LEARN ACCOUNTING in Under 5 Hours!  ## Metadata - Author: [[YouTube]] - Full Title: LEARN ACCOUNTING in Under 5 Hours! - Category: #articles - Document Note: --- tags: [accounting-basics, financial-education, business-finance] author: The Organic Chemistry Tutor source: YouTube reference: https://www.youtube.com/watch?v=gPBhGkBN30s date created: 2024-12-19 15:30 --- # 🏷️ Title: LEARN ACCOUNTING in Under 5 Hours! ## 🧰 Action Inbox - [H1] Complete accounting cycle from identification to closing — comprehensive tutorial #accounting-cycle - [H2] Master debits and credits using DEALER method — mnemonic device #bookkeeping - [H3] Practice journal entries with T-accounts — visual learning tool #journal-entries ## 🧭 Table of Contents - [📝 Summary](#-summary) - [📖 Main Content](#-main-content) - [🗒️ Notes](#️-notes) - [📚 References](#-references) - [🗣️ Paraphrase](#️-paraphrase) - [📰 Newsletter](#-newsletter) - [✅ Action Items](#-action-items) - [🧪 Hypotheses](#-hypotheses) - [📊 Methodology](#-methodology) - [❓ Questions](#-questions) - [🔮 Future Research](#-future-research) - [💡 Implications](#-implications) - [🧠 Learning Styles Assessment](#-learning-styles-assessment) - [📊 Accessibility Assessment](#-accessibility-assessment) - [🌍 DEIB Assessment](#-deib-assessment) - [✅ Logical Validity](#-logical-validity) - [🛡️ DARVO Analysis](#-darvo-analysis) - [🎯 Conclusion](#-conclusion) ### 🔗 References - [Original Video](https://www.youtube.com/watch?v=gPBhGkBN30s) - [Channel Resources](https://www.youtube.com/c/TheOrganicChemistryTutor) ## 📝 Summary - **What happened**: Comprehensive 5-hour accounting tutorial covering fundamental concepts from the accounting cycle through financial statements - **Why it matters**: Provides foundational knowledge needed for business operations, financial management, and professional accounting - **Key stakeholders**: Students, small business owners, entrepreneurs, and anyone needing accounting literacy - **Risks and tradeoffs**: Time investment required vs. comprehensive understanding gained; theoretical knowledge vs. practical application - **Bottom line**: Complete accounting education covering essential concepts for business financial management ## 📖 Main Content This tutorial presents financial accounting as a systematic process of identifying, recording, summarizing, and analyzing business transactions. The content builds from foundational concepts like the accounting equation (Assets = Liabilities + Equity) through the complete accounting cycle including journal entries, T-accounts, trial balances, adjusting entries, and financial statements. The instructor uses practical examples throughout, including a fictional newspaper business "Rough Times" and a window cleaning business to demonstrate real-world applications of accounting principles. ## 🗒️ Notes #### ⏱️ [00:00](https://www.youtube.com/watch?v=gPBhGkBN30s?t=0) — [H1] Introduction to Comprehensive Accounting Tutorial - Key idea: 5-hour compilation of accounting fundamentals arranged in logical order - Evidence: "Almost 5-hour long accounting epic" with timestamps and original video links #### ⏱️ [02:30](https://www.youtube.com/watch?v=gPBhGkBN30s?t=150) — [H1] Financial Accounting Definition - Key idea: Process of identifying, recording, summarizing and analyzing financial transactions - Evidence: "Financial accounting is the process of identifying recording summarizing and analyzing an entity's Financial transactions and Reporting them in financial statements" #### ⏱️ [05:15](https://www.youtube.com/watch?v=gPBhGkBN30s?t=315) — [H2] The Accounting Equation Foundation - Key idea: Business assets equal what the business owes to others and owners - Evidence: "The stuff that your business owns is equal to the stuff that your business owes" #### ⏱️ [08:45](https://www.youtube.com/watch?v=gPBhGkBN30s?t=525) — [H2] Double Entry Accounting Principles - Key idea: Every transaction has equal and opposite effects on at least two accounts - Evidence: "Double entry accounting which means this transaction affects at least two accounts and the total debits are equal to the total credits" #### ⏱️ [12:20](https://www.youtube.com/watch?v=gPBhGkBN30s?t=740) — [H2] Debits and Credits as Flow Indicators - Key idea: Credits represent sources of economic benefit, debits represent destinations - Evidence: "Credits represent the sources that economic benefit flows from whereas debits represent the destinations that it flows to" #### ⏱️ [18:30](https://www.youtube.com/watch?v=gPBhGkBN30s?t=1110) — [H2] Journal Entries and General Ledger - Key idea: Journals record transactions which are then posted to accounts in the general ledger - Evidence: "After this you can always jump into my accounting Basics playlist and explore everything I mentioned in a lot more detail" #### ⏱️ [25:40](https://www.youtube.com/watch?v=gPBhGkBN30s?t=1540) — [H2] Trial Balance Preparation - Key idea: Trial balance summarizes all account balances to check for errors - Evidence: "Trial balance is an internal report that summarizes the closing numbers in all of your general ledger accounts" #### ⏱️ [32:15](https://www.youtube.com/watch?v=gPBhGkBN30s?t=1935) — [H2] Adjusting Entries for Accrual Accounting - Key idea: Adjustments align books with accrual method recognizing revenue when earned - Evidence: "Adjusting entries are journal entries that bring your books in line with something called the acral method of accounting" #### ⏱️ [38:50](https://www.youtube.com/watch?v=gPBhGkBN30s?t=2330) — [H2] Financial Statements Creation - Key idea: Three main statements show financial position, performance, and cash flows - Evidence: "The three main financial statements are called the balance sheet the income statement and the cash flow statement" #### ⏱️ [45:20](https://www.youtube.com/watch?v=gPBhGkBN30s?t=2720) — [H2] Closing Entries Process - Key idea: Temporary accounts are closed to prepare books for the next period - Evidence: "Closing entry is a journal entry that you post to clear out all of your temporary accounts like revenues expenses and dividends" #### ⏱️ [52:30](https://www.youtube.com/watch?v=gPBhGkBN30s?t=3150) — [H2] DEALER Mnemonic for Account Types - Key idea: Memory device for remembering which accounts are debits vs credits - Evidence: "DEALER - dividends expenses and assets equal liabilities owner's equity paid in plus Revenue" #### ⏱️ [58:45](https://www.youtube.com/watch?v=gPBhGkBN30s?t=3525) — [H2] T-Accounts Visual Representation - Key idea: T-shaped diagrams help visualize account activity with debits left, credits right - Evidence: "A te account is a visual representation of an account it is called a te account simply because it looks like a t" #### ⏱️ [67:20](https://www.youtube.com/watch?v=gPBhGkBN30s?t=4040) — [H3] Journal Entry Components - Key idea: Complete journal entries include number, date, accounts, amounts, and description - Evidence: "Journal entry or J when abbreviated is a record of a financial transaction" #### ⏱️ [75:15](https://www.youtube.com/watch?v=gPBhGkBN30s?t=4515) — [H3] Invoice Structure and Purpose - Key idea: Invoices document transaction details and trigger accounting entries - Evidence: "An invoice is a record of a transaction that splits out and identifies the sales tax so they actually required by law" ## 📚 References - [The Organic Chemistry Tutor YouTube Channel](https://www.youtube.com/c/TheOrganicChemistryTutor) - [Original Video with Timestamps](https://www.youtube.com/watch?v=gPBhGkBN30s) ## 🗣️ Paraphrase - **Accounting Cycle**: The systematic process begins with identifying business transactions, recording them in journals, posting to ledgers, creating trial balances, making adjustments for accuracy, preparing financial statements, and closing temporary accounts - **Double Entry System**: Every financial transaction affects at least two accounts with equal debits and credits, ensuring the accounting equation always balances and providing built-in error checking - **Financial Statements**: Three core reports (balance sheet, income statement, cash flow statement) provide different perspectives on business performance and position to stakeholders like investors and lenders ## 📰 Newsletter **Master Business Accounting Fundamentals in One Comprehensive Tutorial** Whether you're starting a business or need to understand financial statements, this complete accounting course covers everything from basic concepts to advanced applications. Learn the systematic approach that businesses worldwide use to track their financial health. **Key Takeaways:** - Master the DEALER method to remember account types and their normal balances - Understand how the accounting equation drives all business transactions - Create professional financial statements using the accrual method **Practical Applications:** - Use T-accounts to visualize transaction effects before recording - Implement double-entry bookkeeping to prevent errors - Prepare adjusting entries to ensure accurate financial reporting Resources: [QuickBooks Training](https://quickbooks.intuit.com/learn-support/), [AICPA Resources](https://www.aicpa.org/), [IRS Business Guides](https://www.irs.gov/businesses) ## ✅ Action Items #### DevRel - Create interactive accounting tutorials with sandbox environments for hands-on learning - Develop accounting API documentation with clear examples and error handling - Build developer tools for automated journal entry validation and posting #### Community - Establish accounting study groups with peer review of practice problems - Create mentorship programs pairing experienced bookkeepers with beginners - Develop certification pathways for different skill levels in business accounting #### WordPress - Design accounting plugin architecture following WordPress coding standards - Create documentation templates for financial reporting features - Implement accessibility standards for accounting interfaces and data tables ## 🧪 Hypotheses - Students who complete hands-on journal entry exercises retain accounting concepts 40% longer than those using theoretical study alone - Visual learners show 25% better comprehension when T-accounts are used before introducing formal journal entries - Small business owners who understand basic accounting principles make 30% fewer costly financial errors - Interactive accounting software reduces learning time by 50% compared to traditional textbook methods ### 📊 Methodology - Compare retention rates between hands-on vs. theoretical accounting instruction over 6-month period - A/B test visual learning tools (T-accounts) vs. traditional journal entry introduction - Survey business owners on financial decision accuracy before and after accounting training ### ❓ Questions - How can accounting education be adapted for different learning styles and neurodivergent learners? - What are the optimal practice intervals for retaining complex accounting concepts long-term? - How do cultural differences affect understanding of Western double-entry accounting principles? ### 🔮 Future Research - Integration of AI tools for automated accounting error detection and correction - Development of gamified accounting education platforms with progression tracking - Cross-cultural studies on accounting concept comprehension and teaching methods ### 💡 Implications - **Practice**: Systematic approach to financial management enables better business decisions and compliance - **Education**: Comprehensive accounting literacy becomes essential for entrepreneurship and business leadership - **Technology**: Automated bookkeeping tools still require human understanding of underlying principles - **Compliance**: Proper accounting practices ensure legal compliance and accurate tax reporting ### 🧠 Learning Styles Assessment Reading level estimate: Grade 10-12 (technical content with clear explanations) #### 👀 Visual learners - **Present**: T-account diagrams, balance sheet layouts, journal entry templates - **Improve**: Add flowcharts for accounting cycle, infographic summaries, color-coded account types #### 🔊 Aural learners - **Present**: 5-hour narrated tutorial with clear verbal explanations - **Improve**: Add chapter summaries, key concept audio reviews, mnemonic device practice #### 🗣️ Verbal learners - **Present**: DEALER mnemonic, detailed definitions, step-by-step explanations - **Improve**: Add glossary with pronunciation guide, accounting storytelling examples #### 🧩 Kinesthetic learners - **Present**: Hands-on examples with window cleaning business transactions - **Improve**: Add interactive worksheets, physical manipulatives for account balancing #### 🧠 Logical learners - **Present**: Systematic accounting cycle progression, mathematical equation balancing - **Improve**: Add decision trees for transaction analysis, logic flowcharts #### 🧑‍🤝‍🧑 Social learners - **Present**: Business scenarios involving multiple parties and stakeholders - **Improve**: Add group practice problems, peer review exercises, discussion prompts #### 🧘‍♀️ Solitary learners - **Present**: Self-paced video format with pause/replay capability - **Improve**: Add self-check quizzes, reflection questions, independent practice sets #### 🌿 Naturalistic learners - **Present**: Business ecosystem examples showing interconnected transactions - **Improve**: Add environmental accounting examples, sustainability reporting concepts ### 📊 Accessibility Assessment #### Screen reader semantics - **Present**: Clear headings structure, descriptive titles for each section - **Improve**: Add alt text for T-account diagrams, ARIA labels for financial data tables #### Keyboard navigation - **Present**: Standard video player controls accessible via keyboard - **Improve**: Add keyboard shortcuts for chapter navigation, skip-to-content links #### Contrast and readability - **Present**: Clear visual distinction between debit/credit columns - **Improve**: Ensure 4.5:1 contrast ratio for all text, larger font options for numbers #### Text resizing and reflow - **Present**: Video maintains readability when zoomed to 200% - **Improve**: Ensure accounting tables remain usable at high zoom levels #### Media and captions - **Present**: Audio narration throughout 5-hour tutorial - **Improve**: Add closed captions, provide downloadable transcripts with timestamps #### Forms and interactions - **Present**: Basic video interaction controls - **Improve**: Add accessible practice forms for journal entries, error validation ### 🌍 DEIB Assessment #### Cultural breadth - **Present**: Uses universal business concepts applicable globally - **Improve**: Include examples from diverse business types and cultural contexts #### Inclusive language - **Present**: Gender-neutral business examples, avoids cultural idioms - **Improve**: Add plain language explanations for technical terms #### Neurodiversity support - **Present**: Logical progression, consistent structure, clear section breaks - **Improve**: Add content warnings for intensive numerical content, provide outline summaries #### Representation - **Present**: Diverse business scenarios including service and product businesses - **Improve**: Include varied business owner identities, different business sizes #### Psychological safety - **Present**: Encouraging tone, acknowledges learning difficulty - **Improve**: Emphasize that mistakes are normal learning tools, provide support resources ### ✅ Logical Validity #### Strong reasoning - **Deductive strength**: Builds from accounting equation to derive all other principles systematically - **Inductive strength**: Uses multiple specific examples to establish general accounting principles - **Causal reasoning**: Clearly explains cause-effect relationships in transaction recording - **Analogical strength**: Effective analogies like "economic benefit flow" and "heads/tails" for debits/credits #### Fallacies - **Appeal to tradition**: "This has been done for ages" - while true, doesn't justify current relevance without additional reasoning - **Oversimplification**: Some complex scenarios reduced to basic examples may not reflect real-world complexity #### Tone of voice - **Overall tone**: Patient, educational, encouraging with acknowledgment of difficulty while maintaining confidence in learner success ### 🛡️ DARVO Analysis - **Deny**: No relevant denial patterns present in educational content - **Attack**: No attacks on alternative accounting methods or critics - **Reverse victim/offender**: Not applicable to educational tutorial content - **Emotional cues**: Positive, supportive emotional framing throughout ## 🎯 Conclusion This comprehensive accounting tutorial provides essential financial literacy for business operations. - Document Tags: [[journal]] [[accounting]] [[bookkeeping]] - Summary: LEARN ACCOUNTING in Under 5 Hours! - URL: https://www.youtube.com/watch?v=gPBhGkBN30s Hey there, I’m James and in this video, you'll learn how basic accounting works from start to finish. For the past three years, I’ve spent most of my time making these free accounting tutorials to help people study, pass their exams, or get a deeper understanding for their own businesses. We’ve covered a lot of different topics, and the order has been a little random at times. So what I’ve done is pick out my favorite videos and arrange them in a logical, progressive order. The result of which is this almost five-hour long accounting epic. It’s a biggie, but I put the timestamps and links to the originals down in the description. I’ve also made cheat sheets for all of the topics covered today, so if you’d like to support the channel, then you’re welcome to buy those on my website. The link is in the description too. And quickly, before we jump in, I’d like to say a big thanks to all my channel members. You guys helped make this possible. Thanks for your support. Let’s do this! We’ll start with the accounting cycle. Accounting is like a big tree; it’s been around for ages and it has lots of Branches of accounting include financial accounting, managerial, tax, audit, and bookkeeping. But generally, I think when people say accounting, they usually mean financial accounting. So what is financial accounting? It's the process of identifying, recording, summarizing, and analyzing an entity's financial transactions and reporting them in financial statements. Hey, I'm James, and if this definition doesn't mean much to you, it's all good. Stick around me for the next 10 minutes or so, and you'll see exactly how financial accounting works. We've got a lot to cover, but I do recommend watching this right through to the end at least once so that you can get an idea of the big picture. Let's do this. Imagine that you own Rough Times, a tabloid newspaper covering all the latest gossip on our furry friends. During March, you run a promotional offer for annual subscriptions that begin on April 1st. People can't get enough of your stories, and you end up with thousand dollars in new subscriptions, all paid for in cash. The first step in financial accounting is to identify the transaction. Well, that's easy. I just mentioned one. You made forty thousand dollars in new annual subscriptions. These start on April 1st and continue through to March 31st next year. So what’s next then? It's time to prepare a journal entry. A journal is a record of a financial transaction, and it looks like this. You have a unique journal number, a date, a description, the accounts affected. In this case, that’s cash and subscription revenue. Then you have your debits and credits, which are both forty thousand. Rough times is serious business, so you’re using double-entry accounting, which means this transaction affects at least two accounts, and the total debits are equal to the total credits. But why do we do it this way? What is double-entry accounting? The first thing you need to know is that financial accounting is built on one simple idea: The stuff that your business owns is equal to the stuff that your business owes. We call the stuff that your business owns assets. These are valuable resources that you’ll benefit from in the future. Things like cash and inventory but on the other side of this formula, we use two different words to describe the stuff that your business owes: liabilities, when you owe stuff to third-party lenders or suppliers. These are your obligations that you'll need to fulfill in the future. And equity, when rough times owe stuff to you, the owner, this represents your claim on the business's net assets. So, assets equal liabilities plus equity. This little formula is called the accounting equation, and it has big implications. It was written down a long time ago by this guy in this book, and it revolutionized the way we record transactions. It's the foundation of double entry accounting, the theory that there are at least two equal and opposite sides to every transaction. Because this accounting equation is always true, it must always balance. Debits and credits are the words we use to reflect these two sides. Credits represent the sources that economic benefit flows from, whereas It flows to nowadays pretty much every large business in the world uses double entry accounting, and so does rough times. In this case, you debit cash by forty thousand dollars to increase your assets, and you credit subscription revenue by forty thousand dollars to record your income. Are you hanging in there? I know there's a lot to take in, and some of these terms might not make sense right away, but that's okay. Just give it some time and let it all seep in. After this, you can always jump into my accounting basics playlist to explore everything I mention in a lot more detail. I'll drop a link to that down below in the description, just below that big red subscribe button. I don't know what voice that was, but anyway, the next step is to post the journal into your general ledger. The general ledger is a place where you store all of your financial data. It contains a complete record of your accounts and journal entries. Back in the day, it used to be this huge book that you'd fill out by hand, but thankfully we've moved on now, and businesses like yours use accounting Software which treats the general ledger as kind of a central database. So, how do we get this journal into your general ledger? You post it to your accounts. Accounts are places where you record, sort, and store all transactions that affect a related group of items. Broadly speaking, there are six types of accounts: assets, liabilities, and equity, which we already know from the accounting equation. Then there are revenue, expenses, and withdrawals, also known as dividends. These feed into the equity part of the equation. If you’d like to see how and why that works, then you can check out my video on equity; I’ll pop a link to that in the description. This journal affects two accounts, and we can picture what they look like by drawing out two t's and labeling them cash and subscription revenue. These are called T accounts, and they help us visualize what your accounts look like. Debits go on the left and credits go on the right. When you post this journal, you debit the left-hand side of your cash account by Forty thousand dollars, and you credit the right-hand side of your subscription revenue account by 40,000 as well. When we total these up, you now have 48 000 in cash, and you’ve made 75,000 in subscription revenue. But rough times have other accounts too; it has a whole collection of assets, liabilities, equity, revenue, and expense accounts stored in your general ledger. You post this journal during March when you collect the cash. But now let’s fast forward to the end of your financial year, December 31st. We need to put together your unadjusted trial balance. What’s a trial balance? It’s an internal report that summarizes the closing numbers in all of your general ledger accounts. It can help us check for errors, but ultimately, we use it to make financial statements, as you’ll soon see. But what does it look like? Here’s your general ledger again, and now let’s jump ahead to the end of December. Building a trial balance is actually quite simple; you list out all of your accounts and their closing balances, and that’s all there is to it. A closing balance is the cumulative Total of all transactions affecting an account. As usual, debits are on the left and credits are on the right. At the bottom of your trial balance, you have your total debits and total credits. These should match each other exactly because the accounting equation is always true. Trial is another way of saying test, which is what the trial balance was originally used for — as a test to check that your debits and credits are in balance. This is an unadjusted trial balance because we haven't adjusted it yet, but we will now, actually, because you’ve ended a financial year, so we need to post some adjusting entries. Adjusting entries are journal entries that bring your books in line with something called the accrual method of accounting. What’s that? To understand, you really need to know about the accounting rule books. Yes, accountants have to be good and follow the rules, but the rules change a bit depending on where you’re based. You might follow the international financial reporting standards or some variation of the generally accepted Accounting principles, IFRS or GAAP, these two rulebooks make sure that your financial statements reflect a true and fair view of your business, which is important because a lot of people rely on financial statements, particularly those who've lent you money or invested in your business. Anyway, IFRS and GAAP have one major thing in common: they both want you to follow the accrual method of accounting, which means you need to recognize your revenue as you earn it and record your expenses as you incur them. This is the most accurate way to calculate your profit. But here's the thing: Rough Times hasn't been playing by the rules. In March, you ran a promotion for annual subscriptions starting on April 1st. You collected cash and posted a journal to recognize that whole amount as revenue on March 31st. This is called cash accounting and it's not the same as accrual accounting. In cash accounting, you recognize your revenue as you receive cash and record your expenses as you pay. It’s important to understand that receiving cash is not the same as earning revenue. Let me show you. You received forty thousand dollars in cash during March, but you actually earn that revenue over the next twelve months. This is when you do the work; this is when you release each issue of Rough Times. So today, as things stand on December 31st, you’ve recognized twelve months of income for this financial year. We haven’t earned three months of it yet and you won’t until the end of March next year. But it’s all good; that’s what adjusting entries are for. These are the journal entries that you post to bring your books in line with your accrual method. We can fix this situation by reversing three out of twelve months of your subscription revenue, which is ten thousand, and temporarily holding it as a liability in an account called deferred revenue or unearned revenue. This is a liability account because you still have an obligation at the end of the year to provide your customers with Rough Times from January to March. Let’s post this one to your general ledger and run ourselves a new adjusted trial balance. This time it's adjusted because you've posted your adjusting entries. We can see that your subscription revenue has gone down by ten thousand dollars, and your liabilities have gone up by ten thousand dollars. Your debit and credit totals still match each other because there were two equal and opposite sides to the journal, and now you're playing by the rules because you're following the accrual method of accounting. Nice one! Now we can create your financial statements. Financial statements are accounting reports that summarize your businesses activities over a period of time. These are external reports designed to give your investors, lenders, and creditors an understanding of your business's financial health. The three main financial statements are called the balance sheet, the income statement, and the cash flow statement. We can build all of these using your adjusted trial balance. Your balance sheet looks like this: It gives us a snapshot of your business's assets, liabilities, and equity. At a single point in time, which can teach the readers about your financial position. They can see what you own and what you owe at the end of your financial year. Now let's check out your income statement. This summarizes your business's revenues and expenses over a period of time. Here, that's the previous year, and it gives the readers a glimpse of your financial performance and profitability. If you were cash accounting, then this income statement would also mirror your cash flows, but you're using the accrual method, so profit and cash flow aren't the same thing. You keep track of your cash flows separately in a cash flow statement. This report summarizes your cash inflows and outflows over the same period of time. Once you’ve created these three financial statements, you can send them out to your investors, lenders, and creditors. If Rough Times was listed on a stock exchange, then investors all around the world would compare your performance against their expectations and decide. Whether to buy or sell shares in your business, they’d analyze your statements using financial ratios, which is something that we haven’t covered on this channel yet. So, if you’d like to see some videos on that, then by all means please let me know down in the comments. But we’re not finished yet. Once you’re done with your financial statements, you need to post some closing entries to prepare your books for next year. A closing entry is a journal entry that you post to clear out all of your temporary accounts, like revenues, expenses, and dividends. For rough times, your journal would look something like this: You’d debit your revenue accounts and use credit to your expense accounts to clear them down to zero. The balance of six thousand four hundred and forty dollars goes to retained earnings in the equity section of your balance sheet. These are your profits that you’re holding on to for the future. So if we look at your trial balance again, then we can see your revenue and expense accounts have been reset to nil. And now you’re ready to tackle the new year. Together, these steps make up the accounting cycle, and this is what financial accounting is all about. It's the process of identifying, recording, summarizing, and analyzing your business's financial transactions and reporting them in financial statements. Wowza! We covered a lot there, didn't we? I promise I don't expect all of that to make sense right away, but I do think it's important that you get to see the big picture for the rest of this video. We'll walk through all the steps of the accounting cycle at a more leisurely pace, and we'll begin with the accounting equation. The key principle behind the accounting equation is that the stuff the business owns is equal to the stuff that the business owes, and it is vitally important that you remember that this equation balances always, always, always. Now, let's say I come up with this amazing idea for a business; I want to make popcorn and sell it. I've got five dollars in my pocket and I decide to lend it to the business. Now, there is a word to describe the stuff that the business owns, and that is called assets. On the other side of the accounting equation, we actually have two Different words to describe what the business owes depend on who the lender is. We use liabilities to describe what the business owes to third parties, and we use equity to describe what the business owes to its owner, in this case, me. So, assets equal liabilities plus equity. There we have it, the full accounting equation. Simple, right? So, that five dollars that my popcorn business now has is called an asset, and that five dollars that my business owes back to me is called equity. See, it balances: assets can include things like cash, accounts receivable, inventory, plant, property, and equipment, land in buildings, investments, and goodwill, whereas liabilities can be made up of accounts payable, loans payable, wages payable, and taxes payable among other things. The most common forms of equity are stockholders' or owners' equity and retained earnings. I will cover retained earnings in detail in a further video, but for now you can just think of it as profit held for future use. Now let's add some totals to the above and see if this thing still balances. Of course, it does; the accounting equation always balances, and a balance sheet is basically a snapshot. Of our different assets, liabilities, and equity at a single point in time, a balance sheet is one of the most important financial statements there is. There is a lot you can tell about a business by looking at its balance sheet. Right? So at the beginning of this video, I promised you a couple of examples, so here we go. If I head down to the shop and spend five dollars on corn, then I no longer have five dollars in cash, but I now have five dollars of inventory. The categories have now changed, but my total assets stay the same. My balance sheet is in balance. Now I need to buy this corn, but I don't have enough money to then buy a pot, so I go to one of my friends and I ask them if I can borrow ten dollars. The business's cash increases by ten dollars, and loans payable go up by ten dollars as well. Total assets are now fifteen dollars, and my liabilities plus my equity are now also fifteen dollars. We're still in balance. I then go and spend this ten dollars on a pot. My cash goes down by ten dollars, and my equipment goes up by ten dollars. Let's say I go and sell this first batch of popcorn at a 60 percent markup on cost, so I've made sales of eight dollars. My inventory has now gone; however, I now have eight dollars in cash and have made a small profit of three dollars. My profit is three dollars because my sales were eight dollars and my corn cost me five dollars to buy. Eight less five is three dollars. Remember, I said that we can think of retained earnings as profit held for future use, so my retained earnings are going to increase by three dollars because my business has made a profit of three dollars. My total assets have now increased from fifteen dollars to eighteen dollars. So, to recap, in this video, we have learned that the stuff that the business has is equal to the stuff that the business owes. This can be reworded to form the accounting equation: assets equal liabilities plus equity. This equation always balances. The expanded accounting equation forms the balance sheet, and a balance sheet is a snapshot of a business's assets, liabilities, and equity at a single point in time. Interesting, but what are debits and credits? In this video, I’m going to explain to you what debits and credits aren't. Define them and show you why this is going to help you out to properly understand debits and credits. I think it's important to make a couple of points clear so we can remove any misconceptions. Debits and credits are neither good nor bad. Debits and credits are not the same as adding or subtracting. Debits and credits are words used to reflect the duality or double-sided nature of all financial transactions. If you need an analogy to help you visualize this, then you can think of debits and credits as heads and tails on a coin since there are equal and opposite sides to every transaction. In the world of finance, money doesn't magically appear or disappear. For money to go to one account, it has to come out from another. Accountants consider every transaction to involve a flow of economic benefit from a source to a destination. What is economic benefit? Economic benefit is the potential for an asset to contribute either directly or indirectly to the flow of an entity's cash. I was saying that accountants consider every transaction to involve a The flow of economic benefit from a source to a destination. Well, credits represent the source and debits represent the destination. Destinations that economic benefit can flow to include assets like cash, buildings, and amounts owed to you by others, but also expenses where a business pays a third party for a good or service they have provided, and dividends where a business distributes some of its cash to its owners. On the other hand, sources that economic benefit can flow from include owner's equity, where businesses owners give their cash to the business. Liabilities, such as amounts owed to a bank in exchange for a loan or to suppliers for providing a good or service, and revenue. So, let's bring back up that accounting equation that we discussed in the previous video, and I'll prove this to you: assets equal liabilities plus equity. Now we know that assets are represented by debits and liabilities by credits. However, equity is a tricky one to understand. To understand it properly, we have to expand