14and goes to the manufacturer of the souvenir.
28. 1:16Each plate costs one euro,
29. 1:18so Claudio buys 100 pieces with his 100 euros.
30. 1:23He walks to the beach and sells the plates to tourists
31. 1:25for five euros a piece, and by noon, he sold out.
32. 1:30He goes home happily,
33. 1:31and repeats the same process the next day.
34. 1:35After a month, he wants to know how much the business made.
35. 1:39What if he sold more than one item?
36. 1:41Which one was more profitable?
37. 1:44Would it make sense to expand his business,
38. 1:46like rent a fixed stand at the beach?
39. 1:50Without a way of recording
40. 1:51the daily activities of his business,
41. 1:54he's not going to be able to answer these questions.
42. 1:58Accounting makes this possible.
43. 2:00Not only will each financial transaction be recorded,
44. 2:04but Claudio will also get detailed reports,
45. 2:07summarizing his financial performance.
46. 2:10We call these reports financial statements.
47. 2:13Let's start with Claudio's profitability.
48. 2:16If you want to find out about a business's profitability,
49. 2:19you go to their income statement.
50. 2:22This is one of the main financial statements.
51. 2:25There you can find out how much sales a business had
52. 2:28in a certain period, which costs,
53. 2:31and what was the resulting profit or loss.
54. 2:34There is another name you may hear for the income statement.
55. 2:37Do you know what it is?
56. 2:39P&L, for profit and loss.
57. 2:41It's a fairly simple business model,
58. 2:43and the P&L for Claudio's business would look like this.
59. 2:47He sold 100 plates for five euros each.
60. 2:51That's what we call sales or revenue, which were 500 euros.
61. 2:57The plates he sold, he didn't get for free, right?
62. 3:00He incurred costs to buy them.
63. 3:03Each plate cost him one euro.
64. 3:05Therefore, in total, his costs were 100 euros.
65. 3:10We call this the cost of goods,
66. 3:12which we need to deduct from revenue.
67. 3:15To keep it simple,
68. 3:16we don't consider any other costs for now,
69. 3:19like fees and taxes.
70. 3:21If we add this up, we can see that Claudio made a profit,
71. 3:26or a net income of 400 euros.
72. 3:28That's how a simple income statement would look like.
73. 3:32Next, we're going to take a quick look
74. 3:34at the second main financial statement, the balance sheet.
75. 3:38The balance sheet shows which assets the company owns,
76. 3:42the liabilities it owes to others,
77. 3:45and the equity that belongs to the owners.
78. 3:48Assets are usually things of value,
79. 3:50or resources the company owns and uses.
80. 3:54For instance, land and buildings, office equipment,
81. 3:58inventory, or cash, just to name a few.
82. 4:02Liabilities are what you owe to others.
83. 4:06For example, a bank loan,
84. 4:09or what you owe to your suppliers for goods,
85. 4:11or to the IRS in taxes.
86. 4:14The third component is equity.
87. 4:17This is a bit more abstract.
88. 4:19It's the residual amount that would be left
89. 4:22if the company sold all its assets
90. 4:26and paid off all its liabilities.
91. 4:29In other words, it's the difference between total assets
92. 4:33and total liabilities.
93. 4:36This leftover money belongs to the owners of the company.
94. 4:41In the balance sheet, the assets are on one side,
95. 4:44and equity and liabilities are on the other side.
96. 4:48If you draw a line between the two, and one on top,
97. 4:53it looks like a T.
98. 4:55This is what accountants use to
99. 4:57visualize accounting transactions.
100. 5:00It's a very helpful tool,
101. 5:02and we're going to come back to these T accounts all the time.
102. 5:06You can see that the left side of the T
103. 5:09is just as big as the right side.
104. 5:12That's because everything the company owns, so its assets,
105. 5:16was purchased either from debt, so somebody else's money,
106. 5:21or its own money, meaning equity.
107. 5:24For money to go to one account,
108. 5:27it has to come out of another.
109. 5:30We call this a flow of economic benefit
110. 5:33from a source to a destination.