it into the components that make it up. Now, full disclosure here, we're about to do some maths. Don't be afraid; we're just going to do some simple rearrangement here. If mass isn't your thing, maybe watch this next section through a couple of times so you can wrap your head around it. You'll be okay. Equity equals owner's equity paid in less dividends paid out plus retained earnings. I said in the previous video that we can think of retained earnings as profit held for future use. Well, profit is made up of revenue less expenses, so let's replace retained earnings in our accounting equation with revenue less expenses. We have equity equals owner's equity paid in less dividends plus revenue less expenses. And now let's take this definition of equity and break it out in our accounting equation: Assets equal liabilities plus owner's equity paid in less dividends plus revenue less expenses. And finally, let's do a little rearrangement, so we have dividends plus expenses plus assets equal liabilities plus owner's equity paid in plus revenue. The left-hand side represents debits; these increase when debited and decrease when credited. The right-hand side is the opposite. These are credits. These increase when credited and decrease when debited. Now I mentioned at the start of the video that I have a tip for you to remember all this. This is going to help you out. Well, here it is: Dealer. If you are ever in doubt about which side of the accounting equation these terms sit on, then you only have to remember this one word: Dealer. Right, I think we covered a lot there, so let's recap some of those main points. Debits and credits are words used to reflect the duality or double-sided nature of all financial transactions. Debits represent the flow of economic benefit to the destination. Credits represent the flow of economic benefit from the source. Debits include dividends, expenses, and assets. Credits include liabilities, owner's equity, paid in, and revenue. This is reflected through the accounting equation, which can be expanded and rearranged to show as dividends plus expenses plus assets equal to liabilities plus owner's equity. Paid in plus revenue is an easy way to remember this as a dealer. Before we move on, I would like to clear something up that I know a lot of people find confusing. It certainly confused me when I was studying accounting, and that is why are debits and credits the other way around in banking? Why are debits and credits backwards in banking? I’ve said in previous videos that cash is an asset which has a normal debit balance, so debits increase it and credits decrease it. However, when I deposit money into my bank account, they credit my account which increases my balance. And when I withdraw money to pay for something, they debit my account, which decreases my balance. We appear to have a direct contradiction here. I’m going to explain why that is not the case. To solve this little puzzle, we need to put ourselves into the shoes of the bank. From the bank’s point of view, our checking account is a liability, not an asset. If we go to the bank and deposit money into our checking account, the bank debits their cash to increase it, and it credits its amounts owing to us because it owes us that money back whenever we What we can do is go down to the bank and withdraw our money from our checking account. So, from the bank's perspective, checking accounts are liabilities, not assets. Liabilities are normal credit accounts, so credits increase liabilities and debits decrease liabilities. From the customer's point of view, nothing has changed. The checking account is still an asset to the customer. Debits increase assets and credits decrease assets. So, there we have it: debits and credits aren’t backwards in banking; it’s all about perspective. From the customer’s point of view, their checking account is an asset, but from the bank’s point of view, their checking account is a liability. What are T-accounts? To kick things off, I would like to lay out the definitions of some important terms that will crop up throughout this video. First, what is an account? An account is a place where we can record, sort, and store all transactions that affect a related group of items. A T-account is a visual representation of an account; it is called a T-account. Simply because it looks like a "T" and it looks like a "T," so that we can easily distinguish between all of the debits and credits that impact it. Finally, what is the general ledger? It's a place where a business stores a complete record of all of its financial transactions and accounts. Now that I've clarified these terms, let's get back to T-accounts. In its most simple form, a T-account looks like this: Debits go on the left; credits go on the right. If you are having a hard time remembering the sides, you can add a little "DR" and "CR" to the top of the T account. "DR" and "CR" are how we accountants write debits and credits in shorthand. Last week, I taught you a simple way to remember which accounts are debits and credits: DEALER. D-E-A L-E-R. Dealers, dividends, expenses, and assets go on the left; these increase when debited and decrease when credited, whereas liabilities, owner's equity, paid-in, and revenue go on the right. These increase when credited and decrease when debited. Now we will run through a quick example to illustrate this. Business has a cash account with a hundred dollars in it. That's your opening balance. You take out forty dollars to pay a bill, and then you decide to take out twenty-five dollars more to buy some new supplies, so you are left with thirty-five dollars in the account, which we will call your closing balance. Balance, by the way, is another way of saying total as a point in time. So here, your opening balance means your total cash at the beginning, and your closing balance means your total cash at the end. Typically, when you are doing a calculation, you might choose to lay it out like we have done here. However, when you're using T-accounts, you would show it like this. Cash is an asset; that's the A in dealer, so debits increase it and credits decrease it. Like I said before, debits are on the left and credits are on the right. The final balance is still 35 dollars; it is a different way to present the exact same information, the benefit being that it is easy to distinguish between all of the different debits and credits. In this case, your closing balance goes on the left-hand side because it happens. To be bigger than zero, however, if your supplies had instead cost 65, then you would be left with negative cash or an overdraft of five dollars. So your closing balance would go on the right-hand side instead. Now you might be thinking, why is all this necessary? I can already tell from that little calculation that I did there; well, this is a simple example for demonstration purposes. In reality, T-accounts are way bigger than this. Splitting out debits and credits allows us to spot things quickly in the general ledger. If you're new to accounting, it can be helpful to jot down T-accounts as you're working through a problem to help you visualize this all in your head. Eventually, you might not need to do this anymore because your brain can just naturally process this, but it takes a bit of practice to get there. Okay, so now I have another term for you and we touched on this one last week: double-entry bookkeeping. This means that every accounting entry has an opposite corresponding entry in a different account. In the context of T accounts, this means that to record a transaction, you will need to write down Both sides of it in at least two t accounts. You might want to pause the video now and grab a tea or a coffee or something to get in the zone for this next bit because I'm about to take you through some examples of double entry bookkeeping with T accounts. Okay, let's get to it. Now, you might be wondering why I was cleaning those windows at the start of this video. Well, I've recently started my own window cleaning business. I'm going to take you through some of those transactions that took place in the first month of operation. First of all, I, the business owner, invested 100 of my own money into this window cleaning business, and in return, the business issued me a hundred dollars in stock. Then, the business decided to take out a further 200 loan from the bank to fund its activities. Soon after receiving the bank loan, the business spent thirty dollars in cash on window cleaning equipment. Next, it spent a further fifty dollars on cleaning supplies. The supplier offers 30-day terms, so the payment was made on account. Finally, the business gets its first client and makes a hundred and fifty dollars cleaning their windows. But in doing so, it uses half of its cleaning supplies. The first transaction affects two accounts: cash and stock, so we will need to account for both of these categories. Cash is an asset, as I mentioned earlier; it’s the "A" in DEAR. So, debits increase it. I, therefore, need to put a hundred dollars on the left-hand side of the cash T-account, since debits always go on the left. Stock is a form of equity, which represents the second "E" in DEAR. So, credits increase it. Credits always go on the right, so we will need to put a hundred dollars on the right-hand side of our new stock T account. Moving on, in the second transaction, a business takes out a 200-dollar loan from the bank to fund its activities. This transaction affects cash and loans payable, which both need to increase by two hundred dollars. We already have a cash T-account, so now we'll be needing another one for loans payable. The cash part here is straightforward since we've done this already. We need to debit cash, a further Two hundred dollars loans payable is a form of liability. The loan increases it. The 200 dollar increase in our loans payable is recorded in our T-account by adding it to the right-hand side. In transaction number three, the business spends thirty dollars of its cash on window cleaning equipment. So we need to credit cash by thirty dollars to decrease it and debit our new equipment T-account by thirty dollars. We record the credit to cash by adding thirty to the right-hand side of the cash T-account, since credits always go on the right. Equipment is another form of asset, so the debit to the equipment goes on the left-hand side. Next, our business spends a further fifty dollars on cleaning supplies, which it pays for on account. Paying for something on account means that you agree to pay the supplier at a later date. So for now, you need to hold on to that cash, but you need to recognize a liability since you owe the supplier for the goods they sold you. Supplies are a form of asset, so we need to create a new T-account for supplies and debit the left-hand side of it by fifty dollars. We owe fifty dollars to the supplier, so we need another T account for accounts payable. Accounts payable is a liability. The "L" in dealer, so we need to credit the right-hand side of the key account by fifty. Is your head hurting yet? We only have one transaction to go, so it'll all be over soon. In our last transaction, the business gets its first client and makes a hundred and fifty dollars cleaning their windows using half of its supplies in the process. This one is a bit more tricky because there are two sides to it, but don't worry, we'll work through it together. First, we need to recognize our revenue. We made a hundred and fifty dollars cleaning the clients' windows, so revenue needs to go up by a hundred and fifty dollars. And so does our cash. Revenue is the "R" in dealer, so credits increase it. We need to make a new revenue T account and credit it by a hundred and fifty on the right-hand side. The cash we have made is recorded as a fifty dollar debit to the left-hand side of the cash T account. Now there's one more thing we need to take note of and then our work is done. We said half of our cleaning supplies were used up on This job, so we can't recognize them as an asset anymore. They now make up our cost of sales, which is a type of expense. Expense is the first "e" in dealer, so debits increase it. In our fourth transaction, we spent fifty dollars on supplies. So if we have used half, then we need to credit supplies by twenty-five to decrease them and debit our brand new cost of sales T-account by twenty-five to increase it. There we have it: our first month of transactions all laid out visually in front of us in T-accounts, with debits on the left and credits on the right. So there you have it: an account is a place where we can record, sort, and store all financial transactions. A T-account is a graphical representation of an account. The general ledger is a place where a business stores a complete record of all of its financial transactions and accounts: debits on the left, credits on the right. And finally, double entry bookkeeping means that every financial transaction affects at least two accounts. What are journal entries? In the previous video, I showed you that a T-account is a visual representation. Of an account and how to record transactions using them. However, in day-to-day life, T-accounts aren't that practical to use; they take up lots of space, and it's easy to miss a side of a transaction. We need another, more efficient method for recording our transactions. But why is it important to record our transactions? First, you can use financial reports to measure the performance of your business to see if you're doing well or badly. Second, it enables you to manage your cash flow so that you don't run out of it. Third, it's helpful to keep things organized. It's also useful at tax time to avoid missing out on any deductions. Finally, if your business were to get audited, it's handy to have that paperwork ready. In fact, the process of recording all financial transactions is so important that we have a word for it: bookkeeping. Bookkeeping can be done on any budget, no matter how big your business is. Here are a few examples of some different accounting software packages that you can use on different budgets. I will throw the links to a few of these in the description below. Now that we know why bookkeeping is important, we need a method to record transactions. Earlier, I said that accounts are impractical, so we’re going to have to try out something else: journal entries. So, what are journal entries? A journal entry, or JE when abbreviated, is a record of a financial transaction. It looks like this: first, we have the journal number. This is a unique reference number that is used to identify the journal. Then, there is the journal entry date. This is the date that the journal is posted in the general ledger. It’s important because it affects the accounting period that the transaction is going to show up in. Next, we have the names of the accounts that are impacted by the journal, in this case: cash and owner’s equity. Notice that owner’s equity is indented. We indent the name of the account that is getting credited so that it is easier to see. Then, we have separate columns for all of the debit and credit entries, and finally, there is the journal description. Below, it’s good practice to give a solid explanation here, since you may need to refer back to the journal in the future. And a good description will make it much easier to remind yourself why you entered it in the first place. Remember, we're talking double-entry bookkeeping, so there must be at least two sides to the journal, and the totals of those debit and credit columns must match each other exactly because the accounting equation always balances. If you're using accounting software like QuickBooks or any of those other ones that I mentioned to you previously, it usually won't let you post the journal unless the debits and credits match each other exactly. Since this is a key control, however, if you're using sheets or Excel, then you're on your own and you'll need to watch out for this. There are two types of journal: automatic journals and manual journals. Automatic journals only exist when you're using accounting software. These can save you loads of time by posting automatically behind the scenes as you enter invoices and receive payments. On the other hand, manual journals are typically only used for adjusting entries and unique transactions. You need to fill out all of the fields in a template like the one I showed you earlier, by yourself. Right, I think it's time for that example that I promised at the start. In last week's video, I started my own window cleaning business. It's been up and running for a week now, and it's going well, but my equipment is getting all gross and dirty, so I need to go get it cleaned. I take it to the laundry and they charge me twenty dollars. I pay them in cash. In order to do this, we're going to need one of those journal templates. First, we need a unique journal entry number so that we can identify this transaction. We discussed our first five transactions in the previous video, so let's call this one number six. The journal entry date should be today, the 21st of September, since that is when the equipment was cleaned. So this transaction is going to show up in the September accounting period. Next, we need the account names that are impacted by this journal. In this case, we're talking laundry costs and cash. Laundry costs are an expense. That's the first E in DEALAR, so debits increase it. They charge me twenty dollars, so I need to put this number in the debit column. Cash is an asset; that's the A in DEALAR, so credits decrease it. We need to indent the account description for cash to help us identify it as a credit, and we're going to need to put 20 in the credit column. Finally, we need to give this journal a description. Let's call it "Laundry Costs, Week One." Great! So, now that journal is all prepped up, it's ready to be posted in the general ledger. Our work here is done. Let's recap what we just learned. Bookkeeping is the recording of all financial transactions in a business. A journal is a record of a financial transaction. The totals of the debit and credit columns always match. Automatic journals are used in accounting software to save you time, and finally, manual journals are used for adjusting entries and unique transactions. What is an invoice? A normal business transaction involves two parties: a buyer and a seller. The seller provides goods or services to the buyer, and in return, they want to get paid. This is a transaction, so that's the whole point. So, the buyer owes money to the seller. But how much exactly, and what specifically are they paying for? And how long do they have to make the payment? To answer all of these questions, the seller Sends them an invoice which sets out all of this information so the buyer knows what they owe. They've got an itemized list of all of the goods and services that they're paying for, and they know the terms of the transaction. They're happy, so they send the money to the supplier, and the transaction's complete. I've got bills I've got to pay. Bills and invoices are actually the same thing; they relate to the document that is sent to the buyer to request the payment for the goods and services that have been provided by the seller. Great! So now I've got a feel for invoices. But why are they important? Well, for starters—and we've touched on this already—sellers want to get paid, so it's important to them that invoices are sent out as early as possible so they’re not waiting around for that cash. The government is also keen on invoices. Most countries charge some form of sales tax on transactions involving taxable goods and services, like GST, VAT, state or provincial tax. You might have heard of some of these. An invoice is a record of a transaction that splits out and identifies the sales tax. Actually, required by law for transactions involving registered businesses. If you'd like to know the specifics, then I recommend you check out your local tax authority's website. From an accounting point of view, invoices are also important because they trigger the accounting entries and the books of both the buyer and the seller. They're used to track accounts receivable and accounts payable. So we know what invoices are, and we know that they're important, but what do they actually look like? Let's create one and find out. There are plenty of ways to make invoices. Google Sheets actually has a built-in invoice template if you need to fire one off quickly. But if you want to be more organized and have the ability to track payments and make reports, then I recommend you use some sort of cloud accounting software like QuickBooks Online, Xero, or FreshBooks. I'll link to all of these down below. Here we've got an invoice that I've thrown together using the sample company from QuickBooks Online. This is a very typical invoice layout, so it's a great place for us to start and run through all of the key features. First of all, we've got the names and Addresses of both the buyer and the seller who is this transaction between. Well, in this example, we've got Craig's Design and Landscaping Services selling to Cool Cars, and on the other side, we've got the invoice number 1038. This is a unique number that identifies the invoice. Usually, invoice numbers are sequential, so the next invoice raised by this company would most likely be 1039. Below that, we have the invoice date. In this case, it's the 17th of January. This is the day that the invoice was created, and it's critical to include it because it starts the countdown for when the payment is due from the buyer and how long they have got. Well, that is determined by the sale terms, which in this case is net 30 days. So, the whole payment is due within 30 days of the invoice date; that is a common wait time, but terms can vary depending on what has been agreed. 30 days after the 17th of January is the 16th of February, which is the due date that we can also see here. Next, we have the description of the goods and services that this invoice relates to. In this case, it appears to be some kind of custom design work. It's best to be as specific as possible in the invoice. Description, because you don’t want to cause any confusion and delay, that payment to the right of the description. We have the quantity, rate, and amount. Here, the service has been provided just once, and the amount per unit was for 350 dollars. So in this case, both the amount and the subtotal are for 350. Below that, we’ve tacked on a sales tax of 8 because the taxable service has been provided. That comes out at 28, and that leaves us with an invoice total inclusive of tax of 378 dollars. Before we wrap up this video, I’d like to answer four common questions that people tend to have when it comes to invoices. Question one: When should I invoice? Invoices are most commonly sent out after the goods and services have been provided. However, they can also get sent out before, depending on what’s been agreed between the two parties. However, the accounting treatment in each situation is different. Question two: Are invoices and sales receipts the same thing? The short answer is no. However, this is confusing because there are a few similarities. Both serve as evidence of a transaction, and both are Produced by the seller and given to the buyer, however, the key difference is that an invoice is a request for payment, so it’s issued before the payment is made, whereas a receipt is issued after. Question three: What’s the difference between a sales invoice and a supplier or a purchase invoice? Well, they’re actually the same thing; they’re both invoices. The difference in their names depends on your perspective. If you’re the seller, then you call it the sales invoice, and if you’re the buyer, you’d call it a supplier or a purchase invoice. Finally, question four: Is an invoice legally binding? In general, no, they’re not. An invoice by itself isn’t legally binding. If they were, then what would stop you from just making all the money by just firing out invoices to whoever you want? In order for them to become legally binding, both the buyer and the seller have to agree on the terms. I can’t speak for the specifics of your country, but in general, it’s important that both sides have evidence of the agreement, at least an email or, better yet, a signed contract. You don’t want to be that person that gets into a situation where the client or customer Is refusing to pay? Oh no, we wouldn’t want that at all. I mentioned that the three main types of account in a balance sheet are assets, liabilities, and equity. Let's break down what each of these really means, starting with assets. What are assets? Assets are one of the three pillars of the accounting equation alongside liabilities and equity. They're hugely important because they're what businesses use to operate and generate a profit. In this video, I'll break down the accounting definition of assets for you and take you through some of the common types that exist in most businesses. We accountants like to split assets apart into different categories, like current, non-current, tangible, or intangible. Don’t forget to watch this video through until the end because you'll discover what all of these terms mean. Let's go! I think most of us have kind of a preconceived idea of what an asset is. We think of an asset as something that we own that’s useful or has value; something along those lines. And that’s not far from the truth, although the definition of assets in accounting is a bit more specific. Are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events? Say, what do I know? What on earth does that mean? Let's break the definition down and try to make some sense of it. The first word that stands out to me is probable. Assets are probable future economic benefits. The word probable carries with it a degree of uncertainty, and I want to emphasize this because I think that often we take numbers for granted without questioning them. The reality is that the future is uncertain, and a lot of the time we accountants have to make estimates. Let me give you an example: if you're running a business and you've got 10 clients who all owe you money, can you say hand on heart that you'll receive back every penny? Every penny? It's not uncommon for customers to go bankrupt or to dispute invoices after the work is done. So, what accountants do in these situations is make an allowance for doubtful debts. We estimate what might not be recovered and expense it to provide for situations where there's uncertainty, and that brings me to the next part of the The definition of assets is probable future economic benefits. What are future economic benefits? These are the things that bring value to you or your business, either directly or indirectly. Valuing assets based on future economic benefits means that we can't simply hold them in the books at the value that they originally cost us. Imagine you buy a laptop today and you plan on keeping it and using it entirely for work. Will that same laptop carry the same future economic benefits in five years' time? Probably not. It might well have cracked by then and not be worth anything anymore. It can be hard to measure the lifespan of a laptop, so instead we assume that all laptops have a useful economic life of, say, five years. Useful economic life is a term that you'll hear often when talking about assets. It's how long an asset will remain useful to you, and it's different from an asset's actual life, because useful economic life is an estimate. So if that laptop cost you one thousand dollars today, and we assumed a useful economic life of five years, then we would depreciate or reduce its value by two hundred dollars a year for the next five years until it's worth nothing at all. This is not an exact science; no, clearly not, but estimates like this are used every day to simplify scenarios and help accountants value assets. Lastly, I want to bring your attention to another part of the definition: assets are probable future economic benefits obtained or controlled by a particular entity as the result of past transactions or events. Obtained or controlled, this highlights another important concept that we use in accounting called substance over form. This means that when preparing financial statements, we prioritize the economic substance of transactions over their legal form. An example of this is when a business rents a building for a long period of time, say 60 years, and that building's remaining useful economic life is 65 years. Although the business is considered the lessee and technically doesn't own the building, the economic reality of the situation is that basically, they do. It makes sense because they have the right to use it for the majority of its remaining useful economic life. Following this principle of substance over form, we can account for this building as an asset even though legally it isn't. The implications for the accounting and tax treatment of the building, now I'm oversimplifying this situation. There are a few other factors to consider when making this call, but that's the gist of it. Okay, so now we know what an asset is; let's run through some examples of common assets that you should know about. But first, and bear with me here, a balance sheet is a snapshot of a business's assets, liabilities, and equity at a single point in time. In the asset section of a balance sheet, we list out all of the different types of assets that a business owns or controls. These assets are often arranged in order of liquidity. But what is liquidity? You can think of it as how quickly you can turn an asset into cash. Following that vein of thought, assets in the balance sheet can be divided into two distinct categories: current assets and non-current assets. Current assets are the ones that we can convert into cash in a short period of time, typically within a year. The three types of current assets that show up most often are cash, accounts receivable, and inventory. Inventory is your physical stock or the goods that you intend to sell to make a Profit occurs when your business sells inventory that your customers owe you money for, which we call accounts receivable. When your customers actually pay you, your accounts receivable turn into cash, the most liquid asset of them all. Other current assets include prepayments and short-term investments. You can think of prepayments as situations when you're paying for something in advance. Rent is a good example, because most of us pay rent at the start of the month. At the moment that rental payment is made, we need to recognize a prepayment as an asset on the balance sheet; it's an asset even though we aren't going to convert it into cash, because we're going to get some of that sweet future economic benefit out of it. Remember the definition: not all assets convert into cash. Short-term investments can be made when your business has cash to spare. You might choose to put some of that money to work by investing it in stocks and shares. This investment is considered to be a short-term investment or current asset if you're in it for the short game and you plan to sell those stocks or shares within a year's time. However, if you want to hold on to them for longer. After a year, they become non-current assets. Non-current assets are long-term assets that are used in operations to generate profits and that can't easily be converted into cash. There are three main categories of non-current assets: the first, which we touched on a moment ago, are long-term investments. These are investments that we plan to hold on to for longer than a year. The other two categories of non-current assets are tangible or intangible assets. Tangible or fixed assets are those that have a physical presence; you can actually touch them. The most common types are land and buildings, or PPE, which stands for property, plant, and equipment. These include things like furniture, machinery, and cars. But not all assets have a physical presence; we call those that don't intangible assets. Intangible assets include things like intellectual property, patents, royalty rights, trademarks, and copyright. If you're a photographer, then you might own the royalty rights to some of your own photos. If a company wants to use one of your images for their website or blog, they should pay you a royalty fee. Recognize your work, so this intellectual property that you own is bringing you probable future economic benefits. You should be an asset. Right? The answer is sometimes. The thing with intangible assets is that they can be very difficult to value. How can you calculate the future economic value of your own licensed photos? You can't really. So most of the time, businesses don't capitalize intangible assets that they've generated internally. What does capitalize mean? When we capitalize something, we record it as an asset in the balance sheet, as opposed to expensing it in the income statement. We only capitalize intangible assets that we've purchased from someone else, and these are held at the cost value that we paid for those assets, or a lower amount, because we amortize intangible assets to decrease their value over time, much like we depreciate fixed assets. An intangible asset that doesn't fit into the category of intellectual property is goodwill. Goodwill is the amount that one company is prepared to pay for another over and above the fair value of its net assets. When Facebook bought Instagram back in 2012 for something stupid like a billion. Dollars where Instagram and their assets at the time worth that much, not by a long shot. The majority of that purchase was for goodwill; that's the premium that Facebook was happy to pay for Instagram's brand and potential future earnings over and above the fair value of their net assets. What are liabilities? Assets are equal to liabilities plus equity. Liabilities can be broken down broadly into three categories: current liabilities, non-current liabilities, and contingent liabilities. We'll explore the meaning of all of these terms in this video, and I don't know why, but the word liabilities always makes them seem like a bad thing, like something we want to avoid. But that is not the case. Liabilities are just a normal part of business; they aren't anything to be afraid of, and I'm going to explain why right now. Hold on tight because you're about to hear the full accounting definition of liabilities. A liability is a probable future sacrifice of economic benefits arising from present obligations of a particular entity to transfer assets or provide services. Other entities in the future, as a result of past transactions or events. What the I thought the assets definition was bad, but this is something else. Let's break it down and see if we can make any sense of it. Liabilities are probable future sacrifices of economic benefits. The word probable hints at uncertainty. When dealing with liabilities, we accountants often have to use our own judgment of situations to estimate future outcomes. This is especially the case with accruals, which I'll get into later in this video. Future sacrifices means that we're going to need to give up something in the future. What are we going to give up? Economic benefits, which relates to the things that have value or, more specifically, assets and services. That doesn't only mean cash. This definition also says that liabilities are present obligations resulting from past transactions or events. So, in order to recognize a liability, the transaction or event that is committing us to transferring assets or providing services must have happened already. Yikes! Are you still there? I hope I haven't lost you yet. It's important to understand what liabilities are because They're a crucial part of normal business. A simpler way to think of liabilities is that they are a source of third-party funding that a business uses to buy assets and fund operations. If we bring that accounting equation back up, then we can see that businesses have two broad financing options to choose from when buying assets: liabilities and equity. Does that make sense? I think things might become clearer with some examples. Let's find out. Now that we've got a feel for what liabilities are, let's talk through some of the common types of liability that are worth knowing about. To get a summary of a business's liabilities, we can take a look at its balance sheet. A balance sheet is basically a snapshot of a business's assets, liabilities, and equity at a single point in time. In the liabilities section of the balance sheet, we list out all of our different liabilities. Typically, these categories are arranged in order of their due date, with the short-term liabilities at the top of the list and the longer-term liabilities further down. Short-term liabilities, or what we accountants like to call current liabilities, are a Business's obligations need to be settled within one year from now. The most common type of liability is accounts payable. Accounts payable relate to the bills or invoices we receive when buying something from a supplier on credit. But why would a business want to buy something on credit? And for that matter, what does credit even mean? Buying something on credit means that you're agreeing to pay later. Or if your head works like an accountant, you're making a present obligation to transfer assets or provide services to another entity in the future. In a standard business transaction, we have two parties: a buyer and a seller. The seller provides the buyer with a product or a service along with an invoice or a bill, and in return, the buyer sends them cash to settle the payment. However, sellers sometimes like to incentivize buyers to spend more money and bring their purchases forward by offering them credit terms. Picture a restaurant buying some ingredients from a food wholesaler. One day, the restaurant realizes that they've run out of carrots, a vital ingredient of their award-winning minestrone soup. It's Friday morning, and They're stressing out about it because it's going to be a busy night, and to make things worse, they're running low on cash. Larry, the restaurant owner, does the local food wholesaler and says, "Hey mate, look, we're badly in need of some carrots, but the issue is I'm a bit strapped for cash right now." "Larry, don't sweat it, you're our best customer. We'll have those carrots delivered to you right now and don't worry about the cash. We know you're good for it. We'll add 30-day credit terms to your invoice, you legend! I knew I could count on you." The seller, despite the risk of reduced cash flow, has offered Larry one-month credit terms, which they note down in the invoice. This suits Larry well because he likes to buy things on credit. Having a one-month grace period gives him flexibility to manage his cash flow. Did you hear that? The countdown starts when they receive the invoice, and in 30 days, they make the payment transaction complete. From an accounting point of view, when the buyer receives the invoice from the supplier, they recognize an accounts payable balance for the amount that they owe, and on the other side of the transaction, the seller recognizes an Equal and opposite accounts receivable balance for the same amount. One person's accounts payable is another's accounts receivable. Another kind of current liability is salaries payable. Most businesses employ staff that they need to pay. Obviously, when does that payment usually happen? Well, it depends, but often it's at the end of the month. So when the books are prepared at the end of the month, we need to recognize a balance for salaries payable. Businesses also have to pay tax on the profits they generate, so they need to recognize taxes payable on their balance sheet as well. Next, there's interest payable. So you might have noticed by now that most current liabilities include the word payable, which makes them easy to identify. But that's not always the case. Accruals or accrued expenses are adjusting journal entries typically posted by accountants at month end to recognize expenses that have been incurred but haven't been recognized yet in the books. Let's refer back to Larry. The restaurant is fast approaching month end, so Larry gives his accountant a call. "Hey buddy, would you mind getting our books up to date? I'd like to check our performance for this This month, of course, are there any accruals I need to post? Yeah, we had a plumber in last week to fix the dishwasher, and I don't think they've sent us an invoice yet. Ah, right. You are— what did they quote? He didn’t say, but last time it was 500 for a similar job. In this situation, the restaurant has incurred an expense during the current month because the plumber has provided them with a service. However, they haven’t received an invoice, so the liability and the expense haven’t been recorded in the books yet. So, Larry’s accountant posts an accrual in the books to recognize an accrued liability and an expense of 500. This is an estimate because there’s no supporting invoice to match the transaction to, but by recording this transaction, Larry’s accountant is ensuring that the business’s income statement and balance sheet will give an accurate picture of the restaurant’s financial performance when Larry comes to review it. The accruals are probably worthy of a whole video by themselves. If you’d like to hear more about them, let me know down in the comments below. Geez, we’ve got a lot of current liabilities! Here, and that isn’t even all of them. Two other big ones that I haven’t even mentioned yet are unearned revenue and short-term loans. You can think of unearned revenue as the opposite of a prepayment. They come up when someone pays you for a good or service in advance. Now, that might sound like an asset, and you’re right; cash is an asset. But we’re double-entry bookkeeping, so there’s another side to the transaction. In this case, it’s unearned revenue, which is a liability because you have an obligation to transfer assets or provide a service in the future. Short-term loans are exactly what it says on the tin. They are loans that need to be settled within one year from today. But short-term loans can also refer to the current portion of long-term loans, which are non-current liabilities. Non-current liabilities are obligations that aren’t expected to be settled within a year. There are many types of non-current liability I’m going to mention a few now, but I’m not going to get into the nitty-gritty because this video could go on all day, and who’s got time for that? When a business wants to raise money from outside to fund its operations or invest in new assets, it A business has a couple of options: it could seek a long-term loan from a bank or financial institution, who in return will expect to be repaid with interest. Alternatively, the business could choose to issue bonds. Bonds are similar to loans, but the key difference is that the money is raised directly from the public. You can think of them as formal IOU notes. You'll still be charged interest, although it may be cheaper than getting a loan from a bank. The flip side, however, is that bonds are less flexible. Other non-current liabilities that I think we've all heard of are mortgages on properties and employee pensions. A lesser-known one is deferred income tax, which is definitely for another day. But you can think of it as a byproduct of the timing differences between your accounting and taxable profits. That wraps up current and non-current liabilities. However, I mentioned earlier that there's a third category: contingent liabilities. These are less common than the other two, but nevertheless, it's worth being aware of them. A contingent liability is a potential obligation that may arise depending on the outcome of an uncertain future event. It can be risky. To ignore contingent liabilities because the outcomes can be serious. Let me explain. Our favorite restaurant owner, Larry has a problem: one of his customers slipped and fell in the restaurant and broke their wrist. They're suing the restaurant for damages because there was no wet floor sign. If the outcome of the litigation is probable and can be reasonably estimated, then the contingent liability should be recorded as a loss in the income statement and a liability in the balance sheet. However, if the outcome is only considered to be possible or remote, then the liability might only need to be noted in the footnotes of the restaurant's financial statements or not even disclosed at all. Management needs to make a judgment of whether the outcome is going to be probable, possible, or remote, and that decision will influence the accounting treatment of the contingent liability. What is equity? Equity is the oddball in the accounting equation, and there are so many different terms and jargon that come with it as part of the parcel. Wow, so many! And this isn't even all of them, but I've cherry-picked these ones to teach you today because if you can Understand these, then you'll have a solid grasp of what equity means, and to be honest, you'll be far ahead of most of the other people out there who are still battling with this topic. Oh, and by the way, if my voice sounds funny today, it's because I've been struck down by the man flu. We've had a chilly week in Vancouver, and it's finally got to me. But anyways, are you ready? Let's do this. At the start of this video, I promised you two definitions of equity in accounting, and here's the first: Equity is the residual value of an entity's assets after deducting all its liabilities. Uh, that's it. Hold on, I'll explain how this works. First, let's bring up the accounting equation again. You'll be seeing this quite often in this video, and it'll become clear why later on: assets are equal to liabilities plus equity. If we rearrange this formula, then we can see that equity is made up of assets minus liabilities. Now we accountants have another word to describe assets minus liabilities: net assets. I said a moment ago that equity is the residual value of an entity's assets after deducting all its Liabilities residual value basically means what's left over after you take all of an entity's assets and deduct its liabilities. In other words, what we've got here is equity, which represents the net assets of a business. Simple? Hey, yes, it looks simple, but what does it actually mean? Definition number two is going to help us shed some light on this. It says that equity represents the net funds invested into a business by its owners. I like this description of equity because it gives us some context. Let me explain with the help of the accounting equation. On a broader scale, there are two ways that funds can be invested into a business to finance its operations, and you're currently looking at both of them. It could choose to borrow money from third-party lenders like banks, which in essence are liabilities, or it could choose to use the net funds invested into the business by its owners. In other words, it could choose equity. So now we know that equity represents the net assets of a business, and at the same time, it represents the net funds invested into the business by its owners. So what we're saying here is that the owners of a business own or You have a claim on all of its net assets and we call this equity. Make sense now? Now that we’ve got an idea of what equity means, let’s have a look and see what it’s actually made of. Full disclosure: here, equity is made up of a lot of things, and some parts are a bit complicated. But I mentioned at the start that I’ve cherry-picked the parts that I think are most important and that will give you the most value: three in particular that together will give you a solid understanding of what equity is, and I’ll share them with you in a moment. But first, I think it’ll be easier for you to picture all of this if we work with an example. Imagine that you’ve got an idea for a business. You’ve been following the plastic-free February movement on the internet, and you’ve come across this video. Ninety percent of all you realize that plastic makes up 90% of all ocean debris. So you come up with an idea to decrease the number of plastic bags by developing your own reusable shopping bag to help save the planet. But there’s a problem. You have a choice to make: that all startup businesses end up Facing how to structure your business, you could choose to go it alone, become a sole proprietor and avoid incorporating the business as a separate legal entity. You could go in 50/50 with a mate and form a partnership, or you could decide to create your own corporation, a separate legal entity that's owned by its shareholders. Now, there are pros and cons to each of these, but that's for another day. Let me know down in the comments if you'd like to hear more about it. I want us to rewind for a second. I said that equity is essentially made up of three things, and the reason why I've laid all this out here is because the words we use to describe these three things change depending on the structure of the entity, and I think that's partly what makes equity seem so complicated. There is so much different jargon that we use to describe what is essentially the same thing. Let me show you the first thing that makes our faculty: capital contributions. Capital relates to the funds raised to support a business, and contributions simply mean that these are given to the business. Owners invest into the business out of their own pockets. Now, the way that we describe this changes depending on who the owners are, and that changes based on the structure of the business. If you are a sole proprietor, then there's only one owner— you. So, you'd call the money that came out of your own pocket owner's equity. However, if you were part of a partnership, then the owners of the business would be the partners, so you'd call the capital contributions partner contributions. And if you created a separate legal entity, a corporation, then the owners of the business would be the shareholders, and you'd call the funds invested shareholders' equity. So, we have three different terms that describe basically the same thing. Capital contributions are one of the ways that businesses tend to fund themselves during the early startup phase before they become profitable. Imagine that you choose to become a sole proprietor, at least at first, and you invest $1,000 of your own money into your reusable bag business. What's your business's financial position? Let's bring up the accounting equation again. Your business has assets. Of one thousand dollars in the form of cash, and you, the owner, have a claim of one thousand dollars on those assets, which we call owner's equity. The accounting equation is in balance, as it should be, because when we're looking at a snapshot of a business's assets, liabilities, and equity at a single point in time, we're looking at its balance sheet. Now, capital contributions aren't the only thing making up equity. When your business generates revenues or incurs expenses, it'll make a profit or a loss, which is just revenues less expenses. What happens to that profit, and who does it belong to? You, of course. You're the owner, so you could choose to reinvest these profits back into the business or hold on to them to use in the future. Over time, these profits and losses that you're holding on to build up, and we call them retained earnings. Retained earnings are defined as accumulated profits held for future use. And thankfully, this term stays the same regardless of whether you're a sole proprietor, a partnership, or a corporation. Your business's equity is made up of two things: capital contributions and retained earnings. Time your reusable bag business starts to make some real money; so much, in fact, that you no longer need to dip into your own pocket to fund it. Using capital contributions, you can cover all of the expenses using the accumulated profits that you've held onto and set aside. Your retained earnings within a year— your business is booming. You've got much more money coming in than what's going out; in other words, you've got a net cash inflow. But back home, all is not so rosy. You've invested so much of your own savings into the business through capital contributions that you're running out of money to live on for yourself. You need to withdraw some cash out of the business to cover your own personal expenses. Well, how does that work? Retained earnings are made up of a couple of things. Remember I said that they're your accumulated profits held for future use. So, a big chunk of your retained earnings is your accumulated profits, which are your revenues less your expenses, which comes straight from your income statement. An income statement is a financial report that you use to track your revenues and expenses over a period of time. Earnings are also made up of withdrawals; the money that's taken out of the business and distributed to its owners. We have different terms to describe withdrawals depending on the structure of your business. For sole proprietors, we call them drawings, and for partnerships, we call them partner drawings; and for corporations, we call them dividends, which are profits distributed to the shareholders. Again, we have three terms all used to describe what is essentially the same thing. Withdrawals, as the sole proprietor of your reusable bag business, you can use drawings to withdraw your accumulated profits for personal use. This impacts the accounting equation by decreasing assets because the business's cash has gone down and decreasing equity because your claim on those net assets has decreased. Hold on, now I want to show you something interesting; we've broken equity down into capital contributions, retained earnings, and withdrawals. But let's see how this all fits together using the accounting equation. Earlier, I said that when we look at a snapshot of the accounting equation at a single point in time, we're looking at a balance. The balance sheet is made up of three things: assets, liabilities, and equity. We know that equity is made up of capital contributions from the businesses' owners and retained earnings, which are its accumulated profits held for future use. Retained earnings break down further into accumulated profits less withdrawals. Accumulated profits are a business's revenues less expenses, which when looked at over a period of time make up its income statement. So what we've got here is the expanded accounting equation, and I like this because we can see how two of the businesses' major financial statements: the income statement and the balance sheet are linked together through equity. There are two main methods of accounting: the cash method and the accrual method. In the next two videos, I'll explain how each of these work. So what is the cash method of accounting? The cash basis of accounting is a method of recording financial transactions. Under this method, transactions are only recorded once cash changes hands. We record revenue only when cash is received and we record expenses only when cash is paid out. Let me elaborate on this with a simple Example: imagine you've got a baking business and a customer places an order for a birthday cake. The ingredients for this cake cost you ten dollars to buy, and you are selling it at a 150 percent markup on cost. So the customer pays you 25 dollars. You've got two transactions to record. First, you need to record the expense, which in this case is the cost of buying the ingredients for the cake. You debit your expenses by ten dollars to increase them, and you credit your cash by ten dollars to reduce your cash balance. You then need to recognize your revenue, which is the twenty-five dollars that the customer pays you. You debit your cash by twenty-five dollars to increase it, and you credit your revenue by twenty five dollars to increase it as well. If you're new to debits and credits, or you'd like a refresher, I recommend that you check out this video. Now, I want you to consider two scenarios. The first is that you buy the ingredients for your cake, you bake it, and you sell it all the same day, on the 25th of October. The customer pays you in cash. Under the cash basis of accounting, transactions are recorded when money Changes hands, so in this case, you record your expense and your revenue on the same day, the 25th of October. The second scenario is the same as the first, except this time the customer pays on account. Your business has seven-day payment terms, so you receive the cash a week after you baked and handed over the cake to the customer. Under the cash basis of accounting, you record your expense the day that you bought the ingredients for your cake, and you recognize your revenue the following week, on the 1st of November, because that’s when you received the cash from the customer. So what are the pros of using this method? For one, it’s a great way to record transactions for small businesses that deal and operate mainly in cash. It’s simple and easy to understand, so your business doesn’t necessarily need to hire an accountant or someone that understands more complex accounting methods, which makes it cheap to maintain, and you might be able to get away without paying for more pricey accounting software. Finally, many countries accept this method of accounting for tax purposes, so long as your earnings are below a certain threshold, this could be a A viable option for you now you might be thinking, "Wow, this sounds amazing! Why doesn’t everyone do it?" Well, in reality, most businesses are much too complex to use this method of accounting. When you cash account, you don’t have an accurate way of recording your profits, so there can be huge fluctuations in your results. This is caused by recording income and expenses in separate accounting periods. If we go back to that second scenario, we can see that we recorded the expense in October and the revenue in November, so the October accounting period would show a loss of 10, and the November accounting period would show a profit of 25. It would make much more sense to show a profit of 15 in October because that’s when the work was done. In addition to this, you have no way of knowing your financial position because you aren’t recording your payables and receivables. Finally, and this can be a clincher, the cash basis of accounting isn’t allowed under GAAP or IFRS, so if you follow either of these principles or standards, then no dice. [Music] So, the cash basis of accounting can be a great way to record transactions if you've got a small business that relies solely on cash. However, if your business has payables and receivables, this method probably won't work well for you because timing differences between cash in and cash out mean you don't have a reliable way of recording your profit. If that's you, then you'll need to use the accruals basis of accounting instead to match up those revenues and expenses. I'll take you through this method in the next episode of Accounting Stuff. What is the accrual method of accounting? Hey guys, welcome back to Accounting Stuff, the place where we discuss all things accounting. Up until now, we've been talking about some basic accounting theory. Last week, we talked about the cash basis of accounting, and this week we're going to talk about another super important method of accounting: the accrual basis of accounting. The accrual basis of accounting is considered to be a much better method to follow than the cash basis because there's so much information you can extract from it. I'm going to explain why most businesses when they're starting out tend to cash Accounting is easy, but have you ever wondered how the big companies like Apple, Amazon, and Google do their books? Pretty much any household name, they all have one thing in common: they use the accrual basis of accounting. If you've never heard of it before, don't worry; I'm going to explain it all to you right now. Don't forget to stick around to the end, because I'm going to talk through some of the main advantages of using this method and also the reasons why most businesses starting out tend not to use it. Let's get cracking. In the last video, I explained the pros and cons of the cash basis of accounting. If you missed it, there should be a link somewhere up here. With the cash basis, you record your revenue once you receive the cash, and you record your expenses when you pay that cash back out. It's a great way to do your books, and it's simple, and that's the reason why it's an approach used by many small businesses and individuals for personal finance. However, there is one big problem with this accounting method: it can be really hard to work out your business's profitability, particularly when you want to work out how much profit you made for One particular point in time, like one month of the year, for instance, and that's because of the timing differences between when you recognize your revenue and expenses. I'll give you an example of this in a moment. The accrual basis of accounting solves this issue. Revenue is recognized as it's earned, and expenses are recorded as they are incurred. It's a way of recording the substance of transactions, and that makes it a much easier way to record the performance of your business over a specific period of time. Let me explain. Let's go back to that example of a baking business selling a cake that we discussed in the previous video. The ingredients of that cake cost us ten dollars to buy, and we sold it for 25. That leaves us with a profit of 15. Now, let's imagine a scenario where we sell a cake to a customer on the 25th of October. The customer has seven-day payment terms, so we don't receive the cash until the 1st of November. Under the cash basis of accounting, the revenue would be recognized on the 1st of November because that's when we receive the cash. However, under the accrual basis of accounting, the revenue Would be recognized on the 25th of October because that's when the substance of the transaction occurred. That's when we physically handed over the cake to the customer. Now, let's also imagine that we baked that cake using ingredients that we purchased a month ago in September. Under the cash basis of accounting, we would have recorded the expense in September because that's when we paid the cash for the ingredients. However, using the accrual basis of accounting, we would instead record that expense in October because that's when we sold the cake. You can see that under the cash basis of accounting, we recorded a loss of 10 in September and a profit of 25 in November. This timing difference that you can see here could cause us a real headache if we wanted to look back in time and review our performance in October because we wouldn't see any profit there. It might not seem that complicated for this one example, but imagine that we'd sold 100 cakes and they all had timing differences just like this one. It would be a nightmare to work out our profitability for a particular period in. Time because we didn't record the substance of the transactions as they were incurred. However, the accrual basis of accounting neatly solves this issue for us. We record both the revenue and expense in October, so we can see the profit of 15 in October, just like you'd expect. Our revenues and expenses are aligned with each other in the same accounting period. Because in the accrual basis of accounting, we apply the matching principle. The matching principle simply states that revenue and all expenses incurred in order to generate that revenue need to be recognized in the same accounting period. This is a key differentiator between the cash and accrual methods of accounting. The matching principle makes it easier for us to objectively analyze results because you can accurately measure your profit over time. Now that we've clarified the accrual basis of accounting, let's run through some of its pros and cons. First of all, like I just said, it applies the matching principle, so business profitability can be accurately measured for specific time periods. It also measures accounts. Receivable and payable so you can build a picture of your financial position, and is accepted under GAAP and IFRS. So it's possible to produce financial statements under these principles and standards. On the other app, on the other hand, however, the accruals basis of accounting doesn't explicitly track cash flow, so this needs to be calculated separately using the direct or indirect method. It's also more complicated than the cash method of accounting because you have to make estimates and assumptions. This can be unsuitable for small businesses, hence why many of them choose to adopt the cash method of accounting instead. If you're deciding which of these methods to use for your business, then you'll need to weigh up the pros and cons of each in order to come to a decision. Both of these methods are usually allowed for tax purposes, although the cash basis is normally only an option if your revenues are below a certain threshold. You can Google what that threshold is on your tax authority's website. It's also important to know that whichever method you choose could impact your tax payments by bringing them forwards. Backwards depending on your situation, however, in the long run, both the cash and accrual methods tend to produce the same result. Most startups and small businesses tend to start off with the cash method of accounting because it's easier to apply, and it's a good way to track cash flow. However, if and when those businesses continue to grow, there may come a point where it makes sense to make the switch to the accrual basis of accounting instead. What is the revenue recognition principle? To kick things off, let's define revenue. Revenue is the income earned from the sale of goods or the provision of services. The sale of goods could relate to a baking business selling a cake, and the provision of services could be a car wash cleaning your car. So now that we’ve clarified that, what’s the revenue recognition principle? [Music] The revenue recognition principle states that revenue is recognized when it's earned, not when cash is received. Let me show you what I mean. I want you to imagine two scenarios. In the first, a customer orders a cake. From a bakery and pays in advance in November. They receive the cake the following month, in December. Under the revenue recognition principle, revenue is recognized when it's earned, not when cash is received. So in this case, the bakery recognizes its revenue not in November, but in December because that’s when the revenue was earned; that’s when the cake changes hands. In accounting, we call this kind of income deferred revenue because the payment is made in advance for goods that are to be delivered in the future. In the second scenario, a customer gets their car washed in December. They pay for the service on account with 30-day payment terms, which means they hand over the cash in January. Under the revenue recognition principle, the revenue is recognized in December because that’s when the service was provided; that’s when the car wash took place. In this case, we call the revenue accrued revenue because the service was provided in advance of the payment. Now, it’s important to know that accrued and deferred revenue don’t exist under the The cash basis of accounting is because under that method, revenue is only recognized once cash changes hands. What's the relationship between inventory and cost of goods sold? Today, I want to focus on inventory in a merchandising business, specifically how inventory in the balance sheet interacts with the cost of goods sold and revenue accounts in the income statement. This can be a bit confusing, so I recommend you watch this video all the way through to the end so you get the complete picture. There are two main types of business that hold inventory: manufacturing businesses and merchandising businesses. Manufacturing businesses buy raw materials, which they make into finished goods that they then sell to earn revenue, whereas merchandising businesses do things slightly differently: they buy goods that they resell to earn revenue. Okay, so with that in mind, what is inventory? Well, in a manufacturing business, inventory is the raw materials, work in progress, and finished goods held by A business intends to sell inventory to earn revenue. However, in a merchandising business, inventory is the goods held by the business. So you see, the definition for inventory in a merchandising business is a bit simpler. Manufacturing businesses hold three different types of inventory: raw materials, work in progress, and finished goods, whereas merchandising businesses only have one type of inventory: goods. For goods to be treated as inventory, a merchandising business must hold on to it, and it must plan to sell it in the future in order to earn revenue. This future economic benefit is the characteristic that makes inventory an asset. Actually, inventory is normally thought of as a current asset because most businesses intend to turn their inventory into cash within one year. But more on that soon. Let’s imagine that you own a merchandising business. You buy your inventory from a supplier, and then you sell this inventory on to your end customer. So what hats actually, since I'm in Canada and winter's just around the corner, let's do twix instead. So, you've run a merchandising business that sells toques. You buy your toques from your local manufacturer at four dollars a toque, which you pay for in cash, and you sell these toques to your end customers at seven dollars. Your customers pay you on account. How do you account for this? Well, for each toque that you sell, there are two transactions to consider. Transaction one takes place when you buy the toque from your supplier, and transaction two happens when you sell that toque to your end customer. To record these transactions, you'll need to create some journal entries. So, what's the journal entry for transaction one? You've bought a toque from your supplier for four dollars, so you need to debit your inventory account to increase it by four dollars. You debit inventory because inventory is a type of asset, the A in dealer, which makes it a normal debit account. Debits increase it and credits decrease it. If you haven't heard of dealer before, it's a handy acronym that you can use to identify debit and credit accounts. I've made a video explaining what it is in more detail, which you can find up up here. Okay, now where does the other side of this journal entry go? You've bought something, so you have two options. You could credit cash, or you could credit accounts payable. In this example, you paid for the two in cash, so you credit your cash account to decrease it by four dollars. Cash is another kind of asset, the "A" in dealer, which makes it a normal debit account. So, you credit cash to decrease it. Great! So, here's your completed journal entry for transaction one: debit inventory by four dollars and credit cash by four dollars. But how does this journal entry affect your books? Well, we can find that out using T accounts. T accounts help us visualize the impact of transactions on your general ledger. This journal entry affects two accounts: cash and inventory. These are both assets which are held in your business's balance sheet. In T accounts, debits always go on the left and credits always go on the right. So, you debit the left-hand side of your inventory T account by four dollars and you credit the right-hand side of your cash T account by four dollars. Okay, I'm afraid that was the easy part. In transaction two, things become a little more complicated. We need two journal entries to record this transaction. Oh, and if you're finding it hard to remember all of this, I've put together a one-page cheat sheet that summarizes all of the key areas in this video. You can help support this channel by buying it on my website; there should be a link to it up here. In transaction two, you need to recognize your revenue and record your cost of goods sold. To recognize your revenue, you need to credit your revenue account by seven dollars to increase it in your income statement. Revenue is the normal credit account, so credits increase it. Debits decrease it, but where does the other side go? Well, you've sold something, so that means you need to debit cash or accounts receivable. In this example, the customer paid you on account. That's like an IOU; they haven't actually paid you the money yet. That means you need to debit accounts receivable to recognize the €7.00. Hold on to your horses; we've got one more journal entry to do. You need to release the cost of goods sold from your balance sheet to your income statement. Here's what I mean by that: in transaction one, you took up four dollars of inventory in your balance sheet. This is your cost of goods; when you sell the two to your customer, you'll need to release this cost of goods from your balance sheet to your income statement. But how do you do that? Well, you credit your inventory account by four dollars to decrease it in your balance sheet, and you debit your cost of goods sold account by four dollars to increase it in your income statement. Cost of goods sold is a type of expense; the E in dealer is a normal debit account, so debits increase it and credits. To decrease it, nice one! So we've worked out both of your transaction two journal entries, but how do these affect your books? We're going to need some more t-accounts, three more because, as well as affecting cash and inventory, these entries hit accounts receivable in your balance sheet along with revenue and cost of goods sold in your income statement. To recognize your revenue, you debited accounts receivable by seven dollars and credited revenue by seven dollars. To release your inventory, or your cost of goods sold from your balance sheet, you credited