111. 5:36We already said that assets minus liabilities equals equity.
112. 5:41If we rearrange this, like this,
113. 5:43we we get assets equal liabilities plus equity.
114. 5:48Both sides are always in balance,
115. 5:50hence the name balance sheet.
116. 5:53And that is the foundation for any accounting system,
117. 5:58the accounting equation.
118. 6:00The total amount of assets equals
119. 6:02total liabilities plus equity.
120. 6:06Both sides are in balance.
121. 6:08With that in mind,
122. 6:09let's see how the balance sheet looks like for Claudio.
123. 6:13A balance sheet is always created
124. 6:15at a certain point in time,
125. 6:17like at the end of the business year,
126. 6:20or at the end of a quarter.
127. 6:22In our example, it's the end of Claudio's business day.
128. 6:27Claudio started out with 100 euros in cash,
129. 6:30which is also the money, or equity,
130. 6:32he put into the business.
131. 6:34The cash on the left side equals equity on the right side.
132. 6:40The balance sheet, at this point, is in balance.
133. 6:43Then, he spent the cash in the morning,
134. 6:46to buy the colorful plates.
135. 6:48The plates are what we call his inventory.
136. 6:52In the process, his cash got reduced to zero,
137. 6:56but in exchange, he received another asset, inventory.
138. 7:00He didn't get richer or poorer by that, right?
139. 7:03The total amount of assets is still 100,
140. 7:06but of course, his equities too.
141. 7:09After he sold the plates five euros each,
142. 7:12he ended up with 500 euros in his pocket
143. 7:16at the end of the day.
144. 7:18His inventory is gone
145. 7:21because he sold all the plates to the tourists.
146. 7:24At the end of the day, his inventory value,
147. 7:27therefore, is zero.
148. 7:29He doesn't have any more plates.
149. 7:31If we look at Claudio's balance sheet at the end of the day,
150. 7:35we can see that the total value of assets,
151. 7:38the left side, is 500 euros.
152. 7:40That's the cash he came home with.
153. 7:43On the credit side, we only have 100 euros.
154. 7:47The balance sheet is out of balance.
155. 7:49As we know, this can't be.
156. 7:51Both sides always need to be in balance.
157. 7:54So, what's wrong here?
158. 7:56The missing component is the profit he made during the day.
159. 8:00If you go back to the income statement,
160. 8:02we see that Claudio's net income was 400 euros.
161. 8:05This will be added to equity, why?
162. 8:09Because due to his successful business,
163. 8:11he made the business more valuable.
164. 8:14When he started out the day, it was worth only 100 euros,
165. 8:18which was the money he put into the business
166. 8:20when he walked out the door.
167. 8:23When he came home, he had sold all his plates
168. 8:26with a profit of 400 euros.
169. 8:29So, his business is now worth more,
170. 8:31which is reflected in a higher equity.
171. 8:34Net income is the link
172. 8:36between the income statement and the balance sheet.
173. 8:39So, when we add the profit of 400 euros he achieved
174. 8:42to equity, also the right side gets to a total of 500 euros,
175. 8:47and the balance sheet balances like it should.
176. 8:51So, that's how it would look like for Claudio
177. 8:53at the end of his successful day at the beach.
178. 8:57I hope this video was helpful for you
179. 8:58to get familiar with accounting basics.
180. 9:02I'm planning to add more videos for accounting
181. 9:04in the coming weeks.
182. 9:06Let me know in the comments below
183. 9:07if you want me to cover a specific topic.
184. 9:11Now, the videos that are coming,
185. 9:12just to give you a heads up,
186. 9:13what they're about is going to be on debits and credits,
187. 9:17and more details on the balance sheet.
188. 9:21If you enjoyed this video, give it a thumbs up,
189. 9:23and if you want to improve your skills, consider subscribing.
190. 9:27And don't forget to hit that bell
191. 9:29so you don't miss out any new videos.
192. 9:31Thank you for watching, see you in the next video.
193. 9:34(upbeat music)