inventory by four dollars and debited cost of goods sold by four dollars. What's nice about t-accounts is that we can easily see the impact of these transactions on your books. You’re left with negative cash of four dollars, an increase of seven dollars in accounts receivable, and a net movement of nil in your inventory account. You've also earned seven dollars of revenue and incurred four dollars of cost of goods sold. These five t-accounts make up a small section of your business's books, which In turn, these are used to build financial statements like your balance sheet and your income statement. The balance sheet gives you a snapshot of your assets, liabilities, and equity at a single point in time, whereas the income statement summarizes your revenues and expenses over a period of time. So now, let's recap what went down a few moments ago, but this time with the whole picture laid out in front of us. In transaction one, you bought a toque from your supplier. You converted four dollars of cash in your balance sheet into another type of asset: inventory. At this point, you're down four dollars in cash, and you're holding four dollars of inventory in your balance sheet. Then in transaction two, you sold two to a customer. This transaction impacted both your balance sheet and your income statement because you released this inventory from your balance sheet to cost of goods sold in your income statement. At the same time, you recognized seven dollars of revenue in your income statement, and increased your accounts receivable in the balance sheet by seven. Dollars as well that leaves you with negative four dollars of cash and seven dollars of accounts receivable in your balance sheet. In your income statement, you’ve earned a gross profit of three dollars. We touched on this one earlier, but I think it’s worth repeating, so here’s my number one accounting hack. This simple trick will help you to effortlessly identify and distinguish between debit and credit accounts, and here it is. DEALER, D-E-A-L-E-R. Now, if you’re subscribed to my channel, then you might have heard me mention this quite often. DEALER in DEALER A and DEALER the IAN, DEALER, DEALER. Okay, so quite often it’s a bit of an understatement; I actually use this all the time. Here’s how it works: DEALER is an acronym that stands for dividends, expenses, assets, liabilities, equity, and revenue. Alright, so what does that mean? Well, as a general rule in accounting, debits always go on the left. And credits always go on the right. So, how this works is that on the left-hand side, we have dividends, expenses, and assets representing normal debit accounts. That means the debits increase these balances, and credits decrease them. On the right-hand side, we have liabilities, equity, and revenue. These are normal credit accounts, and that means that credits increase them, and debits decrease them — d-e-a-l-e-r. Dealer, this is it, my secret weapon. But before you click away, I want to share one more knowledge bomb that’ll help you understand the true meaning of debits and credits in accounting. After all, what use is a sword if you don’t know how to wield it? I think that’s an expression. Anyway, here it is: every financial transaction involves a flow of economic benefit from a source to a destination. Credits represent the sources that economic benefit can flow from, whereas debits represent the destinations that economic benefit can flow to. What does any of this have to do with dealer? I’ll show you right now. I want you to imagine that you own a Business and your business holds some cash. Where could this cash have come from? What are the possible sources? Well, broadly speaking, there are only three places you could have borrowed it from: a third party like a bank. You, as the owner, could have invested it into the business out of your own pocket, or you could have earned that cash by selling a product or a service. Liabilities, equity, and revenue—these are the three possible sources of economic benefit. On the flip side, what could your business spend this cash on? Well, it could distribute it back to the owners of the business—that would be you in this situation. It could be used to pay your bills, like your rent or employees' salaries, or you could use it to buy new assets like a laptop to work on. In other words, dividends, expenses, and assets are the three destinations of economic benefit. Time for some practice questions. Question one: The owner of a car wash provides their company with a one thousand dollar initial investment. Is the entry to the company's cash account A: a debit or B: a credit? The first thing to take note of is that cash An asset that's the "A" in DEALER. Now, what's DEALER? Here's a little cheat sheet that I made to help us out with these questions. DEALER is an easy way for us to remember the expanded accounting equation. Dividends plus expenses plus assets are equal to liabilities plus owner's equity plus revenue. The left-hand side of this equation consists of normal debit accounts. These increase when debited and decrease when credited. On the right-hand side, we have the normal credit accounts. These increase when credited and decrease when debited. I just said that cash is the "A" in DEALER. It makes an asset, and those increase when debited and decrease when credited. In this question, the initial investment causes the company's cash to increase, so the answer is a debit. Question number two, and this follows on from the first one: Is the entry to owner's equity a debit or a credit? There are two ways we can go about solving this. In method one, we use DEALER. Owner's equity is the second "E" in DEALER, so we know that it's a normal credit account. That means credits increase it and debits decrease it. Wash has invested one thousand dollars into the company, so owner's equity must have increased by one thousand dollars. So we credit owner's equity. Alternatively, we could have used a second method that's a bit quicker. We know that in double entry bookkeeping there are two equal and opposite sides to every financial transaction. Since we've already debited cash in question one, we must have to credit owner's equity in order to keep things balanced. In question three, we're looking at a different transaction: the car wash pays the supplier 200 in cash. Which account is debited? Is it A) accounts payable or B) cash? If the car wash is paying a supplier in cash, then that means their cash balance has to go down because they've paid it over to the supplier. Their accounts payable has to go down too because they're reducing the amount of money they owe to the supplier. Accounts payable is a form of liability; that's the Ellen dealer which makes it a normal credit account. So credits increase it and debits decrease it. Here we want to decrease accounts payable, so the answer is A; we've got to debit it. In question four, a customer When a customer gets their car washed for ten dollars, they pay on account with 30-day payment terms. Which account is credited? Is it a revenue, b cash, or c accounts receivable? Here we can eliminate cash right away because this transaction doesn't involve cash. The customer pays the car wash on account, so they still owe the car wash ten dollars, but they have 30 days in order to hand over the money because they've got 30-day credit terms. So we are left with revenue or accounts receivable, and this transaction represents a sale because a service has been provided to the customer. The revenue recognition principle tells us that we need to recognize this income now because revenue is recognized when it's earned, not when cash changes hands. Revenue is the R in dealer, so it's a normal credit account, meaning credits increase it and debits decrease it. Here, we need to increase revenue, so we need to credit it. Question number five: The following month, the car wash receives the ten dollars from the customer. Which account is credited? Is it a revenue, b Cash or accounts receivable right off the bat. We can remove revenue because this transaction doesn’t involve revenue; we’re still applying the revenue recognition principle, so the revenue was recognized back when it was earned, the previous month in question four. So we’re left with cash and accounts receivable. Cash is an asset, which is the "A" in dealer, so debits increase it and credits decrease it. Since the car wash has received cash, cash needs to be debited to increase it. That leaves us with accounts receivable. In question four, the customer owed the car wash ten dollars, so the car wash needed to recognize an account receivable. Now that the car wash has received that ten dollars back, that balance needs to be reduced down to nil. Accounts receivable are also a form of asset, so debits increase it and credits decrease it. Here, we want to reduce our accounts receivable balance, so we need to credit it. What we’ve covered so far mostly relates to steps one and two of the accounting cycle: identifying transactions and preparing journal entries. We post journal entries in step three. Into the general ledger, so what is the general ledger? I like to think of the general ledger as a database that stores a complete record of all your accounts and journal entries. But don't worry if this doesn't make sense right away; all will be revealed in this video. First, I think we should see where the general ledger fits in the big picture of accounting. A little while ago, I made a video on the accounting cycle, which basically shows us how financial accounting works. If you missed it, I'll drop a link in the description. But as you can see here, we post the general ledger in step three, right after identifying transactions and preparing journal entries. It's these three steps that we're going to focus on today. I've got two example transactions for you, and we're going to prepare the journal entries and post them to the general ledger in two different ways. Now, let's take a step back for a moment and pretend that you make delicious tasty cheeses for a living. Now, wouldn't that be the best? Your business is called Let It Bree, and it's been in your family for generations. Back in the day when your grandparents When running a business, they would have looked after ledgers, using actual books, because that's what ledgers were at the time. These were books that you would regularly record transactions in. Your grandparents were literally bookkeeping, and they would have kept several different ledgers: a cash book, one for receivables, inventory, fixed assets, maybe one for payables, and so on. Then they had the precious general ledger, which is where they stored a complete record of the business's accounts and journal entries. All of these smaller books are called subledgers. They support the general ledger by providing extra detail for certain accounts; more on that soon. Back then, your grandparents would have filled out all these ledgers by hand, but today, the books are gone. Now we've got computers. We still hold on to some of the old terms like bookkeeping and ledger, but their definitions have changed slightly. Now, you can think of a ledger as a database that you regularly record transactions in. A database that stores a complete record of all your accounts and journal entries. Time for those examples, but first, I would quickly like to say thanks to all of my YouTube channel members. You guys are absolute legends. Seriously, I really appreciate your support; it helps push me to keep on making more tutorials like this one. If you haven't signed up yet and you'd like to become a member, then just scroll on down below this video and click on the join button. Simple as that. Thank you again; I appreciate it. Example one: Manual journal entries. Let a breeze general ledger look something like this: It's a collection of all your accounts and journal entries. You have your assets, your liabilities, your equity, your revenue, and your expense accounts, and, as usual, debits are on the left and credits are on the right. It's the end of June and you've got a transaction to record. For the last month, you've been using electricity to power your cheese-making machines, but the electricity company hasn't sent You have a bill yet, which is completely fine. But remember that in accrual accounting, we record our expenses as we incur them, and you're pretty darn sure that you'll be about 400 for June. So let's record this transaction using double entry accounting. First things first, we'll debit overhead expenses to record a 400 cost in your income statement, and then we'll credit accrued expenses by 400 to recognize liability in your balance sheet. We'll add a description and a date: June 30th, because that's the date that we're going to record the transaction in your general ledger. This type of transaction is called an accrued expense because you've used the electricity in the past, but you haven't received an invoice or made the payment yet. If you'd like to learn more about that, I've made a whole video covering accrued expenses, which I'll link to down in the bottom. But what we're looking at here is a journal entry, and that means that this is a record of a financial transaction. And this is a manual journal entry. Because we're posting it ourselves, if we pop back to our diagram, we can see that we're posting this transaction directly into a general ledger, kind of like this. We're skipping past all of the sub-ledgers because you don't have one for accrued expenses. So let's post this, shall we? You already have an overhead expenses account with an eighteen thousand dollar debit balance on the left-hand side. This is your beginning balance which you've brought forward. And you also have an accrued expenses account with a six thousand five hundred dollar credit balance on the right-hand side. These are called T-accounts because they look like T's. When we post this manual journal entry into your general ledger, you debit the left-hand side of your overhead expenses account by 400, and you credit the right-hand side of accrued expenses by 400. So your ending balance in your overhead expenses account is now eighteen thousand four hundred dollars, which will carry forward into the next month, and your accrued expenses have increased. To six thousand nine hundred dollars. This is what we mean by posting a journal, and now we can see how it affects your general ledger as a whole. Your overhead expense and accrued expense accounts have been updated to reflect the transaction. Example 2, and this time we're going to use a subledger and an automatic journal entry. An account with a subledger is often called a control account. Take accounts payable, for example. This is a control account held in your general ledger, and right now it has a balance of three thousand dollars. But what's that three thousand dollars made up of? We can't really tell by looking at the general ledger; it just doesn't give us enough detail. If we want to know who your business owes money to, then we need to look at the accounts payable subledger. You can think of this as a mini database that supports the main accounts payable account in the general ledger. These two things are separate, but they interact with each other, and the totals always have to match. In the accounts payable subledger, we can See that? Let it be known that Bree owes money to three different suppliers. If we look a little closer, we can see exactly which invoices make up the balances. Pretty handy, hey? Now let's take a closer look at Dairy Lane. You've been buying milk from them for a while now, and they're kind enough to let you pay on account, which means that you don't have to pay for your milk right away. Each time you buy some, you're handed an invoice, and you're given 30 days in order to make the payment. At the moment, you owe Dairy Lane a total of 1,700 dollars, which is split across three different invoices. And today, you decide to pay the oldest one, invoice 1485, which is for one thousand dollars. This payment is going to hit two places: your accounts payable sub-ledger and your cash book. In your accounts payable sub-ledger, the one thousand dollar payment is allocated against invoice 1485, so this balance is cleared down to zero, and now you're left with two open Invoices which add up to seven hundred dollars, and your accounts payable sub ledger now totals two thousand dollars. But how does this affect your general ledger, specifically your cash account and your accounts payable control account? Remember, these have to match their subledgers. Well, these days accounting software is pretty smart, and often when you make payments like this, it'll trigger an automatic journal entry in the background. What would that look like? In this case, the journal would debit accounts payable by one thousand dollars to reduce your liabilities and credit cash by one thousand dollars to reduce your assets as well. This automatic journal entry will debit the left-hand side of your accounts payable account, reducing the balance down to two thousand dollars, and credit the right-hand side of your cash account, bringing the balance down to 149,000. If we look again at your general ledger, we can see that it's been updated. Your accounts payable control account now has A balance of 2 dollars, which matches the sub ledger, is great stuff. Automatic journal entries like this can really save you a lot of time. Think of all that extra cheese your grandparents could have made; they didn't have to do this by hand. Step four of the accounting cycle brings us to the trial balance. What is a trial balance? A trial balance, or TB when abbreviated, is an accounting report showing the closing balances of all general ledger accounts at a point in time. Back in the days of accounting on paper, it was used to check that the debit and credit column totals matched each other. However, since the introduction of accounting software, that check has become less and less important, since it’s now done automatically. Nowadays, it is an internal document that is typically used by accountants to check for errors and assist in the production of financial statements. It is also used by auditors in deciding which accounts to review. Okay, so now we know what a trial balance means, but what does it look like? It looks like this. We have a complete listing of all general ledger accounts running down the page, with two columns for the debit and credit totals. In the title, we need to mention the period end date, since we're looking at a snapshot at a point in time. The account names are grouped by their type. Typically, we start off with assets, liabilities, equity, and dividends, since this is the typical layout of a balance sheet. Then we have all of the revenue and expense accounts, which make up the income statement or profit and loss. To reduce the size of a trial balance, accounts with zero balances are normally left out completely. The columns that the account balances go in usually line up with the normal balances of the account types, which we can remember using dealer. Dividends, expenses, and assets are normally debit accounts, so these go on the left, whereas liabilities, owner's equity, and revenue are normally credit accounts, which go on the right. The totals of the debit and credit columns should always match each other. If they don't, then you'll need to check. Over your workings for errors, we're using double entry bookkeeping at all times, so the total debits and credits are always equal. However, debit and credit totals being equal doesn’t mean our trial balance is error-free. We could have switched the debits and credits in a journal and gotten them the wrong way round, or we could have posted the same journal twice, or not even posted it at all. We could have posted the journal to the wrong account entirely, or we could have posted a balance journal to the correct accounts, but the numbers were wrong because we messed up our workings. So by no means does a balanced trial balance mean that it's correct, but it's certainly a good start. For example, we're going to build a trial balance for our window cleaning business. It's been up and running for one month now, so we're going to need to include all of those transactions from the previous two videos. If you missed either of them, you might want to hit that pause button now and go check them out to help clarify things. To create this trial balance, we're going to use something called the working. The trial balance has a very similar format to the one that I showed you before, except this time we aren't going to split debits and credits into separate columns. Instead, we're going to identify debits as positive numbers and credits as negative numbers to help us distinguish between them. To start things off, we need a listing of all of the accounts our window cleaning business has. Then we're going to add seven columns to the right hand side of it, six for each of the journal entries, and a seventh to calculate the total balances in each of the accounts. Below the list of accounts, we are going to add one final row for the totals of the columns so that we can check each of the journals bounce as we enter them. Now, it's time for us to enter these journals. I'm going to move through this next section quite quickly, so if any of these accounting entries are making sense, then check out those previous videos and you'll be fine. First, the business owner invests 100 and in return, the business issues 100 in stock. We're going to debit cash by 100. And credit owners' equity by a hundred dollars. Then the business takes out a further two hundred dollar loan to fund its activities. We need to debit cash again by two hundred dollars and credit loans payable by two hundred dollars as well. Third, the business spends thirty dollars in cash on window cleaning equipment. We credit cash by thirty dollars and we debit equipment by thirty dollars. Next, it spends a further fifty dollars on cleaning supplies. The payment is made on account. So we debit supplies by fifty dollars and credit accounts payable by fifty dollars. After that, the business makes one hundred and fifty dollars cleaning windows, using half of its supplies in the process. We debit cash by one hundred fifty dollars and credit revenue by one hundred fifty dollars to recognize the revenue. We also credit supplies by twenty-five and debit cost of sales by twenty-five dollars as well to account for half of the supplies being used up. Finally, in the journal entries video, we spent twenty dollars at the laundry to clean our equipment, so we debit laundry. Costs by twenty dollars, and we credit cash by twenty dollars. Now that we have all of our September journals written out, we can take the totals for each account. You'll notice that the sum of these totals is zero; that's a good sign because it shows that our trial balance is balanced. Now, one last thing to finish this off, let's reformat our working trial balance to show our debits and credits in separate columns, and let's rename this to trial balance for the period ended 30th of September. The total of our accounts with a debit balance is 500, and the total of our accounts with a credit balance is also 500. So, here we have our final trial balance for the September accounting period. Let's recap what we just learned: The trial balance is an accounting report that shows the closing balances of all GL accounts at a point in time. It is an internal report used by accountants to check for errors and help produce financial statements. The totals of the debit and credit columns must always match each other exactly for it to balance. Doesn't mean that the trial balance is error-free. It's time for step five of the accounting cycle. This is where we post adjusting entries. I'll explain how they work in general and then we'll jump into each type one by one. What are adjusting entries? If you haven't heard of adjusting entries before, it's the name that we give to the journal entries that we post at the end of each accounting period in order to bring our books into alignment with the accrual basis of accounting. Sound complicated? Well, it is kind of. So I've decided to create a mini-series devoted to unraveling the mystery of adjusting journal entries, and this is video number one. We'll start off by taking a look at the big picture of accounting, and then we'll drill in to uncover the problems posed by the accrual basis and how adjusting journal entries can help us work around them. I'll explain what the four types of adjusting entry are and how to identify them: prepaid expenses, deferred revenue, accrued expenses, and accrued revenue. My plan is to follow this video up with four more where we'll discuss how to record adjusting entries. And go through worked examples for each type, so subscribe and hit the bell to be notified when those come out. I'll take all of these videos and pop them into one playlist that you can find up here once it's done. Got it? Good! Let me know in the comments which kind of adjusting entry you're having the most problems with, and don't forget to watch this one through to the end to find out how all of this works. Let's get cracking! I said that adjusting entries are the journal entries that we post at the end of each accounting period to bring our books into alignment with the accrual basis of accounting. But what does that mean? Why would we do that? I think we need to take a step back and look at the big picture of financial accounting. Financial accounting is the process of recording, summarizing, and analyzing an entity's financial transactions and reporting them in financial statements to its existing and potential investors, lenders, and creditors. So ultimately, as financial accountants, our job is to produce financial statements to assist our key stakeholders with their decision making. But what are financial statements? You can think of them as formal reports that summarize a business's financial performance, position, and cash flow. Collectively, they give all of the interested parties an idea of the business's financial health. When preparing financial statements, there are some rules that we need to follow. The specifics differ slightly from country to country, but broadly speaking, we follow the generally accepted accounting principles (GAAP for short) or the International Financial Reporting Standards (IFRS). Now, both GAAP and IFRS have something in common; they both require us to produce our financial statements in accordance with the accrual basis of accounting. Now, the accrual basis of accounting is key to understanding adjusting entries. So, what is it? In accrual accounting, revenue is recognized as it's earned, and expenses are recorded as they are incurred, regardless of when cash or an invoice changes hands. I made a whole video explaining what this means and its pros and cons versus the easier cash method of accounting that you can find linked up here and down below in the comments. But the key takeaway here is that payments and invoices shouldn’t dictate when we recognize our revenues or expenses. Instead, we need to think about the substance behind each transaction. That’s the real trigger. But the problem is that this doesn’t just happen naturally, and that’s when adjusting entries come in. Let me explain. A normal business transaction involves two parties: a buyer and a seller. The seller provides goods or services to the buyer and sends them an invoice. In return, the buyer repays them in cash. So there are three parts to this transaction: we have the transfer of goods or services, the invoice, and the payment. Keep that in mind for a moment. Alongside all of this, the financial statements we produce are designed to cover a range of time, which we call an accounting period. Depending on the business's reporting requirements, this could be anything from a month to a quarter or even a full year. If all three parts of this transaction happen in one accounting period, then we’re all good; no adjusting entries are necessary. But when they fall into different accounting periods, then we’ve got a problem. This is where adjusting entries come in. There are two main types: prepayments and accruals. Prepayments occur when goods or services have been paid for in advance, whereas accruals happen when goods or services are to be invoiced in the future. In a prepayment, goods or services have been paid for in advance. I’ll show you how this works. I think it's best if we think of this in terms of two accounting periods: the past and the future, with us being bang in the middle, balancing on a tightrope in the present. In a prepayment, goods or services have been paid for in advance, so that means that the payment happens back in the past for goods or services that are going to be delivered or consumed in the future. The problem here is that normally, the invoice and payment part of the transaction naturally triggers an accounting entry that recognizes the whole transaction in the past. So if we were the buyer, then we would have recognized an expense in the past, and if we were the seller, then we would have recognized the revenue in the past. But we are accrual accounting, so revenue should be recorded as it’s earned, and expenses should be recorded as they are. Incurred, the goods or services are going to be provided in the future, so the revenues or expenses should also be recognized in the future, not the past. So right now, before the period closes, we've still got a bit more time to make changes in the past. We need to post an adjusting entry to reverse out those revenues or expenses from the income statement and hold them in the balance sheet where they don't impact our past financial performance. Then, in the future accounting period, we'll post another adjusting entry to release these from the balance sheet to the income statement, so we've correctly recorded our revenue as it was earned or our expenses as they were incurred. That's how prepayments work in general, but really there are two types depending on where we fit into the transaction. We have prepaid expenses and prepaid revenue, which is more commonly known as unearned or deferred revenue. If we're the buyer in the transaction, then we're dealing with prepaid expenses because we're the ones receiving or consuming the goods or services. However, if we're the seller, then we're on the other side. Of the transaction, and we're dealing with prepaid revenue because we're the ones providing the goods or services. Accruals occur when goods or services are to be invoiced in the future. These are almost the opposite of prepayments. Goods or services are delivered in a past accounting period, whereas the invoice and eventual payment come later in the future. Again, we have a problem: the accrual basis of accounting is telling us that revenues or expenses should be recognized when they're earned or incurred. In this case, the substance of the transaction happened in the past because that's when the goods or services were delivered or consumed. However, the natural accounting trigger in this situation happens in the future when the invoice is raised by the seller and received by the buyer. So, as things currently stand, the transaction is going to be recognized in the future income statement. To correct this, we need to post an adjusting entry into the past accounting period to accrue the revenues or expenses into the income statement, and the other side of that journal will be to temporarily hold their call as an asset or a liability in the balance. Sheet in the future, once the invoice has been raised by the seller and given to the buyer, we'll need to reverse this accrual so that we aren’t recognizing this transaction twice. That will release the original adjusting entry from both the income statement and the balance sheet. Again, there are two categories of accrual: accrued expenses and accrued revenue. If we're the buyer in the transaction, then we're dealing with accrued expenses because we're the ones receiving or consuming the goods or services. However, if we're the seller, then we're on the other side, and we're dealing with accrued revenue instead because we're the ones making the money by providing those goods or services. So, adjusting entries are required to bring our books in line with the accrual basis of accounting which is required under both GAAP and IFRS when producing financial statements. Adjusting entries are divided into two categories: Prepayments occur when goods or services have been paid for in advance, whereas accruals occur when goods or services are to be invoiced in the future. If you’re on the buying side of the transaction, then you pre-pay or accrue. Expenses depend on the timing of the payment or invoice. However, if you’re on the selling side, then you defer revenue when you’ve been paid in advance and accrue revenue when you’ve already provided goods or services and plan to invoice the customer in the future. What are prepaid expenses? A prepaid expense is a future expense that has been paid for in advance. Now, what does that mean? It means that we made the payment in a past accounting period, but we don’t actually receive the underlying goods or services until a future accounting period, right? Time for an example, but first I want you to meet someone. [Music] This is Betty, my humble Toyota Yaris. She’s not the biggest and she’s certainly not the fastest. In fact, she’s kind of old, but she moves me around from A to B, and for that privilege, I have to buy car insurance. Unfortunately, I live in Vancouver, which has some of the highest auto insurance premiums in Canada. Poor Betty, who I bought for three thousand dollars, cost me a whopping $2, 400 to insure for 2019. I paid for this in advance on December 15, 2018, and I Initially, I coded the whole payment to insurance expenses. Question: what monthly adjusting entries do we need to post to record this transaction in line with the accrual basis of accounting? We'll begin by taking stock of the facts. At the end of 2018, we'd already paid for our insurance coverage for the following year. So, this was a future expense which I had paid for in advance. Does that sound familiar? Yes, we are dealing with a prepaid expense. I paid $2,400 in advance on December 15, 2018, which I coded to the insurance expense account. Now, what would that journal entry look like? Well, I paid out two thousand four hundred dollars, so my cash balance has to decrease by two thousand four hundred. Cash is an asset, which is the "A" in dealer; that makes it a normal debit account. So, debits increase it and credits decrease it. That means that on December 15th, I would have credited my cash account by two thousand four hundred dollars. The other side of the journal went to the insurance expense account. Well, expenses of the ian dealer are also a normal debit account, so to increase them I would have debited the insurance expense account by two thousand four hundred dollars. Here we have the initial journal entry when I posted it; it would have hit both the cash account in the balance sheet and the insurance expense account in the income statement. We can visualize the impact of this journal entry on the general ledger using T-accounts. In T-accounts, debits always go on the left and credits always go on the right. So this is the result of that initial entry back in December 2018, and it would have been fine if we were cash accounting because when we cash account we record expenses once cash is paid out. But the problem is we're accrual accounting, so expenses should always be recorded as they are incurred. That means that our expenses at the end of 2018 are overstated by two thousand four hundred. Time for our first adjusting entry; I'm going to show you how to record a prepaid expense. We're going to need to post this one into the December 2018. The accounting period before it gets closed for good. Our insurance expense account is overstated by $2,400. So, our adjusting journal needs to clear all of this out. Last time we debited the account, so this time we need to credit the insurance expense account by $2,400. But where does the other side of this journal entry go? We can't put this anywhere in the income statement because that will affect our profit for the year. That leaves us with one option: the balance sheet. But where in the balance sheet is a prepaid expense — an asset or a liability? Well, there's an easy way to check this. Assets bring us future economic benefits, whereas liabilities involve a future economic sacrifice. In this situation, I've already paid for the car insurance, so now it's down to the insurance company to provide me with coverage for the next 12 months. I'm going to receive the benefit of that coverage, so this prepaid expense should be recognized as an asset in the balance sheet. In fact, prepaid expenses are always recognized as assets in the balance sheet. That means the other side of the journal entry is a debit of $2,400 to prepaid expenses in the balance sheet. Let's update our T-accounts to find out what impact this journal entry had on the general ledger. So at the end of 2018, we have negative cash of $2,400, no insurance expense in an income statement, and a $2,400 prepaid expense, which we're holding as an asset in the balance sheet. This is exactly where we want to be. Now when it comes to 2019, we have some more adjusting entries to post; 12 in total, one for each month of the year. So let's bring up a timeline for 2019 and break it down into 12 accounting periods, from January 1st all the way through to December 31st. In accrual accounting, expenses are recorded as they are incurred. So we need to release our prepaid expense from the balance sheet as we consume or get the benefit from our insurance policy. In January 2019, I've consumed 1/12 of the insurance coverage. 1/12 of $2,400 is $200. So the insurance expense that we need to Recognize in our income statement is 200 for January 2019. The adjusting journal entry that we need to post looks like this: we need to debit the insurance expense account by 200 to increase our expenses in the income statement, and we need to credit prepaid expenses by 200 to decrease our assets in the balance sheet. So with 11 months of insurance coverage left on the policy, we're carrying 2,200 of prepaid expenses as an asset in the balance sheet, and we've incurred an insurance expense of 200 in the income statement. This process of releasing prepayments from the balance sheet needs to continue for the rest of the year. At the end of May, we have consumed 5/12 of our insurance coverage, so we need to have posted this journal entry five times, recognizing a two hundred dollar insurance expense in the income statement on each occasion. With seven months of insurance coverage left on our policy, we have one thousand four hundred dollars of prepaid expenses held in the balance sheet and one thousand dollars of insurance costs expensed in our income statement for five months of policy. Consumed over a 12-month period, which gives us one thousand dollars. Likewise, you could do the same to work out the prepaid expense in the balance sheet. We have seven months of coverage or future economic benefit left on the policy, so we have prepaid expenses of two thousand four hundred dollars multiplied by seven over twelve, which gives us an asset of one thousand four hundred dollars in the balance sheet come December 31st. The adjusting entry we need to post is exactly the same as the ones that we posted for the previous 11 months. Debit insurance expenses by two hundred dollars in the income statement and credit prepaid expenses by two hundred dollars in the balance sheet. However, this time we've consumed all of our insurance policy. We are no longer expecting to get any future economic benefit, so we are no longer holding any prepaid expenses in the balance sheet. This asset has been reduced to zero because we have released all of it to the income statement, where we have recorded an insurance expense of two thousand four hundred dollars for 2019. Our cash account is still showing a credit for December in the prior year. Because that's when we paid for the policy, so we've recorded our expenses as we incurred them, and our books are in line with the accrual basis of accounting. What is deferred revenue? Deferred revenue is what we call the payments that a business receives in advance for goods or services that haven't yet been delivered or provided. You might have heard of prepaid revenue or even unearned revenue. Well, all of these are actually the same thing. They're just different ways of saying deferred revenue. Um, okay, that's a bit old—three different terms that all mean the same thing. Let's try to clear things up with a couple of examples. In this first one, I want you to imagine that you're the owner of a seaplane—random, I know, but bear with me. I live in Vancouver, and for a while now I've been wanting to visit Vancouver Island. If I were to take the ferry out there, this whole trip would take me three to four hours. But lucky for me, you own a seaplane, so I head downtown to the seaplane terminal, and boom! There's a spot on your seaplane, and it's leaving in 20 minutes. The ticket cost me 200. So I pay you the money, and half an hour later we're checking out the beautiful gardens on the island. In this transaction, you're the seller and I'm the buyer. You provided me with a service by flying me out from Vancouver all the way over to the island. The question is: how should you account for this transaction? Well, as the owner of the seaplane, you've received two hundred dollars in cash. Cash is a type of asset; the "A" in DEALER, so debits increase it and credits decrease it. Your cash balance has gone up, so you need to debit your cash account by 200 to increase your cash. The other side of this transaction is going to affect revenue in your income statement. Revenue is the "R" in DEALER, a normal credit account, so credits increase it and debits decrease it. Your revenue has gone up, so you credit your revenue account by 200 to increase your income. This is what your journal entry looks like, and we can see how this journal entry affects your general ledger using T-accounts. I'm sorry I've got a sore throat today. This journal entry affects two accounts: cash and revenue. Remember, when using T- accounts, debits always go on the left, and credits always go on the right. So we debit your cash T-account by two hundred dollars to increase cash in your balance sheet, and credit the revenue T-account by 200 to increase revenue in your income statement. Nice one, that's the first example. Finished! It wasn't so bad, was it? You're probably thinking, "Well yes, because there weren't any adjusting entries in this one." You are spot on! This transaction didn't include any deferred revenue or adjusting entries of any kind because both the payment and services happened on the same day, in the same accounting period. For deferred revenue to get involved in all of this, we would need a special set of circumstances. I would need to pay to you in advance in a past accounting period, and you would need to be providing me with the service in the future accounting period. I'll show you how this works in this second example. This time, no more seaplanes. I want you to picture yourself as a commercial pilot on a passenger jet. It's June, and I'm getting homesick. I want to buy a return flight from Vancouver to the UK to see all of my friends and family. It's been ages since my last visit, so this time I decide to go there for a whole month. I buy a return flight for $800 in June on your airline. My outbound flight is going to be the next month, in July and the return leg is going to happen the following month, in August. This is our timeline. We have three accounting periods: June, July, and August to account for this transaction. You're going to need to post three adjusting entries, one in each month. So let's do the first one In June, I paid for my tickets, but from your point of view at the airline, you received eight hundred dollars in cash. You need to post a journal to debit your cash account by eight hundred dollars to increase your cash right up to this point. This journal is looking very familiar; it's basically the same as the one from the first example. You just need to post another $800 credit to revenue. And we've got— this is embarrassing; let me think. You're a commercial pilot of an international airline. Large businesses like that use the accrual basis of accounting. But if we were to recognize this income right now, then we would be cash accounting. Because in cash accounting, you record revenue as you receive the cash. Whoops, so I wasn't meant to credit revenue this time round because we are accrual accounting. Okay, I think I've got this now. This time we don't credit revenue in the income statement because we are accrual accounting. In accrual accounting, revenue is recognized as it is earned, not when cash changes hands. You haven't provided me with a service yet, so you can't recognize any of this revenue. So this entry can't go anywhere that affects the income statement. So that leaves us with one option: the balance sheet. But is deferred revenue an asset or a liability? Let's work it out. Assets bring us future economic benefit, whereas liabilities involve a future economic sacrifice. In this situation, I've already paid for a plane ticket, so now it's down to you to fly me out to the UK and back. You've got work to do. Future economic sacrifice, so you need to recognize this deferred revenue as a liability in the balance sheet. In fact, deferred revenue is always recognized as a liability in the balance sheet. So, the other side of this journal entry is going to need to increase our deferred revenue in the balance sheet. Deferred revenue is a liability; the L in dealer, so it's a normal credit account. Credits increase it, and debits decrease it. So, you need to credit your deferred revenue in the balance sheet to increase it by 800. Let's see how this journal affects your general ledger. Now you've got three T accounts: cash and deferred revenue in the balance sheet, and revenue, normal revenue, in the income statement. Your cash account has a debit balance of 800 from my initial payment, and your unearned or prepaid revenue account holds a liability of 800. The normal revenue account is empty because we can't recognize any revenue at this point. Let's fast forward to the end of July. You've flown me out to London, so half of my return trip is complete. If revenue is recorded as it's earned, then you've earned half of your The problem is, as things currently stand, you are holding 800 as a liability in the balance sheet. This deferred revenue is not the same thing as normal revenue that flows through your income statement. You are going to need to post an adjusting entry to fix this situation. Let's do it. We'll start off by debiting deferred revenue by 400, because we want to reduce this liability in the balance sheet and release half of it to the income statement. But where does the other side of this adjusting journal entry go? We need to credit to the revenue account by 400 to increase our revenue in the income statement. Let's jot down how this adjusting entry is going to affect your T accounts. We need to debit the left-hand side of the deferred revenue T account by 400 and credit the right-hand side of the revenue T account by 400. So as things currently stand, you have cash of eight hundred dollars from that initial payment, and you are holding deferred revenue of four hundred dollars as a liability in your balance sheet. We have released the other four hundred dollars, which we now recognize as Revenue in the income statement in August. You fly me back to Vancouver so the second leg of our round trip is complete. You have one more adjusting entry to post. This adjusting entry is going to be exactly the same as the one that we posted previously. We need to debit deferred revenue by four hundred dollars to decrease it in the balance sheet and credit the normal revenue account by four hundred dollars to increase that in the income statement. You post this adjusting journal entry and it hits your general ledger. So in your August balance sheet, you are still carrying that 800 of cash from the initial transaction, but you no longer have any deferred revenue. Why? Because it has all been released to the income statement, four hundred dollars in July when you performed half of the services and the other four hundred dollars in August, where you completed the round trip. You have successfully recorded your revenues as they were earned. So your books are in line with the accrual basis of accounting. What are accrued expenses? An accrued expense is a past expense. That hasn't been recorded or paid for yet. Let's pause for a moment and think about what this means. An accrued expense is a past expense that hasn't been recorded or paid for yet, so this expense will be recorded or paid out in the future. But right now, in the present, we're still waiting for that to happen. Got it? This will all become clearer with the example that we'll get into shortly. But first, let's think about how a typical business transaction works. Imagine that we're the buyer and we want to buy something from someone, the seller. They send us the goods or provide us with a service, and in addition to that, they hand us an invoice. In return, we pay them in cash. Voila! Transaction complete. With accrued expenses, the seller provides us with the goods or services sometime in the past, but we don't receive the invoice from them or make the payment to them until later in the future. Why, why, why does all of this matter? Because as financial accountants, we like to use the accrual basis of accounting. And in accrual accounting, expenses are recorded as they are incurred, not when cash changes hands. I like to think of payments as accounting triggers. When we pay money out of our bank account to a supplier, we code the payment to the relevant account in the general ledger. Receiving an invoice is also an accounting trigger. When using accounting software like QuickBooks Online, you are required to enter the details from the invoice into your accounts payable ledger once you’ve received it. I’ll explain how this works later in the example. Okay, why does all of this matter? My point is that we have two accounting triggers: the invoice and the payment. If both of these are going to happen later in the future, then right now in the present we’ve got a problem. We have no accounting triggers to record the goods or services when we receive them. In the past, that’s when the substance of the transaction took place. That’s when the expense was incurred, and accrual accounting is telling us that we need to record the transaction here. But how do we go about accruing an expense in the past? I’ll show you right now. Let’s imagine that we own a business and there are some basic overhead costs associated with running our office. Things like Electricity, heating, and water we call these utility expenses, and for now let's focus on water. In our office, we are billed for our water usage on a quarterly basis, four times a year, and on each occasion the bill covers our water consumption for the previous three months. Today is November first, the first day of a new billing cycle. That means that three months from now, on the 31st of January, we'll receive a water bill covering three months: November, December, and January—three accounting periods. To keep things simple, let's assume that water normally costs us about fifty dollars per month. Let's jump forward now to November 30th. One month has passed and it's the end of an accounting period. Do we have any adjusting entries to post? Yes, we do. We've been using water for a whole month, but we haven't received a bill or paid for any of that consumption yet, so we need to accrue an expense into our general ledger. And how do we do that? We post a journal entry. We need to recognize a utilities expense in our income statement. Water normally costs us fifty dollars per This month, we need to increase our utility expenses by 50. Expenses are the first "E" in DEAR. Normal debit accounts increase them, and credits decrease them. Our utility expenses need to go up, so we debit our utilities expense account by 50. But where does the other side of this transaction go? We are practicing double-entry accounting, so there is another side to this adjusting journal entry. We’ve already hit expenses in our income statement, so we need to temporarily hold the other side of this journal entry somewhere in our balance sheet, specifically in our accrued expenses account. But are accrued expenses an asset or a liability? Let’s work it out: assets bring us future economic benefits, whereas liabilities involve a future economic sacrifice. We’ve already received economic benefits from this transaction because we’ve been using water for the past month, but we haven’t paid for it yet. At the present moment, we are committed to making a future economic sacrifice, so we have to recognize an accrued expense as a liability in the balance sheet. Expenses are always recorded as liabilities in the balance sheet, and liabilities are the "L" in dealer normal. Credit accounts, so credits increase accrued expenses, and debits decrease them. So, we need to credit our accrued expenses to increase them by fifty in the balance sheet. Great! Let's see how this adjusting journal entry affects our general ledger. Using T-accounts, we have two T-accounts: the utilities expense account in the income statement, and accrued expenses in the balance sheet. Remember, when using T accounts, debits always go on the left and credits always go on the right. We debit the left-hand side of the utilities expense account by fifty dollars, and we credit the right-hand side of accrued expenses in the balance sheet by fifty dollars. So, we have accrued a utilities expense of fifty dollars in our income statement for November. Now let's jump forward to the end of December; another month has flown by. Do we have any more adjusting entries to post? Yes, we do. We've consumed another month's worth of water, and we still haven't received a We need to accrue some more utility expenses. The journal entry looks like this: It's exactly the same as the one we posted last month. Why? Because we estimated that water costs us roughly fifty dollars per month. So, we need to recognize another fifty dollars of utility expenses in December. On the flip side, we need to increase our accrued expenses in the balance sheet by another fifty dollars. How does this impact our books? Our utility expenses now come to one hundred dollars. Fifty of which was expensed in November and another fifty in December. In our balance sheet, we are now carrying accrued expenses of one hundred. This liability keeps getting bigger. We’ve now gone two months without an accounting trigger to settle this once and for all. We haven't received a bill or a payment in November or December. So, we are making our best estimate of what the bill might be at this stage. Okay, now we'll jump forward to the end of January, the final month of our quarterly billing cycle. The water The company has sent us an invoice covering the past three months, and it comes to $153. So it's not bang on the $150 that we expected, but that's okay. We used our best estimate and we actually came in pretty close. Like I mentioned before, I like to think of invoices as accounting triggers. Here's what I meant by that. When we enter this invoice into QuickBooks Online or whatever accounting software you're using, we need to categorize the transaction. When we do this, it automatically triggers a journal entry that gets posted behind the scenes in our general ledger. If you run a business and receive lots of invoices, then this automatic posting can become a huge time saver, and it's one of the many benefits of using accounting software. I'll pop a link down in the description to a free trial of QuickBooks Online so you can test it for yourself. It's an affiliate link, so by signing up, you'll have the opportunity to support me in making more accounting tutorials just like this one. The automatic journal entry looks like It debits our utilities expense account by 153 dollars to increase our expenses. The other side of this journal entry is going to credit our accounts payable account by 153 dollars in the balance sheet. I just want to point out at this moment that we haven't actually paid our water bill yet; we have only received the bill, and now we have 30 days in order to make the payment. We owe money to the water supplier, so we have a liability in our balance sheet. How does this affect our general ledger? this. We need to credit our new T-account accounts payable on the balance sheet by 153. That's the final balance of what we owe to the supplier, and we debit the utilities expense account in the income statement by 153. But hang on; our utility expenses are now 253 dollars. That's quite high; our final bill was only 153 dollars. How does any of this make sense? We accrued 50 of utility expenses in November and another 50 in December. When we add the 153 dollars that was automatically journaled in January, we get. 253 Both our expenses in the income statement and our liabilities in the balance sheet are overstated by 100. That's because we have one more adjusting journal entry to post. We need to release our accrued expenses from the balance sheet, so let's do that. The journal entry looks like this: We need to reduce our accrued expenses in the balance sheet. Accrued expenses are liabilities, so we reduce them by debiting the account by 100. Our utilities expense account and income statement is also overstated. This is a normal debit account, so to decrease it, we credit the utilities expense account by 100. We post this journal entry into the January accounting period, debiting the left-hand side of accrued expenses in the balance sheet by 100 and crediting the right-hand side of the utilities expense account in the income statement by 100. When we close off the quarter, we have incurred utility expenses of one hundred and fifty-three dollars in our income statement: fifty dollars, which we accrued in November and another fifty in December. And then in January, we took up a further fifty-three dollars. There are no more accrued expenses in our balance sheet because we released our $100 accrual in January, and we now owe $153 to our water supplier, which we recognize as a liability in accounts payable. We've recorded all of our expenses in the correct periods as we incurred them, so our books are in line with the accrual basis of accounting. What is accrued revenue? Accrued revenue is revenue that has been earned but not invoiced yet. Sometimes, you'll hear it called unbilled revenue, but accrued revenue is what it's more commonly known as. That was the definition, but what does it really mean? Accrued revenue is revenue that we've earned in the past that we haven't billed the client for yet. So as of now, in the present, we haven't raised an invoice yet. That'll happen later in the future. I think it's easiest if we think of this in terms of a buyer and a seller. If we're the seller, then we provide goods or services to the buyer. Once we've done that, once the work is done, we send them an invoice, and in return, they send us The cash transaction is complete; we accrue revenue whenever we have provided goods or services in the past that we haven't billed the client for yet. At some point in the future, we intend to raise an invoice, and after we've done that, we'll receive the payment. You might be wondering, "Why do we do this? Why do we even bother?" It all comes down to the accrual basis of accounting, because in accrual accounting, revenue is recognized when it's earned, not when cash changes hands. The issue with this scenario is that we provided the goods or services in the past; that's when we did the work, that's when we earned the revenue, but we haven't raised the invoice yet. Invoices prompt us to record transactions in our general ledger. So under normal circumstances, we wouldn't be recognizing this revenue until the invoice is raised, which in this situation will be sometime later in the future. So right now, in the present, we need to post an adjusting entry into our general ledger to recognize the revenue in the past when we earned it. Sound confusing? It's all good; things will become a lot clearer with this example. I I want you to imagine that you're a web developer and I'm a small business owner who's desperately in need of a website. I've checked out some of your work and I have to say I'm impressed, so I hire you to design my website for $500. It's June 1st, and you immediately get started. Come the end of the month, you've finished up your work and the website's live. I'm happy with the finished product and I'm ready to pay, but the thing is you're busy with another job, so you don't get around to raising the invoice until mid-July. Let's work through the adjusting entries in this problem from your point of view. On June 1st, do you have any adjusting entries to post? No, you haven't done any work yet, so you haven't earned any revenue. What about June 30th? Yes, now you need to post an adjusting entry. Over the previous 30 days, you, the seller, provided me with a service by designing my website. You earned this revenue, but you haven't raised the invoice yet, so you need to accrue this revenue into your books. How do you do that? By posting a journal entry. You need to recognize revenue in your income statement. Revenue is the In dealer a normal credit account, credits increase revenue and debits decrease revenue. Your revenue needs to go up, so you credit your revenue account in your income statement by 500 dollars. But where does the other side of this transaction go? We're using double-entry accounting, so there's another side to this adjusting journal entry. You've already recorded revenue in your income statement, so we need to temporarily hold the other side of this transaction somewhere in your balance sheet, in your accrued revenue account. But is accrued revenue an asset or a liability? Let's find out, shall we? Assets bring us future economic benefits, whereas liabilities involve a future economic sacrifice. You've already made an economic sacrifice by providing me with a service in June, but you haven't been paid for this service yet. You're going to see that economic benefit later in the future, so you need to recognize accrued revenue as an asset in the balance sheet. Accrued revenue is always recorded as an asset in the balance sheet, and assets are the A and dealer normal debit accounts. So debits increase. Accrued revenue and credits decrease accrued revenue, so you need to debit your accrued revenue account to increase it by $500 in the balance sheet. Nice one! Let's see how this adjusting entry affects your general ledger using T accounts. You have two T accounts: a normal revenue account in your income statement and an accrued revenue account in your balance sheet. Remember, when using T accounts, debits always go on the left and credits always go on the right. You guessed it, so you credit the right-hand side of your normal revenue account by $500 in your income statement and you debit the left-hand side of accrued revenue in your balance sheet by $500. This adjusting entry has allowed you to recognize $500 of revenue in your income statement in June when you earned it. Okay, let's fast forward to July. What happens when you raise the invoice? You need to post another journal entry. In this transaction, you're the seller, so you have raised a sales invoice. Sales invoices are recorded in accounts receivable. Accounts receivable is a subledger that tracks all of the amounts. Owed to you by your customers, it's a type of asset. A dealer has a normal debit account. So, to record your sales invoice, you need to debit accounts receivable by 500 to increase it in your balance sheet. What's the other side of this journal entry? You've debited something, so now you need to credit something else to keep your books in balance. Last month, you took up five hundred dollars of accrued revenue in your balance sheet and now you're about to take up five hundred dollars more of accounts receivable. You don't want to overstate your assets, so we can release that accrued revenue from your balance sheet. Now, accrued revenue is a normal debit account, so you decrease it by crediting 500 from the account. How does this journal entry affect your general ledger? Well, now you've got three T accounts: normal revenue in the income statement, accrued revenue in the balance sheet, and accounts receivable, which is also a balance sheet account. When you raise the invoice in July, you debited accounts receivable by five hundred dollars and credited accrued Revenue by five hundred dollars; you'll notice that your income statement hasn't been touched. You have still recognized five hundred dollars of revenue in June when you earned it, but you no longer have any accrued revenue in your balance sheet. Why? Because you raised a sales invoice, so this asset, these amounts owed to you have been transferred to accounts receivable in the balance sheet. When I make the payment a few days later, you'll receive cash for your services. You'll need to debit your cash account by five hundred. Because cash is an asset, and credit accounts receivable by five hundred to close the invoice. This five hundred asset which you initially held as accrued revenue has jumped from account to account in your balance sheet to accounts receivable when you raise the invoice, and then to cash once you received the payment for your services. So that's prepaid expenses, deferred revenue, accrued expenses, and accrued revenue, but these aren't the only adjusting entries in accounting. We also have depreciation. What is depreciation? [Music] Imagine that you own a bakery. One day, Your oven breaks, so you rush out to buy a new one, plug it in, or hook it up, whatever you do with ovens. And then you're back at it, mixing, kneading, folding, proofing. [Music] Oh hey there! I'm James, and this is the counting stuff. Anyway, as time passes, your new oven slowly wears down, just like your old one, and eventually it will break too. This is where depreciation comes in. What is depreciation? It's the process of reducing the book value of a tangible fixed asset due to use, wear and tear, the passing of time, or obsolescence. An asset is something that you own that's valuable and which will bring you economic benefit in the future, something like your oven, which you'll use to make money. Your oven is a fixed asset because you'll use it for a long time, and it's a tangible asset because it physically exists. You can touch it; you can't touch intangible assets, and they don't appreciate; they amortize instead. But that's for another day. The book value of your oven is its carrying amount in your business's accounts. We'll get into this soon, but first, why do we depreciate? In accrual accounting, revenue is recognized as it is earned, and expenses are recorded as they are incurred. With depreciation, we're particularly interested in the second line; expenses are recorded as they are incurred. What does this mean for fixed assets like your oven? Let's say that your oven has a useful life of 10 years; you buy it at the beginning of year 1, and it costs you eight thousand dollars. So you physically hand over the cash then, but when do you actually use your oven? Bit by bit over the next 10 years, depreciation journals are adjusting entries that we post at the end of each accounting period to bring your books into alignment with the accrual basis of accounting. We do this to make sure that all of your oven's use and wear and tear is properly recorded as it's incurred, not when you paid for it, but spread out over the next 10 years. How does depreciation work? It begins with buying your oven. If you were using the cash method of accounting, you would expense the entire cost of your oven straight to your income statement as soon as you hand over the cash, but when you're using the accrual The method of accounting you'd capitalize it instead. Capitalization is the process of recording a cost as a fixed asset in the balance sheet, as opposed to an expense in the income statement. So you take up your asset cost of 8,000 and hold it in your balance sheet. Then, over the next 10 years, you gradually write it off, releasing it as an expense to your income statement. Now, there are a few ways to do this. This graph shows the book value of your oven over time. The simplest appreciation method of all is called straight-line depreciation. This is a fixed cost method where the depreciation expense is spread out evenly over your oven's useful life. But, we also have the double declining balance and some of the year's digits methods. These are what we call accelerated variable cost depreciation methods where the expense is higher in the early years. Then, we have the units of production method; this is also a variable cost depreciation method, but it's not accelerated. Instead, the depreciation expense mirrors the actual physical use. Of your asset over the past few weeks, I've made videos covering each of these, which you can find in my depreciation playlist. I'll link to it down below in the description, along with my depreciation cheat sheet. Seamless plug, but in this video, let's assume that you're using the straight line method. Here's your completed depreciation schedule. This table summarizes the depreciation expenses, accumulated depreciation, and book values of your oven over its useful life. You can learn how to make one of these in my straight line depreciation video, but I'd recommend sticking around because I'm going to show you how to record all of these transactions in your business's books, how to record depreciation using journal entries. A journal entry is a record of a financial transaction, and to help us figure these out, we'll use dealer. If you've been watching accounting staff for a while now, then you might be familiar with this, but if you haven't, then maybe click subscribe. Why not? Dealer is an accounting acronym that stands for dividends, expenses, assets. Liabilities, equity, and revenue represent normal debit accounts, which means they increase when debited and decrease when credited. L, E, and R are normal credit accounts; these do the opposite; they increase when credited and decrease when debited. So let's do this: How to capitalize an asset purchase. At the start of year one, you bought your oven for eight thousand dollars. But what's the journal entry? This is journal number one and as usual, it has four columns: date, the account affected, debits, and credits. You're going to post this in year one to record your asset purchase. But which accounts will be affected? We know that cash needs to go down by eight thousand dollars. Cash is an asset, the A in dealer, so it's a normal debit account, which means that debits increase it and credits decrease it. So we'll credit your cash account by eight thousand dollars to decrease its value in your balance sheet. We're practicing double-entry accounting, so there are at least two sides to this transaction. What's the other one? It has to be a debit because total Debits need to match total credits, but we can't debit expenses in the income statement, not yet anyway, because we're using the accrual method. So, we need to capitalize the cost of your oven and hold it as a tangible fixed asset. Assets are normal debit accounts, so we'll debit your baking equipment account by eight thousand dollars to increase assets in your balance sheet. We can see the impact of this journal on your bakery's books using T-accounts. So far, you have one for cash and one for baking equipment. A T-account is a visual representation of an account where debits go on the left and credits go on the right. In journal one, you credit the hand side of your cash account by eight thousand dollars to decrease it, and debit the left hand side of your baking equipment accounts by eight thousand dollars to increase it. This is a balance sheet to balance sheet transaction. How to record a depreciation expense using journal entries. During year one, you write off eight hundred dollars as a depreciation expense to your income statement. What does this journal look like? We know it's going to hit the depreciation expense account in your income statement. Expenses are the first E in dealer normal debit accounts, which means the debits increase them, so you debit your depreciation expense account by 800 to increase it in your income statement. But where does the other side go? We need to decrease assets in your balance sheet. So, you might think it logical to credit baking equipment, and you're not wrong. That would make sense, but we don't do that. Instead, we're going to credit an account called accumulated depreciation by 800. Accumulated depreciation is the cumulative total of all depreciation expenses incurred. This might take a little bit more effort, but doing it this way helps to keep things organized, and that's a good thing. It'll make more sense with T accounts. You'll need two new ones: accumulated depreciation and depreciation expense. In your second journal, you debit depreciation expenses by eight hundred dollars to increase them in your income statement and you credit accumulated. Appreciation by eight hundred dollars to reduce the value of your oven in the balance sheet. Your baking equipment and accumulated depreciation accounts both sit in the asset section of your balance sheet. Baking equipment is a normal asset account, whereas accumulated depreciation is what we call a contra asset account. What's a contra asset? It's a normal credit account which contrasts or runs against the flow of normal assets. A contra asset. If you want to know the book value of your oven, then all you have to do is net these two accounts together: eight thousand dollars minus eight hundred dollars, which leaves you with seven thousand two hundred dollars in your balance sheet. So in year one, your cash went down by eight thousand dollars and baking equipment went up by eight thousand dollars, but later on this is offset by an eight hundred dollar increase in accumulated depreciation because you've written off eight hundred dollars as a depreciation expense to your income statement. We can see all of this here in your depreciation schedule. At the end of year one, you have eight hundred dollars in Depreciation expenses are eight hundred dollars in accumulated depreciation and a closing book value of seven thousand two hundred dollars. Are you still with me? It gets better; I promise we’re using the straight line method, which means your depreciation expense is exactly the same for the next nine years. So the next nine journal entries are identical to the one we just posted. Each year, you debit the depreciation expense account in your income statement by eight hundred dollars and credit accumulated depreciation in your balance sheet by eight hundred dollars, and here's the impact on your books: At the start of year one, you buy an oven, so your cash went down by eight thousand dollars, and your baking equipment went up by eight thousand dollars. This is a balance sheet to balance sheet transaction, but during each of the next 10 years, you post adjusting entries to record a depreciation expense in your income statement of eight hundred dollars and eight hundred dollars in accumulated depreciation, a contra asset account which offsets the asset cost in your baking equipment account. After 10 For long years, the entire cost of your oven has been written off to your income statement. So if we net together your baking equipment and accumulated depreciation accounts, we can see that the closing book value of your oven has decreased to zero, which agrees with your completed depreciation schedule. So what's next? Nothing? Well, not exactly. If you continue to use your oven, then this will be fully depreciated, but you'll still be carrying it in your books, eight thousand dollars in your baking equipment account and eight thousand dollars in accumulated depreciation, but combined a net book value of zero. When you stop using it, you'll need to post one more journal entry. Assuming no gain or loss on disposal, you'll debit accumulated depreciation by eight thousand dollars and credit baking equipment by eight thousand dollars. This journal clears out all of the older entries in your baking equipment and accumulated depreciation accounts, leaving you with a balance of zero in each account. How does straight-line depreciation work? Straight line depreciation is a fixed cost depreciation method where the expense is spread out evenly over an asset's useful life. What does that all mean? Let me show you. Imagine that you're a farmer. I know it's a bit random, but stay with me. You own a whole bunch of tangible fixed assets. These are the physical things that help you out on the farm. They are tangible, meaning that you can touch them, and they're fixed, so you intend to use them for more than one year. As time passes, these tangible fixed assets wear down and aren't worth as much as they were when you bought them. Take your combine harvester. Let's assume that this one cost you 450,000. You expect to get 12 years of use out of it, and after that, you'll probably sell up the scrap and get back around ninety thousand dollars. Let's depreciate it using the straight line method. Step one: write down what you know. You know that this asset is a combine harvester and that you're going to depreciate it using the straight line method. The asset cost is what you initially paid for it: 450,000. A lot of money, you estimate that its residual value, or salvage value, is 90,000 and that it has a useful life of about 12 years. Step 2: Build a depreciation schedule. The depreciation schedule is a table and straight-line depreciation. It has five columns: year, opening book value, depreciation expense, accumulated depreciation, and closing book value. But what do all of these terms mean? Year is the accounting period. Opening book value is the carrying amount of your combine harvester at the start of the year. This sits in your balance sheet. Depreciation expense is the value that you write off as an expense to your income statement during the year. Accumulated depreciation is the cumulative total of all depreciation expenses incurred, and closing book value is the carrying amount of your combine harvester at the end of the year. Step 3: Calculate the depreciation expense, accumulated depreciation, and book values for each period. This is Where things get real. Yes, we need to fill in all of the blanks. Let's begin with your opening book value. This one's easy; it's your asset cost: $450,000. Now, let's work out your depreciation expense. I mentioned at the start that straight line depreciation is a fixed cost depreciation method where the expense is spread out evenly over the assets used for life. So grab your calculator; we're about to do some maths. The depreciation expense can be calculated by taking your straight-line depreciation rate and multiplying it by your depreciable cost. Your straight-line depreciation rate is one divided by the useful life of your combine harvester. So, that's one over twelve years, which rounds to eight point three three percent. Depreciable cost is the difference between your asset cost and residual value. Four hundred and fifty thousand dollars minus ninety thousand dollars is three hundred and sixty thousand dollars. This is the portion of the book value that we're depreciating. Three percent multiplied by three hundred and sixty thousand is thirty thousand dollars. Your combine harvester's depreciation expense in year one makes sense. If you need any help remembering the formula, you can find it on my depreciation cheat sheet, which you can buy on my website; link in the description. Next, we need to work out your accumulated depreciation, which is the sum of all depreciation incurred to date. In year one, this is thirty thousand; exactly the same as your depreciation expense. Your closing book value is the carrying amount of your combine harvester in your balance sheet at the end of the year. We can work it out by taking your opening book value and subtracting your depreciation expense. Four hundred and fifty thousand dollars minus thirty thousand dollars is four hundred and twenty thousand. Now, with year one out of the way, we just need to repeat the process over and over again for the next eleven years. Your closing book value in year one becomes your opening book value in year two. Your depreciation expense is fixed because we’re using the straight line The method shows that it's thirty thousand dollars. Accumulated depreciation is sixty thousand dollars. Your closing book value is four hundred and twenty thousand minus thirty thousand, which is three hundred and ninety thousand dollars. The process doesn’t change. Here’s the completed depreciation schedule. You started off with a combine harvester costing four hundred and fifty thousand. You then wrote off thirty thousand as a depreciation expense to your income statement each year for the rest of your asset's useful life. You might notice that after twelve years, the closing book value of your combine harvester is ninety thousand. This matches the residual value that we chose earlier, which is good because it means we haven't made any mistakes. This is always a good sign. Let’s take another look at that graph. Here, we’re tracking your combine harvester’s book value over time. Your asset cost at the beginning is four hundred and fifty thousand dollars and its residual value at the end is ninety thousand dollars. Its depreciable cost is the difference between the two, three hundred and sixty thousand dollars. It has a useful life of twelve years. Straight-line depreciation is a fixed cost method, which means the expense is spread out evenly over your asset's useful life. But there are other variable depreciation methods as well, where the expense is higher in the early years, and these can be a bit more tricky. I have videos covering the variable depreciation methods as well, but in the interest of time, let's keep things moving. Adjusting entries turn our unadjusted trial balance into an adjusted trial balance, which is step 6 of the accounting cycle. In step 7, we create financial statements: the income statement, the balance sheet, and the cash flow statement. Let's spend a bit of time on each of these. What is an income statement? An income statement is the summary of a business's revenues and expenses over a period of time. In its basic form, an income statement looks like this: it's a summary of a business's revenues and expenses over a period of time. When we take our total revenue and subtract our expenses from it, then we work out Our profit or our loss; we make a profit when our revenues exceed our expenses, and on the flip side, we make a loss when our expenses are more than the income. We've earned; this is why the income statement is also known as the profit and loss statement, or the P&L for short. It lays out a roadmap for how we ended up here at the bottom line: our profit or loss. The income statement always covers a period of time, which could be anything that we want it to be, but typically we run it for a month, a quarter, or a full year. If a balance sheet shows us a snapshot of a business's assets, liabilities, and equity at a single point in time, then you can think of it as a photograph or a still frame taken from a video, whereas the income statement covers a period of time. It's like watching a clip of that video; it has a beginning and it has an end. If we look at it carefully and analyze it, then it can tell us a story, but more on that later. [Music] Let's take a closer look at our income statement. Revenues less expenses make us a profit or a loss. The problem with this layout Is that it doesn’t give us much detail. It would be much better if we made things a little more descriptive. For instance, revenue—there are many different types of revenue. If we were running a business that sells physical products, then we might want to call this product sales instead. Or if we provide services, we could call this our services rendered. This extra detail helps the readers of the income statement better understand what they’re looking at. Clarity is the aim of the game here. The same goes for expenses; businesses typically incur many different types of expenses, but broadly speaking, these can be broken down into two categories: our direct costs of doing business and our indirect costs of running the business. Our direct costs of doing business are the costs which we can directly trace through to the products we’ve sold or the services that we’ve provided. For a business that provides services, we might call this our cost of services, and if we sell physical goods, then we could call this our cost of sales or our cost of goods sold. Direct costs like these are variable costs which increase in direct proportion to the sales that we’ve made. If you're running a retail or wholesale business, then these would include things like the original purchase price of the product that you're reselling. Or if you've run a manufacturing business, then this would include the cost of your raw materials or the direct labor costs that went into producing your product. As we make more sales, we incur more of these direct costs. Cost of goods sold can be a bit of a tricky concept to understand at first. It ties in very closely with inventory in the balance sheet. If you'd like to see me make a video explaining how all of that works, then let me know down below in the comments. And if you haven't already, remember to hit that subscribe button so you don't miss out on all of the other accounting tutorials that we have coming out very soon. Back to the income statement: when we take our revenue and deduct our direct costs of doing business, we get to our gross profit. If you're new to accounting, then you'll soon discover that we have many different types of profit. Our gross profit is a really useful tool that allows us to measure the efficiency of our production and The sales process; I'll show you how that works in a minute. But first, let's jump back to indirect costs. These are the costs of running a business which can't be directly traced back to the production of goods or the provision of services. We sometimes call these overheads. Overheads can include fixed costs like rent, employee salaries, insurance costs, admin expenses, legal costs, accounting costs, marketing costs, depreciation, and amortization. There's a lot of them. Fixed costs like these tend to remain the same; they bear no correlation at all to the sales that your business has made. However, not all overheads are fixed. Variable overheads can loosely correlate with a business's sales, although they can't be directly traced back to the production of goods or the provision of services. These include things like advertising costs, which can indirectly drive sales, and sales commissions. Utility costs could also be considered a variable overhead in a manufacturing business because these can increase as we ramp up production. When we deduct our indirect costs of Doing business, from our gross profit, we come to our operating profit. Operating profit measures the net income that we generated from operations. This is the residual amount that's left over after deducting all of our direct and indirect costs of doing business. So this is our basic income statement, but how does it help us measure a business's financial health? It does that by giving us a means to compare our financial performance against comparative accounting periods. A comparative period is a different period of time; it can be whatever we want it to be. We could compare a current month's income statement against last month's income statement, or this year versus last year. When we use comparative periods, we can calculate the change or movement across each line item down the profit and loss statement. As accountants, it's our job to support these movements with a narrative which explains all of the differences. Let's throw in some numbers into an imaginary company, and I'll show you what I mean. We'll compare the movements in our P&L year on year. This is going to be for a medium-sized business, so we can quote our numbers in thousands of dollars. What have we got here? Our imaginary company has made sales of a hundred and ten thousand dollars, which is up ten thousand dollars from what we made in the prior year. Our cost of goods sold has also increased by ten thousand dollars, from thirty thousand dollars to forty thousand dollars. That's left us with a gross profit of seventy thousand dollars, which has remained unchanged. Our overheads are fixed at forty-five thousand, which gives us an operating profit of twenty-five thousand in each period. What can we learn from all of this? Well, our sales have increased by ten thousand, but our gross profit has remained exactly the same. How can that be? A useful metric that we can use to analyze this is gross profit margin. We can calculate our gross profit margin by taking our total product sales and deducting our costs of goods sold and then dividing the whole lot by our product sales. This measures how efficiently we've been producing and selling our imaginary. The product in this case, our gross profit margin in the current year is around 64, which is actually down from last year's gross profit margin of 70 percent. How's that possible? Well, one of two things could be happening here: our sales could be shrinking or our costs could be rising. We could be selling more products but at a discount, or the cost of our raw materials could be rising. These are the questions that we need to be asking ourselves as accountants, investors, or small business owners. We can compare metrics like the gross profit margin across comparative periods to help us identify what questions we should be asking. And then, that's when the work begins. We need to find out the answers and use them to build a narrative that explains what's going on. Gross profit margin is just one of many business metrics that we can use to analyze the income statement. If you'd like to see me make videos on the others, let me know. Now, this is still quite a basic income statement. In reality, there are other indirect costs of doing business which we might need to include as well, things like interest expenses and tax. These tend to slot in below. Operating profit is not considered to fall within the normal cost of operations. This is why operating profit is also known as EBIT, or earnings before interest and tax. When we deduct our interest and tax from our operating profit, we calculate our net profit, the bottom line, because it's at the bottom of the profit and loss statement. So, you can see that there are many different types of profit and loss to consider in accounting. We start off with our revenue, and we deduct our direct costs of doing business to come to our gross profit, our top line profit. Below this, we take out the indirect costs of running our business to find our operating profit, our EBIT, our earnings before interest and tax. When we remove interest and tax, we calculate our net profit, the bottom line. Together, these different types of profit help us measure performance over a period of time. The main goal of most businesses is to maximize their profits, so it's important to be clear on what that means and to be aware of the differences between gross profit, operating profit, and net profit, which can each tell us a different part of the Story: how do you make an income statement? Financial statements are accounting reports that summarize a business' activities over a period of time. There are three main ones that you should know about: they're called the income statement, the balance sheet, and the cash flow statement. In this video, I'll show you how to make an income statement; we'll cover the other two next on this channel. So if you'd like to watch those, then consider subscribing. The income statement is a financial report that summarizes a business' revenues and expenses over a period of time. It works like this: if you take a business' revenue and subtract its expenses, then you're left with a profit or a loss. That's why it's sometimes called the profit and loss statement, or the P&L. But we'll call this one the basic income statement; it's nice and simple, but it doesn't give us much information. We need to expand it out to see the full detailed income statement. At the top, we have operating revenue, which is the income earned from doing Business and then we take away any direct operating costs. These are the cost of sales, and that leaves us with a gross profit or a loss. Beneath that, we subtract any indirect operating costs or overheads to reach an operating profit or loss, and finally we take away the indirect non-operating costs, things like interest expenses and tax, which brings us down to the bottom line: the business's net profit or loss. If you'd like to learn more about these terms, then you can check out my other income statement video, and I also summarize it all on my income statement cheat sheet, and I'll leave links to both of those down in the description. How do you make a basic income statement? The first thing you'll need is a trial balance. The trial balance is an accounting report showing the closing balances in all general ledger accounts at a point in time. Here's one for a dating app called Tumble. It's an adjusted trial balance which means that all of Tumble's adjusting entries have already been posted, and it was run on December 31st. Which happens to be the end of Tumble's financial year. This trial balance holds a complete list of Tumble's accounts and closing balances. Debit balances go in the left column and credit balances go in the right column. But how does this help us make an income statement? Well, we can start by drawing a line because accounts in a trial balance are usually arranged in order. Above this line, we have Tumble's assets, liabilities and equity. These are all balance sheet accounts which we can ignore. We're interested in this stuff below the line: Tumble's revenue and expenses, which are their income statement accounts. The basic income statement is Tumble's revenue minus its expenses. In this case, they earned 60 million dollars in revenue and incurred 50 million, 350 thousand dollars in expenses. That leaves them with nine million six hundred and fifty thousand dollars in profit, baby! But how do we make the detailed income statement? The method is pretty much the same. If we go back to Tumble's adjusted trial balance, then all we need to do is Categorize their expenses like we did before. The cost of sales is a direct operating cost. General administrative, selling, marketing, depreciation and amortization are all indirect operating costs. Finally, interest and tax expenses are indirect non-operating costs; but please, please be careful with depreciation and amortization. If the long-term assets that they relate to aren't used in operations, then these would also be indirect non-operating costs. In this video, I'm assuming that they are used in operations, right? That's the hard bit out of the way. All we need to do now is lift these numbers out of the adjusted trial balance and put them in the corresponding sections of the income statement. That leaves us with a revenue of 60 million dollars, just like before, less 17 and a half million dollars in cost of sales, which is a direct operating cost, which gives us a gross profit of 42.5 million dollars. Then we deduct indirect operating costs. To reach an operating profit of 10 million, 450,000 and below that we subtract the indirect non-operating costs, interest and tax, which leaves us with a net profit of nine million six hundred and fifty thousand dollars on the bottom line. What is a balance sheet? A balance sheet looks like this. The way it's presented can vary, but there are some key elements at the core of the balance sheet that the rest of it is built around. Here, we have a balance sheet for a business called Craig's Design and Landscaping Services. That's because I took this one from the sample company in QuickBooks Online. QuickBooks Online is the biggest cloud accounting platform in the world, and they specialize in small to medium-sized businesses. So I thought this one would make a good example. If you're thinking, "This all looks a bit crazy," then no worries. I'm only showing you the finished product. We'll piece together a simpler one of these for ourselves in a moment. Right? I think it's time for a definition. A balance sheet is a snapshot of a business's assets, liabilities, and equity at a single point in time, and that's exactly what we're looking at. We have assets over here on the left, and on the right-hand side, we have liabilities and equity. Beneath both of the headers, we have all of the detail, all of the individual groups of accounts summarized with their closing balances. At the bottom of the balance sheet, we have our total assets and total liabilities plus equity. You'll notice that both of these numbers are exactly the same. That's what we want to see; it's the aim of the game here, because the balance sheet, as suggested by its name, always has to balance. So, your total assets must be equal to your total liabilities plus equity. If they don't match each other exactly, then we've got a problem. In the past, people used to make their balance sheets manually, and this was a pain in the you could easily waste hours or even days trying to figure out where the errors were in your workings. But thankfully, nowadays accounting platforms like QuickBooks Online exist. They ensure that your balance sheet always stays Balanced, but anyway, I promise you that we'll build ourselves a balance sheet from scratch. I mean it, so here we are. We have a clean slate. We're going to build this balance sheet from the ground up using one key principle: double entry accounting. In double entry accounting, every accounting entry has an opposite corresponding entry in a different account. Or, put simply, the stuff the business owns is equal to the stuff the business owes. We accountants call the stuff that the business owns "assets." But the stuff that the business owes is a little bit more complicated. We use two different words to describe it depending on who the business owes stuff to. When a business owes stuff to third parties, like lenders, suppliers, and employees, we call them "liabilities." However, when a business owes stuff to its owners, we call it "equity." So, we have assets that are equal to liabilities plus equity. This is the basic accounting equation, and it always balances. Total assets must be equal to total liabilities plus equity. Now, every financial transaction that a business is involved in affects this accounting equation, so the values of our assets, liabilities, and equity must be Constantly changing, but it's possible for us to take a snapshot and freeze their values at a single point in time. When we do that, we're looking at a balance sheet. The thing is though, that these three buckets are far too broad. There are many types of assets, liabilities, and equity, and it would be helpful if we could distinguish between them. Time for us to hop into Google Sheets and flesh out this balance sheet. Assets are broken down broadly into two main categories: current assets and non-current assets. Current assets are short-term assets that can be converted into cash within one year. Some of the most common types of current assets are cash, accounts receivable, supplies, inventory, and prepaid expenses. On the other hand, non-current assets are long-term assets that are used in operations to generate profit. They can't easily be converted into cash, so we expect to hold on to them for more than one year. Two common types of non-current assets are long-term investments and property, plant, and equipment. It's a similar situation for liabilities. We have current liabilities, which are business obligations that need to be Settled within one year from now, these include accounts payable, salaries payable, taxes payable, and accrued expenses. We also have non-current liabilities; obligations that aren’t expected to be settled within one year, stuff like long-term loans. That leaves us with equity, the final piece of the puzzle. This section works a bit differently from assets and liabilities. We have two broad categories to consider: owner’s equity and retained earnings. You can think of retained earnings as profits held for future use, and this is key because it’s the profit in retained earnings that forms the link between the balance sheet and the income statement. Keep that in mind. I’ll demonstrate how it works in this next example. But before we get stuck in, let’s do some housekeeping and tidy up this balance sheet by adding some totals. On the left, we have total assets, and on the right we have total liabilities and equity. These have to match each other exactly because the balance sheet always has to balance. To emphasize this, I’m going to add a little balance checker that’ll take the difference between these two cells. This should always be equal to zero. We've built a template for our balance sheet. It's time for some numbers. Let's go back to the scenario of the window cleaning business that we covered in the videos on T-accounts, journal entries, and the trial balance. I'll drop links to all of these down in the description. We're going to use these transactions again so that you can see how all of these concepts fit together. In the interest of saving you time, I'm going to move through these transactions fairly quickly. So if you find yourself getting stuck and wanting some deeper explanations of the debits and credits, then go back and watch those videos on T accounts and journal entries. By the way, on a side note, the trial balance is not the same thing as the balance sheet. If you'd like to see me make a video explaining the differences, let me know in the comments. There are six transactions that we're going to cover, and we'll work through them one by one, filling out our balance sheet templates as we go. In transaction number one, the owner of the window cleaning business makes capital contributions of one hundred dollars. We're double entry bookkeeping, so this transaction is going To affect two accounts, cash and owner's equity, the business's cash is going to be debited to increase it by $100, and owner's equity will be credited to increase that by $100 as well. Are we in balance? Yes, we are. In transaction number two, the business takes out a further $200 loan to fund its activities. We need to debit cash again by $200 to increase it and credit long-term loans by $200 to increase them too. In transaction three, the business spends $30 in cash on window cleaning equipment. We credit cash. A purchase made on account, paying for something on account means that you're agreeing to pay the supplier at a later date. So, we debit our supplies by $50 to increase them, and this time we don’t credit cash; we credit accounts payable by $50 to increase them instead. Just a couple more transactions left to go. You’ve got these; these ones are going to affect our retained earnings account. Remember that means our profit held for future use, and it links the balance sheet and the The income statement together, I'll show you how this works. Now, transaction five: the window cleaning business makes a hundred and fifty dollars cleaning windows and uses up half of its cleaning supplies in the process. This transaction is a bit more tricky than the ones we've covered up to this point because there are two parts to it, each with their own double entries. The first thing that we need to do is recognize revenue earned. To do that, we debit cash to increase it by 150 and we also credit revenue to increase that by 150 dollars. But hold up, where does revenue go? I can't see it anywhere in our balance sheet. We're going to need to jot down an income statement for our window cleaning business. An income statement is a summary of our revenue earned and expenses incurred over a period of time. So, here we have revenue of a hundred and fifty dollars. Almost there! Next, we need to record the second part of the transaction. Half of our cleaning supplies were used up on this job, so we can't recognize those as an asset anymore. They now make up our cost of sales, which is a kind of expense and belongs in our income. In the fourth transaction, we spend fifty dollars on cleaning supplies. If we've used up half of them, we need to credit supplies by 25 to decrease them and debit cost of sales in the income statement to increase our expenses by 25. However, our balance sheet still isn’t in balance. How can that be? We need to build a bridge between the profit in our income statement and the retained earnings, or profits held for future use in the equity section of our balance sheet. The 125 dollars of profit in our income statement now flows through the retained earnings and balances our balance sheet. One important thing to note is that retained earnings and profit for the year don’t normally match each other exactly as they do in this example. That just happens to be the case because we don’t have any retained earnings from previous years, and none of the profits have been drawn out of the business. That being said, the simplicity of this example is a great way to demonstrate this link between the income statement and the balance sheet. We’ll see how that works one more time in transaction six. Where our window cleaning business incurs laundry costs of twenty dollars, the payment is made in cash, so we need to credit cash by twenty dollars to decrease it and debit laundry costs by twenty dollars to increase them in the income statement. Our profit of a hundred and five dollars rolls up into the retained earnings section of our balance sheet, giving us total assets of 455 dollars and total liabilities plus equity of 455 dollars as well, and our balance sheet checker is showing zero. Good stuff! How do you make a balance sheet? The balance sheet is one of the three main financial statements; the other two are called the income statement, which we did in the last video, and the cash flow statement, which we’ll cover next time. A balance sheet, or a statement of financial position, is a financial report that gives us a snapshot of a business’s assets, liabilities, and equity at a single point in time. Now, if you’ve watched my videos before, then you’ve probably heard this one: the stuff that a business owns is equal to the stuff that a business owes. In other words, a business owns assets. And it owes liabilities to third parties. The difference between the two is called equity, which is what the business owes back to its owners, and so we have the accounting equation: assets are equal to liabilities plus equity. When we take a snapshot of this accounting equation at a single point in time, we're looking at a balance sheet. We'll call this one the basic balance sheet, and as its name suggests, it's got to balance. That means that total assets must always equal total liabilities and equity. A detailed balance sheet will look something like this. We expand out assets into current and non-current. Current assets are short-term assets, things like receivables and prepaid expenses. On the other hand, non-current assets are long-term assets. There are two main types: the ones that you can touch and the ones that you can't touch. We do the same thing with liabilities. Current liabilities are short-term liabilities: payables, accrued expenses and deferred revenue. And non-current liabilities are long-term liabilities. Like long-term loans, equity, on the other hand, is a different kettle of fish. First, we have capital contributions, which is the money invested into the business by its owners. For a company with shareholders, we might call this common stock. Then we have the business's retained earnings, which are its accumulated profits held for future use. I do have a balance sheet cheat sheet, which summarizes all of this. The link is in the description. Anyway, how do you make a basic balance sheet? First, you need another accounting report called a trial balance. This shows us the closing balances for every general ledger account at a point in time. Here's a trial balance for a dating app called Tumble. It was run at the end of Tumble's financial year, December 31st, and it's an adjusted trial balance because all adjusting entries have already been posted. We can see all of Tumble's accounts and balances: debits are on the left, and credits are on the right. At the bottom, we can see that the debits The total is 87 million seven hundred thousand dollars, which matches the total credits exactly. This means that Tumble's trial balance is in balance, which is very important. Because if the trial balance is in balance, then the balance sheet also has to balance. I don't think I've ever said "balance" so much in my life. Accounts in a trial balance are usually arranged in a pattern. Above this line, we have the stuff that Tumble owns — its assets — and below the line, we have the stuff that Tumble owes — its liabilities and equity. We also have its revenue and expense accounts, which we used last time to make the income statement. By the way, if you're finding these videos useful and you'd like to support the channel, then you can click on the join button below. Thanks to all my channel members who've done that already. You guys are absolute legends, and I really appreciate it. Thank you. So how do we make a balance sheet? There are two ways to do this: the right way and the wrong way, and I'll show you both. We'll start with the wrong way because this is a really easy mistake to make. And it goes something like this: we take all of Tumble's assets, liabilities, and the equity accounts, and we pop them in their sections of the balance sheet. In theory, it's the right thing to do, but check this out: Total assets add up to thirty-six million three hundred and fifty thousand dollars, and total liabilities plus equity add up to twenty-five million six hundred and fifty thousand dollars. That's a difference of ten million seven hundred thousand dollars, so this balance sheet doesn't balance. What went wrong? We forgot to include Tumble's revenue and expenses. These are part of Tumble's retained earnings. It's profits held for future use, which also sit in the equity section of its balance sheet. When we include them, total liabilities plus equity also add up to thirty-six million three hundred and fifty thousand. So Tumble's basic balance sheet is in balance. Remember, the balance sheet is a snapshot. Of a business's assets, liabilities, and equity at a single point in time: On the left side, we can see what the business owns, and on the right side we can see what it owes to third parties and its owners. How do we make a detailed balance sheet? We follow the same process, but first we need to divide Tumble's assets and liabilities into current and non-current. Cash, accounts receivable, other receivables, and prepaid expenses are all current assets. Property, plant, and equipment, and intangibles are non-current assets. Accounts payable, taxes payable, accrued expenses, and deferred revenue are all current liabilities, and long-term loans are non-current liabilities. In the equity section, common stock is a type of capital contribution, and everything below that is retained earnings. These are Tumble's profits held for future use: their opening retained earnings at the start of the year, less dividends, plus Tumble's net profit in the current year. And that's it; we can pick up all these numbers and put them in our detailed balance sheet. So we've got. Current assets are 31 million 50,000 and 5.3 million in non-current assets. Current liabilities are 14.4 million dollars and non-current liabilities are 1.2 million dollars. Then we have 1 million and 50,000 in common stock, which is a type of capital contribution. Finally, we have nineteen million seven hundred thousand dollars in retained earnings or profits. The health of each use total assets are equal to total liabilities plus equity, so this balance sheet is in balance. What's the difference between a trial balance and a balance sheet? Both of these reports have balance in their names, which makes them easy to get mixed up. More on that soon, along with a knowledge bomb that I'd like to share with you. But first, I want to explain how the trial balance and the balance sheet are actually very different from one another, but also very similar at the same time. Cryptic. The trial balance is an internal accounting report showing the closing balances of all general ledger accounts at a single point in time. It looks like This we have three columns: accounts, debits and credits. The accounts column contains a complete list of all the general ledger accounts in a business, and to the right of it, we have the total debits or total credits in each account. The trial balance shows us the closing balances of all of these accounts at a single point in time, so we need to make that clear in the title. I'm going to use old faithful, the window cleaning example that we've covered a few times before. So we'll run through our trial balance to September 30th, and here are our closing numbers. At the bottom of the trial balance, we normally take the totals for both the debit and credit columns. This is a check to ensure that our books are in balance, because in double-entry accounting, debits and credits must match each other exactly at all times. Back when accounting was done manually, the trial balance was used to check that total debits were equal to total credits across all accounts. Accountants would literally spend hours or even days trying to work out where they messed up if these totals Didn't match each other exactly. Thankfully nowadays, this check is done for us automatically when we use accounting software. But to us accountants, the trial balance is still an internal document that we use to check for errors. There are a whole bunch of ways that those errors can still sneak their way into here. Another way that we accountants use the trial balance is to help us put together financial statements. You can think of financial statements as formal reports that we use to summarize a business's financial performance, position, and cash flow. The three main types of financial statements are the income statement, the balance sheet, and the cash flow statement. The balance sheet is a snapshot of a business's assets, liabilities, and equity at a single point in time. While this definition might sound similar to the trial balance, it's actually quite different. A balance sheet looks like this: we have all of our window cleaning business's assets, liabilities, and equity laid out for us separately on one page. At the bottom, we have our total assets. And our total liabilities plus equity after all, we're double-entry accounting. So the balance sheet has to balance. We accountants prepare financial statements like the balance sheet to give our businesses' key stakeholders an idea of its financial health. Who are the stakeholders? Our existing and potential investors, lenders, and creditors — external parties that want to know about our financial position. On the other hand, the trial balance is used internally by us accountants to check the integrity of our financial data. We run the trial balance as often as we need to get the job done, whereas typically we only put together a balance sheet when we need to at the end of each financial year. That’s when we have to report our results to the external parties that I mentioned a moment ago. So we have two very different reports with two very different purposes. But here’s where things get interesting. I mentioned earlier that we accountants use the trial balance to help us prepare financial statements, and the balance sheet is a financial statement — one of the most important ones. So when it comes to reporting time, we begin by running a trial balance. This is our starting point. The foundation that we use to build the balance sheet. We can see that here in our window: cleaning business cash, supplies, and equipment are all types of assets that we report in the asset section of our balance sheet. Accounts payable and long-term loans are both liabilities, which we report in the liabilities section, and owner's equity—yes, you guessed it! It is a type of equity which goes here in the equity section of the balance sheet. Finally, revenue, cost of sales, and laundry costs are a bit more complicated— not too complicated, just a bit, because they get reported in two different financial statements. The income statement, which we use to track our profit, and then again in the balance sheet in the equity section, because retained earnings make up our profits held for future use. You might be wondering why these totals are different. That's because we netted together some of our debits and credits in the income statement before we took the profit through to the balance sheet, so the trial balance and the balance sheet are There are two different reports, but they have a strong link that binds them together. We use the trial balance to create the balance sheet. Now, what is a cash flow statement? Dramatic music in three, two, one! You might have heard the expression, "Cash is king." Well, in this video, I'm going to explain why the cash flow statement is so important and how to prepare it using the direct method. We're going to cover the direct method first because it's considered to be more valuable to investors or to anyone who reads the cash flow statement. However, many people opt for the indirect method instead. If you stick around with me until the end, I'll explain why. Right? I think that's enough bathing; let's get started. First, I want to make one thing very clear: Cash and profit are not the same thing. Profit is revenue less expenses; it's the bottom line on an income statement and relates to a period of time. Whereas you can think of cash as a bank balance at a point in time; cash and cash equivalents. Also, include physical or petty cash amongst a few other things. Although most conventional companies use bank accounts, just like you or I might have. I also want to make the point that cash flows are different from cash. Cash flows relate to the amount of cash that has flowed in or out of a business over a period of time. Now that might sound a bit more like profit, but it isn't. When using the accruals basis of accounting, we apply the revenue recognition and matching principles. So, that means that revenue is recognized as it's earned, not when cash is received. Expenses are recorded as they are incurred, not when cash is paid out. That means revenue doesn't equal cash in, and expenses don't equal cash out. The biggest reason that small businesses fail is because of poor cash flow management. Many of these businesses would have been profitable, but without having that cash available, they're unable to pay their staff, their creditors, or the interest on their bank loans. This throttles them. That expression that I mentioned a moment ago, "Cash is king," is used to emphasize the importance of cash flow, particularly in Small businesses, now I feel like I'm harping on about this, so it's time to move on. But I can't stress this point enough: it is crucial to keep track of your cash flows, and we do that using the cash flow statement, or statement of cash flows. This is one of the three main financial statements, along with the income statement and balance sheet. We have all three of them here, made up for a company called Chudley Cannons. The first thing to note is that the cash flow statement covers a period of time, and we put this in the header. Remember, I said that cash flows relate to the amount of cash that flows in or out of a business over a period of time. Here, we have the year ended the 31st of December, but this could easily cover a quarter or a month. I think it's easiest to interpret the cash flow statement by starting at the bottom and working our way back up. At the bottom, we have cash at the start and end of the year, which we get from the balance sheet over here. When we take the difference between these numbers, we get the net increase or decrease in cash for the year. In this case, it's 35,000. This number is key to the statement of cash flows because what we’re going to do above is explain how and why the cash balance changed over the course of the year. We are going to summarize what cash was spent on and what the sources were and reconcile it all back to this number. We do this by breaking it all down into three sections. The last section is cash flow from financing activities. Financing activities include changes to share capital, borrowings from a bank, or from third parties. Here we have long term borrowings, which I assume were from Gringos, the wizarding bank. When a company borrows money, there’s a cash inflow, so your cash balance increases. That’s the case here since you can see that we have a cash inflow of twenty thousand dollars because the number is positive. But cash can also flow out of a business through financing activities when you pay back a loan or buy back share capital. Above financing activities, we have cash flow from investing activities. Investing activities most commonly relate to the sale or purchase of non-current assets or investments in stocks and shares that sit outside of a business's core operations. When a Business invests in non-current assets. Cash flows out because we have to pay the suppliers cash for these assets and on the flip side, when we sell these assets off, cash flows back in. Here, the Chudley Cannons have fifteen thousand dollars of cash inflow from the sale of PPE, which is shorthand for plant, property and equipment, and seventy thousand dollars of cash outflow from the purchase of PPE. They are a Quidditch team, so they might have received the fifteen thousand dollars by selling off their old broomsticks in order to buy some of those new Nimbus 2001s, which cost them seventy thousand dollars. This is an investing activity, not an operating activity because buying and selling broomsticks is not the Chudley Cannons' core business. The broomsticks are long-term investments, which makes them non-current assets. This is different from inventory, which describes assets that are intended to be sold during the ordinary course of business. This brings us on to the first section of the statement of cash flows: cash flow from operating activities. Operating activities are the principal revenue Generating activities of a business that sounds like a mouthful, but it just means the cash that we receive or pay out during the course of our regular business. Cash comes in when our customers pay us based on our accounts receivable, and cash flows back out when we pay our suppliers based on our accounts payable. Now, at the start of the video, I mentioned the direct and indirect methods of preparing a cash flow statement, and I haven't brought them up again until now because everything that we've covered so far is identical under each method. Operating activities is the only section that's different. Today, I'm going to cover the direct method, and soon I'll do another video on the indirect method. You can subscribe to the channel so you don’t miss out. So, the direct method. Under the direct method, the cash flow from operating activities is laid out just like a cash basis income statement. Under the cash basis of accounting, revenue is recognized when cash is received, and expenses are recorded when cash is paid out. When you work out your operating profit under this method, it should match your cash flow from operating activities. Let's check back on the chubby cannons. This cash flow statement has been prepared under the direct method. Under operating activities, we first have cash receipts from customers of two hundred and twenty-eight thousand dollars. The cannons are a sports team, so I would assume that the majority of these earnings would come from ticket sales and the sale of merchandise. This two hundred twenty-eight K of cash in would match their revenue for the same period if they were cash accounting. However, we can see that their income statement and balance sheet have been prepared under the accrual basis. We know this because their income statement shows depreciation, which is a non-cash transaction. So it wouldn’t show up in an income statement prepared under the cash basis. Their balance sheet also contains inventory, receivables, and payables, none of which would appear in a cash basis balance sheet. So we’ve covered cash receipts, but the next four lines under the cash flow from operating activities all relate to cash paid out—cash paid out to suppliers. Employees' interest paid and income taxes paid. When you compare this to the income statement, you can see that each line relates to one of the expense types. Cash paid to suppliers relates to cost of sales. Cash paid to employees relates to the salaries expense. Interest paid relates to the interest expense, and income taxes paid relates to the income tax expense. There is no depreciation in this cash flow statement because depreciation is a non-cash transaction. So that’s the three sections of the cash flow statement, and when we subtotal these, we get 70k of cash in from operating activities, 55k of cash out through investing activities, and finally, 20k of cash in from financing activities. If we add all these together, we get a net increase in cash of 35,000 which reconciles back to the movement of the cash balance in the balance sheet: a closing balance of 185k less the opening balance of 150k is also 35,000. That’s the statement of cash flows prepared under the direct method. It’s a really handy report for investors to Read over because you can easily identify where cash flowed in and where it flowed out. We can see that 76k was given out to suppliers, which was our biggest cash outflow. It's intuitive, so it's the preferred method of producing a cash flow statement. However, at the start, I said that many people go for the indirect method instead. Now, why is that? The thing is, the cash flow from operating activities can be tough to work out using the direct method, particularly for large companies using the accruals basis of accounting. It can be costly and time-consuming to gather all the information you need to put it together. The indirect method is an easier alternative, which is why most corporations favor it, even though it's harder for investors to understand. Both methods are allowed under GAAP and IFRS, and although the direct method is preferred, most companies opt for the indirect method instead. What is the direct method of preparing a cash flow statement? Previously, I showed you a cash flow statement for the Chudley Cannons Quidditch team along with its corresponding income statement. The balance sheet, but if you missed part one, there's a link to that over here as well. In this video, we're going to rewind a bit and prepare that same cash flow statement using T accounts, and in both of these reports, we're going to use the direct method as we work out each number. As we piece it together, we're going to start off with the easy ones and move on to the harder calculations as we progress. So, I recommend watching this video through until the end to get a clear picture of the whole process. Let's begin. So, here we have the cash flow statement for the Cuddly Cannons, and the plan is we're going to recalculate all of these numbers directly from the income statement and balance sheet for the same period, the 31st of December. We will start at the top with cash flow from operating activities and work our way down through all three sections to cash flow from financing activities. We are using the direct method today, so cash flow from operating activities mirrors the layout of an income statement prepared under the cash basis. So, we have cash receipts from customers at the top, which reflect our sales and below that, we have cash paid to Suppliers, employees, and the rest of the expense types in operating activities are the principal revenue-generating activities of a business. So, this section shows the cash that we receive or pay out during the course of our regular business. The first line item that we’re going to calculate is cash receipts from customers. To do this, we’re going to need to look at the movement in our accounts receivable balance. I said in the intro that we’ll need some T-accounts, so let’s draw those out. Accounts receivable is an asset, which is the "A" in DEALER, so it’s a normal debit account. That means our opening balance, or our balance brought forward, goes on the left side of the T-account because debits always go on the left. The accounts receivable balance increases as we make revenue because when we credit sales, we debit accounts receivable. So, sales go on the left side as well. And finally, the closing balance, or the balance carried forward, also goes on the left because it’s a normal debit account. Opening and closing balances for normal debit and credit accounts should always be on the same side as each other. On the side of the T account which is on the right, we have cash receipts from customers. Cash received from customers reduces our accounts receivable, and this is what we're looking to solve for because cash receipts from customers tie back to our cash flow statement. Now we've laid out our T account. Let's enter some numbers. We get our opening balance from the balance sheet for the previous year. In this case, accounts receivable were 98 thousand as of the 31st of December for the prior year, so we can write this down in the T account. Sales come straight from the income statement. This year, the Cannons made sales of 250 thousand. So we need to debit accounts receivable by 250, and finally our closing balance comes from the balance sheet, this time from the current year. Accounts receivable at the end of the current year is 120 thousand. So that goes on the left at the bottom of the T account. Now we only have one missing value: cash receipts from customers, and we can work this out using some basic math. Our closing balance of 120 less our Sales of 250, less our opening balance of 98, gives us minus 228. The negative sign signifies that this is a credit, so we write this down on the credit side of our T-account. As you can see, this ties back to the 228 that we have in our cash flow statement. All is well. Next, I'm going to skip over cash paid to suppliers and return back to it later in this video because it's actually one of the harder balances to calculate. So instead, we move on to cash paid to employees. The balance sheet account that we're going to need for this one is salaries payable. Salaries payable is a form of liability. The L in dealer, so it's a normal credit account. That means our opening balance goes on the right-hand side of the T-account because credits always go on the right. The balance on this account increases as the salaries expense goes up because when we debit the salaries expense, we credit salaries payable, so these go on the right; and lastly, the closing balance joins the opening balance on the right hand side because we have a normal credit account. We are looking to solve. The cash paid to employees will show as a debit on the left-hand side of this T-account because when we pay out cash to employees, we reduce salaries payable. This is the only unknown value for us at this stage because we can easily pull the opening and closing balances from the prior and current year balance sheet and we can get the salaries expense from the current year income statement. So let's do that. The prior year balance sheet shows a closing balance in salaries payable of 30. The current year income statement shows the salaries expense of 80, and the current year balance sheet shows a closing balance in salaries payable of 42. Let's write these down in the T-account and work out cash paid to employees. Our closing balance of negative 42 less the salaries expense of 80, less the opening balance of 30 gives us cash paid to employees of 68. This number is positive, so we debit the T-account by 68. Does it tie back to our cash flow statement? Yes, it does! Perfect! Next up, we need to work out interest paid. We're going to run through this one a bit quicker because the The balance sheet account that we use to work this out is interest payable, which is also a liability. So, the process is very similar to cash paid to employees. That means that the opening balance, the interest expense, and the closing balance all go on the right-hand side of the T account because interest payable is a normal credit account. On the left side, the debit side, we are looking to solve for interest paid. We should tie back to the cash flow statement. We are again going to look for the opening and closing balances in the respective balance sheets and for the interest expense in the income statement. So here we go: the prior year balance sheet shows a closing balance in interest payable of two. The current year balance sheet shows a closing balance in interest payable of three, and the current year income statement shows an interest expense of eight. So let's enter these into our T account to work out interest paid. Our closing balance of negative three, less the interest expense of eight, less the opening balance of two, gives us interest paid of seven. It's positive, so we debit the T account by seven thousand. When we check back against the cash flow statement, we can also see interest paid of seven thousand, so it matches. The last line in cash flow from operating activities is income taxes paid, which we will work out now. The balance sheet account that we're going to need for this one is income tax payable, and since that's also a liability, the process is going to be very similar to the previous two examples. The opening balance, the income tax expense, and the closing balance go on the right-hand side of the T account because we are dealing with a normal credit account. On the debit side, we have income tax paid, which we are solving for. The opening and closing balances will again come from the balance sheets, and we will get the income tax expense from the income statement. The prior year balance sheet shows a closing balance in the income tax payable of four. The current year balance sheet shows a closing balance of six, and the income statement shows an income tax expense of nine. We enter these into the T account to work out income tax paid. Our closing balance of negative six, less the income tax expense of nine, less the opening balance of four, gives us income taxes paid of seven. So, we debit the T-account by seven thousand, and this ties back to income taxes paid in the cash flow statement. How do you find that? Brace yourselves, because we're about to take on something a bit more challenging. We're going to head back to cash paid to suppliers, which we left out earlier, and I'll show you how to calculate it. The balance sheet account that we need here is accounts payable, which is a liability. Now, you might be thinking, "But James, we just did three liability T-accounts, isn't the process going to be exactly the same?" Bear with me for a moment, and I'll explain why it's different. We lay out the accounts payable T-account as we've done before. The opening balance, inventory purchased, and closing balance go on the credit side, and cash paid, which we're solving for again, goes on the debit side. We can easily pull the opening and closing balances from the prior and current year balance sheet. In this case, we have an opening balance. Of 95 and a closing balance of 105, so all we need now is inventory purchased, and we're on our way. But how do we find inventory purchased? There isn't an inventory expense in the income statement. All we have is cost of goods sold. Bummer. What we have to remember here is that we are counting using the accrual basis, and under the accrual basis we apply the matching principle, which states that revenue and all expenses incurred in order to generate that revenue need to be recognized in the same accounting period. Now, what that means for us in the context of this example is that when we purchase goods from suppliers that we intend to sell, we can't immediately recognize an inventory expense in the income statement. That's because our intention is to sell our inventory in order to generate sales, and if we're generating sales, then the matching principle is telling us that we need to recognize those sales and their related expenses in the same accounting period. In order to do that, we need the help of another account. Having an inventory account means that we can store the costs of all goods that are intended to be sold as a debit balance. In the balance sheet, when they are sold, we decrease inventory in the balance sheet and increase cost of goods sold in the income statement. Let me explain this using an inventory t account. Inventory is a form of asset, which makes it a normal debit account. So, the opening balance, inventory purchases, and the closing balance go on the debit side. On the credit side, we have cost of goods sold. We can easily find the opening and closing balances by referring to the prior and current year balance sheet. Here, we have an opening balance of 68 and a closing balance of 94, which we will write down in our t account. We can find cost of goods sold in the income statement, which in this case is 60, so we write 60 on the credit side of the t account. Because when we sell inventory, we debit the income statement to recognize the expense, and we credit inventory in the balance sheet to reduce our assets. That leaves us with inventory purchases, which we can work out using the other numbers. A closing balance of 94, less the opening balance of 68, and adding back the cost of goods sold of 60 gives us inventory purchases of 86. So we debit the T account by 86. You might have noticed already that it was inventory purchases that we were looking for in our accounts payable T account, so we can copy the 86 over to the credit side of accounts payable because when we purchase inventory, we debit inventory to increase it and credit accounts payable to increase the amount that we owe to suppliers. Now that we've worked out that number, we're on the home straight to calculating cash paid to suppliers. Our closing balance of negative 105, less inventory purchases of 86, less our opening balance of 95 gives us cash paid to suppliers of 76, which goes on the debit side of the accounts payable T account and ties back to our cash flow statement. Ouch, did you survive that? Cash paid to suppliers is definitely one of the hardest numbers to calculate under cash flow from operating activities. If you'd like to learn more about accounting, Then I'll throw a link up here to a video that I've made about it previously. So that was cash flow from operating activities, and when we subtotal all of these numbers that we worked out, we can see that the canons have generated 70 000 of cash inflow from their core operations. But hold your horses, we're not done yet. Next up, we have cash flow from investing activities. Investing activities most commonly relate to the sale or purchase of non-current assets or investments in stocks and shares that sit outside of a business's core operations. In this cash flow statement, we have cash flowing out of the business from the purchase of plant, property, and equipment, or PPE for short, and cash flowing back in from the sale of PPE. You might have guessed it already, but the balance sheet account that we need to calculate these numbers is plant property and equipment. This account is an asset, which is the a dealer, so it's a normal debit account, and therefore our opening and closing balances go on the left-hand side. On the credit side, we have the depreciation expense because the value Of non-current assets, reduce as they depreciate. Credits non-current assets in the balance sheet debit depreciation expense in the income statement. Now, I don’t want to overcomplicate things in this tutorial, so we’re going to keep PPE simple and make a few assumptions. At this point, we’re going to ignore accumulated depreciation, assume no gain or loss on disposal, and that all cash related to these transactions has changed hands. Finally, the Canon spent 70,000 purchasing PPE this year. I know that’s a lot of assumptions, but we don’t have a fixed asset register for this example, so we’ll leave it at that. I’ll probably do a whole video in the future covering fixed assets and depreciation. Now that we’ve cleared that up, all that’s left to include are cash paid to purchase PPE and cash receipts on the sale of PPE. The prior year balance sheet shows a closing balance in PPE of 202. The current year balance sheet shows a closing balance of 234, and we can see that the depreciation expense in the income statement was 23. 70,000 on the purchase of PPE, and that all their cash has changed hands. So we would credit cash by 70 to decrease it and debit PPE by 70 to increase it. That leaves us with cash receipts from the sale of PPE on the credit side, which we now need to solve for, a closing balance of 234, less cash paid of 70, less an opening balance of 202, and adding back the depreciation expense of 23 gives us cash receipts on the sale of PPE of 15. So cash would be debited by 15 to increase it, and PPE would be credited by 15 to decrease it. Both cash paid to purchase PPE and cash receipts on the sale of PPE tie back to our cash flow statement, and when we subtotal all of these, we see a cash outflow of 55,000 from investing activities. Cash flow from investing activities is an important section of the cash flow statement because it can significantly offset the cash flow generated from operating activities. Last up, we have cash flow from financing activities, and don't worry, we've got all that hard work out of the way. This section is going to be quick. Financing activities relate to transactions. Involving business owners or lenders, in this case, we're dealing with lenders. Because we have proceeds from long-term borrowings of 20,000, and the number is very simple to calculate. We take the closing balance of long-term borrowings in the current year balance sheet of 100, and we take away the closing balance from the previous year of 80. 100 less 80 is 20, so we have a net cash inflow of 20, 000 from financing activities. Now, let's take the total of all these cash inflows and outflows that we have worked out. We can see that the cannons have a net cash increase of 35,000 for the current year, which ties to the movement in the cash balance, which we can see below and which we can get from the balance sheet. The closing cash balance for the current year of 185, less the closing balance from the prior year of 150 gives us a 35,000 increase in cash. So there we have prepared the Charlie Cannon's cash flow statement using the direct method, working out all of the numbers manually using the income statement and balance sheet. That was hard work, wasn't it? Only a simple example you can imagine that this whole process is more complicated for larger companies with more complex transactions, which is why most of them actually avoid this process altogether, because it can be too expensive and time-consuming for their accountants to work out cash flow using the direct method. The majority of large corporations tend to opt for the indirect method instead, which is the subject of our next video. The indirect method has the benefit of being much easier to prepare; however, it's less useful to investors. What is the indirect method of preparing a cash flow statement? So what's the difference between the direct and indirect method? Anyway, the cash flow statement, along with the income statement and the balance sheet, make up the three major financial statements we use. The cash flow statement summarizes the movement of the cash balance in the balance sheet over a period of time, typically a quarter or a year, and we do this by summarizing all of the cash inflows and outflows into three categories: cash flow from operating activities, cash flow from Investing activities and cash flow from financing activities. The latter two sections, cash flow from investing and financing activities, are completely identical whether using the direct or indirect method. The only section that’s different is cash flow from operating activities, which is why I want to focus on that one in this video. Operating activities are the principal revenue-generating activities of a business. These are the transactions that take place on a regular basis. Under the indirect method, there are three steps to calculating cash flow from operating activities, and I’ll take you through them right now. First of all, we need the business's net profit or loss, which we can find in the income statement. This method relies on starting off with net profit and adjusting it for non-cash transactions again and again until we’re left with only net cash inflow or outflow. Most large companies account using the accrual basis, which means their profit does not equal their net cash inflow. Under the accrual basis, revenue is recognized when it’s earned, not when Cash is received and expenses are recorded as they are incurred, not when cash is paid out. So, revenue doesn't equal cash inflow and expenses don't equal cash outflow, which brings us on to the second section: we need to add back all of the non-cash expenses that exist in the P&L. Typically, non-cash items relate to things like depreciation, amortization, or the gain or loss on disposal of non-current assets. These don't represent cash outflows, but they are deducted in our income statement when coming to that net profit. So, it's logical that we need to add these back in order to remove them from our calculation. The third and final step is that we need to adjust for the movement in working capital. Working capital is simply current assets less current liabilities. Current assets are generally made up of inventory and receivables, whereas current liabilities are made up of payables. To work out whether you need to add or subtract these movements in the calculation, you need to consider the impact they have on the cash balance. An increase in inventory means a business has less cash because it has bought more inventory. The reason why a decrease in inventory means a business has more cash is because it has sold more inventory than it has bought. The situation with accounts receivable is very similar because they are also assets. An increase in receivables means less cash has been recovered from customers, so the cash balance goes down. On the other hand, a decrease in receivables means more cash has been collected, so the cash balance goes up. Payables are a liability, so they work the opposite way to inventory and accounts receivable. An increase in payables means more cash because less has been paid out to suppliers, to whom the business owes money. Lower payables mean less cash because more has been used to pay the bills. Cash flows from non-current assets and non-current liabilities tend not to be included under cash flow from operating activities because they're normally categorized in the other two sections: cash flows from investing activities and cash flows from financing activities. Now that we’ve worked out the basic calculation for cash flow from operating activities, let’s practice. Using this template with a worked example, we'll continue with that Cannons example that I took you through in the previous two videos. Last time I showed you how to calculate cash flow from operating activities with the direct method, and today I'm going to show you how to do it using the indirect method instead. We're starting right now. Step one: We first need to jot down the net profit figure because this is our starting point that we will make adjustments to in order to come to that net cash flow. Net profit can be found easily at the bottom of the income statement. In this case, the Cannons have made a net profit of seventy thousand dollars for the year, so we write this down at the top of the calculation. Next, we have step two. This is where we need to add back all of those non-cash expenses that are shown in the income statement. We've got to reverse these out of our net profit in order to get closer to the cash flow figure. To do this, we look over the income statement and search for any depreciation, amortization, or gain or loss on disposal of non-current assets. In this case, we can only see The depreciation of 23,000, so we need to add back 23 into our calculation to adjust the depreciation. Finally, in step 3, we need to adjust for the movement in working capital. Like I said before, working capital is made up of current assets less current liabilities. Let's have a look over the balance sheet and see what current assets we have. I can see cash, accounts receivable, and inventory. Plant property and equipment is a non-current asset, which affects cash flow from investing activities, so we can ignore that. Cash is what we're reconciling back to in the cash flow statement, so we can ignore that one as well. We are left with only inventory and accounts receivable. A closing balance in inventory of 94 less the opening balance of 68 gives us an increase in inventory of 26. Increases in inventory are represented as deductions in calculating cash flow from operating activities because the business has spent cash on purchasing the raw goods or by manufacturing them. So we enter negative 26 into our calculation. Now let's look at accounts receivable. Here we have a closing Balance of 120 and an opening balance of 98, which gives us an increase of 22 during the course of the year. Increases in accounts receivable need to be deducted from our net profit in calculating the cash flow from operating activities because higher receivables means that less cash has been recovered by the business from its customers. So, we enter negative 22 into our calculation as well. That's the movement in our current assets, but we also need to find the movement in our current liabilities so that we've considered all of the working capital. Reviewing the balance sheet one more time shows us that our current liabilities are made up of accounts payable, salaries payable, interest payable, and income tax payable. Long-term borrowings, as suggested by their name, are non-current liabilities which relate to cash flow from financing activities, so we can ignore them here; whereas share capital and retained earnings relate to equity, so these can be excluded as well. We are left with only these four current liabilities. The sum of their closing balances is 156, and the sum of their opening balances is 131. When we take the difference between these numbers, we have an increase in payables of 25,000 during the year. Increases in payables need to be added to our net profit in order to calculate cash flow. That makes sense because you can imagine that if a business doesn't pay its invoices, then it gets to hold on to its cash; so we add back 25 in our workings. But that steps one to three are completed. All that we need to do now is take the total of those numbers, and we're left with the net cash inflow from operating activities of 70,000. That wasn't so bad, was it? We've come to this number using the indirect method. But a quick check of our calculations using the direct method shows that we also came to 70,000 cash inflow from operating activities. We get the exact same answer using either technique. So which is better? If you've watched my other videos on the direct method, then you'll notice that the indirect method is much quicker, which is why most large companies using the accrual basis of accounting tend to work out their cash flow this way. But if that's the case, then why didn't everyone do this? I suppose it really comes down To understand how the workings of cash flow from operating activities are presented in the cash flow statement, the layout using the direct method is far more intuitive to read because it mirrors the cash basis income statement. We have the cash receipts from customers at the top, and below that, we have the cash paid out to all of the various suppliers and stakeholders. It makes for easy reading for investors who might be glancing over the cash flow statement to extract meaningful information from it. On the other hand, the layout of cash flow from operating activities under the indirect method is far less intuitive. You can think of the indirect method as a shortcut to working out cash flow from operating activities, which is a win for the accountant or bookkeeper who's preparing it because it saves them time. However, the third parties who are reviewing the finished cash flow statement lose out because this report isn't as useful to them. Like I mentioned earlier, we skipped over cash flow from investing and financing activities in this video because these sections are identical under the direct method. How do you make a cash flow statement? A cash flow statement is a financial statement that summarizes a business's cash inflows and outflows over a period of time. We'll get into how that works in a moment, but first, why do we need a cash flow statement? In accounting, there are two main methods for preparing your books: the cash method and the accrual method. With a cash method, you recognize your revenue when cash is received, and you record your expenses when cash is paid out. But under the accrual method, you recognize revenue as it's earned and record your expenses as they are incurred. So what does that mean? If you're cash accounting, then technically, you only have one financial statement: the income statement. It summarizes your revenues and expenses over a period of time, leaving you with a profit or a loss. But with the cash method, we said that you recognize revenue when cash is received, and you record expenses when cash is paid out. That leaves you with a net cash inflow or an outflow. So the income statement prepared under The cash method is equivalent to a cash flow statement. Keep that in mind; we'll come back to it later. Plenty of small businesses do their books this way, which is fine, but the cash method isn't allowed under IFRS or GAAP. If you're following either of these, then you must use the accrual method. Revenue must be recognized as it's earned, and expenses must be recorded as they are incurred. In accrual accounting, we still have the income statement, but this time it represents what a business has earned and incurred, not just cash inflows and outflows. So it's not equivalent to a cash flow statement. Therefore, businesses using the accrual method keep a separate cash flow statement alongside their income statement, and they also keep a balance sheet which holds their assets, their liabilities, and their equity. Not long ago, I made videos covering the income statement and the balance sheets. You can find links to both of those down in the description. What is a cash flow statement? Start, I said it summarizes a business's cash inflows and outflows over a period of time. But what does it look like? We begin with the opening cash amount at the start of the period and compare it against the closing cash amount at the end of the period. You can find both of these numbers in the balance sheet. The movement between the two is the net increase or decrease in cash, and once we know that, then we can get onto the real purpose of the cash flow statement, explaining how we ended up here. There are three main sections: Cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities. Operating activities are the main revenue-generating activities of the business. These are the cash flows involved in selling goods or services. Investing activities sit outside of the business's core operations; they involve the buying or selling of investments or other long-term assets. And finally, financing activities relate to funding the business through raising or repaying cash to third-party banks or the owners of the business. This, my friends, is the basic structure of the cash flow. Statement: positive numbers represent cash inflows, and negative numbers are cash outflows. Now, there are a couple of ways to make a detailed cash flow statement. We can use the direct method or the indirect method. We'll start with the direct method: cash flow from operating activities under the direct method mirrors the income statement prepared under the cash method, which we saw earlier. At the top, we have cash receipts from customers, which mirrors revenue, and then we have the cash paid out to suppliers and employees. Then, interest and tax are paid collectively. These mirror the business's expenses. Cash flow from investing activities includes cash outflows from buying investments or other long-term assets, and the cash inflows that come with selling them. Cash flow from financing activities relates to the raising or repaying of cash or capital. There are two ways a business can do this: using liabilities or equity. They can borrow money from a third-party bank, which would increase their liabilities, or a business can look to its owners, its shareholders, who can make capital. Contributions which increase equity on the flip side, they also make loan repayments back to the bank and distribute dividends back to the owners. When we add up the net cash flows from operating, investing, and financing activities, we can reconcile the net increase or decrease in cash back to the movement in the balance sheet. Now, how does the indirect method work? The only section that changes is cash flow from operating activities. We use three steps to work it out. The indirect method always begins with the net profit or loss from the income statement. Then, in step two, we add back all the non-cash expenses that appear above it. These don’t represent cash outflows and they need to be reversed out. The usual suspects are depreciation and amortization, and any gain or loss on the sale of non-current assets or long-term assets. Finally, we adjust for the movement in working capital. Working capital is the difference between current assets and current liabilities. Increases in current assets like inventory or receivables reduce cash flow, whereas increases in current Liabilities, like payables, increase cash flow. You can find all of these numbers on the comparative balance sheet. Now, you're probably thinking that the direct method sounds a lot easier. Why don't we just use that? You're right, it is easier to read, but it's actually harder for accountants to prepare. So we don't use it as much. The indirect method is much, much easier to work out because we can find a lot of these numbers in the income statement and the balance sheet, as you'll see in this next example. I've realized that there's a lot going on here, so I've put together two cheat sheets covering the direct and the indirect cash flow statement. I like to think of them as one-page reference guides to help you out. If you'd like to support the channel, then you're welcome to buy them on my website. The link, as usual, is up here and down there. How do we make a cash flow statement? Yes, it's time for that example, and we'll be using the indirect method because it's easier. We'll need a couple of things to get started. First, we need an income statement. Here's one for a business called Tumble, which is a fictional dating app. I made this one from nothing in the income statement video, so check that out and maybe click subscribe as well. It summarizes Tumble's revenues and expenses for the year ended December 31st, and here’s Tumble's balance sheet, which we made in the balance sheet video. It shows us a snapshot of their assets, liabilities, and equity at the end of the year. But hold on, we’re using the indirect method, so we actually need to see last year's balance sheet as well. So, this is Tumble's comparative balance sheet. We have the current year one on the left and last year's one on the right. Nice! One more thing before we begin; here are some key facts that happened during the year. Tumble sold some furniture for ten thousand dollars, which originally cost them twenty thousand dollars and had been depreciated by five thousand. The loss on the sale was charged to general and admin expenses. Tumble also spent nine hundred and ten thousand dollars on computer equipment. They raised one hundred thousand dollars in long-term debt and made no repayments. Finally, they issued fifty thousand dollars in common stock and paid out one. Million dollars in dividends. Righto! Let's begin; what are we reconciling? Cash. This is a cash flow statement. After all, let's head over to Tumble's comparative balance sheet. We can see that they held 13 million 895 thousand dollars at the end of last year and this number increased to 17 million dollars at the end of this year. So we can lift these numbers and place them at the bottom of our indirect cash flow statement. Overall, that's a net increase in cash of three million one hundred and five thousand dollars. But how did Tumble pull this off? Let's find out! We'll start with cash flow from operating activities. In step one, we need to find Tumble's net profit or loss for the current year. That's easy; we can get it from the income statement. On the bottom line, we can see that Tumble earns 9 million 650 thousand dollars this year from their core operations. We'll take Tumble's net profit and put it right at the top of cash flow from operating activities. Step two: we need to reverse out all of the non-cash expenses. Non-cash expenses appear above the bottom line in the income statement. Some classic examples include... Are depreciation and amortization these represent the gradual process of writing off long-term assets? They aren't cash flows. This year, there were incurred 850,000 in non-cash expenses. So we'll add this back in our cash flow from operating activities. But that’s not all. We made a loss on the sale of long-term assets. If we jump back to our key facts page, we said that they sold some furniture for ten thousand dollars. So let’s quickly do some workings. This furniture originally cost twenty thousand dollars, and by the time it was sold, it had incurred five thousand dollars in depreciation, leaving it with a carrying value of fifteen thousand dollars. They sold this furniture for ten thousand dollars, which left them with a loss on the sale of five thousand dollars. This is also a non-cash expense and it was charged to general and admin expenses in the income statement. We need to reverse it out in our cash flow statement, so we'll add back a loss on the sale of furniture: five thousand dollars. Step three: we need to adjust for the movement in working capital. Working capital is the difference Between current assets and current liabilities, ignoring cash, current assets are typically made up of inventory and receivables. Current liabilities are payables. We can find the movement in all of these on Tumble's comparative balance sheet. It doesn't look like Tumble has any inventory, but they do have some receivables. Accounts receivable are the receivables and prepaid expenses, which add up to 40 million fifty thousand dollars in the current year and eight million eight hundred and fifty thousand dollars last year. That's an increase in receivables of 5.2 million during the year. An increase in receivables reduces cash flow, so we subtract 5.2 million dollars from cash flow from operating activities. I like to think of it this way: if receivables have gone up, then Tumble is owed more money, which isn’t good for cash flow. Payables work in a similar way. Tumble has accounts payable, taxes payable, accrued expenses, and some deferred revenue. All of this adds up to 14.4 million dollars in payables in the current year. And last year they had 14 million 850,000 in payables. That's the year-on-year decrease in payables of 450,000. We subtract decreases in payables under cash flow from operating activities, because if payables go down, then more supplier accounts have been settled. So, there's less cash when we take Tumble's profit and back their non-cash expenses, and adjust for the movement in working capital. Then we can see that they had a net cash inflow of four million eight hundred and fifty-five thousand dollars from operating activities. A couple more things we need to do here to finish this off, but first I'd like to say a big thanks to all my channel supporters. You guys motivate me to keep on making more accounting tutorials. If you'd like to sign up, then you can click the join button. Next up is cash flow from investing activities. We're done with operating activities, so the rest of the cash flow statement is the same whether you're using the direct or the indirect method. On our key facts page, we can see that Tumble spent 910,000 on computer equipment. This is a Cash outflow from investing activities because they've bought long-term assets. But Tumble also sold the long-term asset. Remember that furniture we talked about? Tumble made a loss on its sale, which we called a non-cash expense. We added it back in cash flow from operating activities, but we also need to record the cash receipt on the sale of ten thousand dollars. This sale isn't part of Tumble's core business, so we record it as a cash flow from investing activities. When we total it against the purchase of computer equipment, that leaves us with a net cash flow from investing activities of nine hundred thousand dollars. This time, it's a cash outflow, so the number's negative. Cash flow from financing activities involves raising or repaying cash or capital used to fund a business. On the key facts page, we can see that Tumble raised $100,000 in long-term debt. This is a liability to a third party, a bank, and this year they made no debt repayments. They issued $50,000 in common stock, which is a capital contribution from the Shareholders who own the business, which increases equity, and they paid one million dollars out in dividends back to these shareholders, that would have decreased their equity. We can pull all these numbers through into cash flow from financing activities. Tomball received one hundred thousand dollars in cash from long-term debt. They raised another fifty thousand dollars in equity, and they paid out one million dollars in dividends, so that’s a net cash outflow from financing activities of eight hundred and fifty thousand dollars. Almost there! When we total the cash flows from operating activities, investing activities, and financing activities, we can see that Tomball had a net increase in cash of three million one hundred and five thousand dollars during the year. This matches the movement in cash that we saw in the balance sheet, so we’ve reconciled this cash flow statement using the indirect method. Before we move on from financial statements, I’d like to share what I believe is the key to understanding them, specifically the balance sheet and the income statement, so let’s do this. Financial statements are accounting reports that summarize a business's activities over a period of time. Essentially, they give the businesses investors, lenders, and creditors an idea of its financial health. But how do they work exactly? It all boils down to one basic principle: the stuff that a business owns is equal to the stuff that a business owes. Seriously, that's all there is to it. A business owns assets, and it owes liabilities to third parties, but it also owes equity to the people who own the business. For a company that's listed on a stock exchange, that would be the shareholders. So, we have assets equal to liabilities plus equity, or shareholders equity, which is what we call the accounting equation. Now, you might be thinking, how does this have anything to do with financial statements? And the answer to that is this equals sign. This equal sign tells us that a business's assets always have to balance with its liabilities and equity. In fact, when we pick a business and look At this accounting equation at a single point in time, we’re looking at a balance sheet. This balance sheet is for a business called Cash Me If You Can which makes microchips and computer stuff, and what we’re looking at is a snapshot of Cash Me If You Can’s assets liabilities and equity at a single point in time. Essentially, it’s a summary of what they own and what they owe on December 31st. Great, but at the start of this video, I said that I’d show you the key to understanding financial statements, and we haven’t quite got there yet. Here’s the balance sheet, but where’s the income statement? Let’s go back to the accounting equation: assets equal liabilities plus equity, or the stuff that a business owns is equal to the stuff that it owes to third parties and its owners. But let’s focus on equity. What kind of stuff does a business owe to its owners? Two things: it shows them their capital contributions and the business's retained earnings. Capital contributions are the money that The owners take out of their own pockets and invest in the business. For example, if cashmere, if you can issue some shares and you buy one, then you’ve made a capital contribution. Now you’re a shareholder and you’re a part owner of the business. Okay, so what's the deal with retained earnings then? These are the businesses' accumulated profits that it’s holding on to for the future. And this doesn’t mean a huge pile of cash that just keeps on getting bigger and bigger. Cash and profit are two very different things. Profit is the financial benefit that a business gains when its revenues are bigger than its expenses, and the business's accumulated profits held for future use is called its retained earnings. This is what’s left over after we add up all of the profits that the business has generated and take away what’s been withdrawn by the owners. And that looks a little something like this. Retained earnings are made up of opening retained earnings, which is last year’s Retained earnings carried forward into the start of this year, plus current year profits, which is the difference between revenues and expenses minus current year withdrawals, the profit distributions to the owners or shareholders of the business, which I'm pretty sure you've heard of. We often call them dividends. I like to think of this as the expanded accounting equation, and in my opinion, it's the key to understanding financial statements. Let me show you why. If we jump back into Cash MovieCan's balance sheet, we can see what the business owns and what it owes on December 31st. They own 1 million 551,000 in assets and the same amount in liabilities and equity, because these two sides of the balance sheet are in balance. Now, if we zoom into the equity section, we can see that Cash Me If You Can owes 1,342,000 dollars to the owners of the business, its shareholders, of which 100,000 is made up of capital. Contributions that the owners have put into the business and 1 million 242 thousand. In retained earnings or profits held for future use. Now, here's where things get interesting. If we expand retained earnings, we can see what they're made of. Last year's retained earnings, which came to one million two hundred and fifteen thousand five hundred dollars, less the current year dividends, which were ten thousand dollars. This number is negative because these profits have been withdrawn by the shareholders. And we can also see that this year, Cash Kashmifi can generate 36 thousand five hundred in profit. Where did they get this number from? Current year profit comes straight from the income statement, which looks like this. The income statement summarizes a business's revenues and expenses over a period of time. It's a financial statement just like the balance sheet, but this one tracks Kashmifi Can's performance over a one year period and tells us how profitable They are pretty cool, hey? So if you go back to the accounting equation and expand it out, we can see that retained earnings is the key that links together two of the most important financial statements: the income statement and the balance sheet. So here we are at the end of the accounting cycle, step eight. It's time for us to post closing entries. What are closing entries? Closing entries are tucked away at the very end of the cycle, in step 8. We post them at the end of each accounting period after we are done creating financial statements. But what are they exactly? Closing entries are journal entries that reset temporary accounts to zero. They transfer their balances into retained earnings, which is a permanent account held in a balance sheet. Remember, a journal entry is a record of a financial transaction, and retained earnings are a business's profits held for future use. But what are temporary and permanent accounts? Let me show you. If you've watched my videos before, then you're probably familiar with DEBIT, but if you're new here, DEBIT is a handy little acronym that can help us remember debit and credit accounts. It stands for dividends, expenses, assets, liabilities, equity, and revenue. Dividends, expenses, and assets are normal debit accounts, whereas liabilities, equity, and revenue are normal credit accounts. But here's the thing: some of these are temporary accounts, and some are permanent. Any idea which is which? Hmm... I'll grab a drink while we think about it. Got it! No worries if not; here's a little trick to help you remember: REDALE. Revenue, expenses, and dividends are temporary accounts, and assets, liabilities, and equity are permanent accounts. Well, I don’t know about you, but I'll cheers to that! Actually, it’s a bit early; yeah, we'll put That away you can find dealer and red L on my closing entries cheat sheet, which I'll leave a link to down in the description. Just be aware of permanent accounts: assets, liabilities and equity. These accounts live in the general ledger, and their balances are always carried forward from one accounting period into the next. On the other hand, revenue, expenses, and dividends are temporary accounts. These also belong in the general ledger but correspond only to one accounting period. Once that period's over, they need to be reset to zero, and we do that using closing entries. If none of this is making sense, don't sweat it; I think this example might help clear things up. Happy New Year! This is a trial balance for a business called Unter, a latecomer to the world of ride-sharing apps. A trial balance is an accounting report showing the current balances in every general ledger account. And this is an opening trial balance because the date is January 1st, the start of Hunter's new financial year. If we flick back to the accounting cycle. We find ourselves right here at the very beginning. Now, let's see how Hunter's temporary and permanent accounts change as we move around this. At the moment, they have some assets, some liabilities, and some equity, a-l-e, which means that all of these are permanent accounts making up Hunter's balance sheet. But hang on, where's revenue? Where's expenses and dividends? Trial balances often have filters applied so that they only show accounts with numbers in them. If we expand this out, then we find the usual suspects: revenue, expenses, and dividends. Red, these are untested temporary accounts which were reset to zero at the end of last year. Okay, great! Now let's skip through steps one to six and get on to the good stuff: the adjusted trial balance. Hunter's drivers have been diligently moving customers from A to B for a whole year now, and we find ourselves at December 31st. Here is the adjusted trial balance—a whole year's Worth of transactions have been posted and adjusted so that this represents a true and fair view of their business. As you can see, all of the temporary red accounts have got numbers in them. Now, these show us the revenue the unter has earned, the expenses that it's incurred, and the dividends that it's declared during the past year. Now, unter can create some financial statements. Revenue and expenses are temporary accounts that make up unters income statement. This summarizes unter's performance over a one-year period. We can see that they've made a tidy profit of three million nine hundred and fifty thousand dollars. But while the income statement only looks at revenues and expenses, unters balance sheet is made up of everything. All of unter's permanent and temporary accounts belong in here: assets, liabilities, and equity are permanent accounts, whereas current year dividends are a temporary account. Current year profit feeds directly through to here from the income. The statement which, as we saw, is made up of temporary revenue and expense accounts. Unter has earned three million nine hundred and fifty thousand dollars in profit, and they've declared half a million dollars in dividends. Step eight: it's time to post the closing entries. I'm going to show you two ways to do this: the long way and the short way. The long way involves four steps, and we'll move through these one by one. In step one, we're going to reset Unter's revenue account to zero by transferring the balance to the income summary account. What is an income summary account? It's a very special, very temporary account that only exists while we're posting closing entries, and it works a bit like this: If we go back to the adjusted trial balance, we're going to reset revenue to zero, but be careful with this because I can see three accounts with revenue in their descriptions: accrued revenue, deferred revenue, and revenue. Revenue accrued revenue is an asset, and deferred revenue is a liability. They are both permanent. The accounts that we use for adjusting entries, so we can leave them alone for this example, we're only interested in this temporary revenue account. So, let's take a closer look at it. Unter earned 20 million dollars this year. This sits on the right-hand side of their revenue T account because revenue is a normal credit account. Think dealer, we want to reset this temporary account to zero, so we need to post a closing journal entry on December 31st. We'll debit revenue by 20 million dollars and credit the income summary account by the same amount, as you can see. This transfers the balance from the revenue account to the income summary account, so we're left with zero dollars in revenue and 20 million dollars in the income summary account. Step two: Now we need to do the same thing again, but this time with all of the expense accounts. We'll reset them to zero and clear their balances to the income summary account. Unter has four different expense Accounts, cost of services, overhead expenses, interest, and tax. We can ignore the crude expenses because it's a permanent liability account. We need to post another closing entry and repeat what we did back in step one. Expenses are normal debit accounts, so their balances are on the left of these T accounts. If we want to reset them to nil, then we need to post equal and opposite credits to each account. The cost of services, overhead expenses, interest, and tax—and that leaves us with a total balancing amount of sixteen million fifty thousand dollars. This will be debited to the income summary account. In every journal, the total in the debit column has to match the total in the credit column. When we post this one, we credit the right-hand side of each expense account, resetting all of them to zero. We debit the left-hand side of the income summary account. Now it’s got a new balance of three million nine hundred and fifty thousand dollars, which is a net credit sitting on the right. On the hand side, sound familiar? It should, because this number is exactly the same as Junta's profit for the year, which we saw in that income statement. Step three: it's time for us to clear out that balance in the income summary account and put it where it belongs: retained earnings, which is a permanent equity account in Junta's balance sheet. Back to our trial balance, here's our income summary account, and it has a three million nine hundred and fifty thousand dollar credit balance, which is a combination of Junta's revenues and expenses for the year. The closing entry for this one is nice and simple: we have a three million nine hundred and fifty thousand dollar credit balance in the income summary account, so we need to debit it by the same amount and credit the balance to retained earnings. When we post this, Junta's retained earnings, or their profits held for future use, increases to thirteen thousand nine hundred and fifty dollars. Bye bye, income summary account; sorry, this just isn’t working out between us. You know you're going to make a lucky accountant really happy someday. So, job done right? Not quite. Step four: we need to reset current year dividends to zero and clear the balance to retained earnings. Unter declared half a million dollars of dividends this year. These are the businesses' profits that they've chosen to distribute to the owners of the business, its shareholders. And we know retained earnings are a business's profits held for future use. So, if Unter issues dividends, then it's not holding on to these profits anymore. So its retained earnings are going to go down, as you'll see right now. Unter has five hundred thousand dollars of dividends, which is a normal debit account. So in this closing entry, we're going to credit the dividend account by five hundred thousand dollars and debit retained earnings by the same amount. When we post this closing entry, Unter's dividends are reset to nil and its retained earnings decrease to thirteen million four hundred and fifty thousand dollars, just as we predicted. Now, can I get a drumroll, please? This is Unter's post-closing trial. Balance; it shows us what's left in each of Unter's accounts after posting their closing entries. You can see that all of their temporary accounts have been reset to zero, and their balances have been transferred to retained earnings. Gee, that took a while, didn’t it? Thankfully, there’s a quicker way: the short way. This time we’re going to take all of Unter's temporary accounts: its revenue, expenses, and dividends and clear their balances to retained earnings using one closing entry. So let's rewind and go back to the adjusted trial balance. Here are Unter's temporary accounts. We have revenue in the credits column, and we have dividends and expenses in the debit column. We can reset all of these to zero using one closing entry by debiting the revenue account and crediting the dividend and expense accounts. The balance of three million four hundred and fifty thousand dollars is credited to retained earnings. Because in double-entry accounting, there are at least two equal and opposite sides to every transaction. When we post this closing entry, all of the temporary accounts are reset to zero. Fantastic! We covered a lot there, didn’t we? So here’s a quick recap: When we post closing entries the long way, there are four steps. First, we clear revenue to the income summary account. Then we clear expenses to the income summary account. Then we clear the balance in the income summary account to retained earnings, and finally, we clear the dividends straight to retained earnings. This might seem like a bit of a faff, but if you’re using a manual accounting system, then the income summary account can help you methodically work your way through this closing process. With the short way, we clear all of these temporary accounts to retained earnings in one go. Often, this happens automatically if you’re using modern accounting software, but whichever method you’re using, we get to the same post- closing trial balance, which usually looks like this: filtered to hide accounts with zero balances. The post-closing trial balance for this year becomes next year's opening trial balance. So there it is, the whole accounting cycle. If you made it this far, then give yourself a big old pat on the back, because you deserve it. And if you've got exams coming up soon, best of luck! I hope you crush those. Thanks. Thanks for watching, and I'll see you soon., LEARN ACCOUNTING in Under 5 Hours!, YouTube, 01ka8g6fy8q6jsbx71db7f3c4d.