Comprehensive Guide to Basic Accounting: The Complete Accounting Cycle Explained

hey there I'm James and in this video you'll learn how basic accounting works from start to finish for the past 3

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 arrang them in a logical Progressive

order the result of which is this almost 5-hour long accounting epic it's a biggie but I've 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 hope 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 there's 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 with 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

$40,000 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 $40,000 in new annual subscriptions these start in

April 1st and continue through to March 31st next year so what 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 and then you have your debits

and credits which are both $40,000 rough times is a serious business so you're using double entry

accounting which means this transaction affects at least two account 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 owes 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 debits

represent the destinations that 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 $40,000 to increase your assets and you credit

subscription Revenue by $440,000 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 and explore everything I mentioned in a lot more

detail I'll drop a link to that down below in the description just below that big red subscribe button didn't 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's six types of account

assets liabilities and equity which we already know from the accounting equation and then there's Revenue

expenses and withdrawals also known as dividends these feed into the equity part of the equation if you 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

label them cash and subscription Revenue these are called te 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 $440,000 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 has 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 to December

31st we need to put together your unadjusted trial balance what's the trial balance it's an internal report

that summarizes the closing numbers in all of your 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 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 and this is an

unadjusted trial balance because we haven't adjusted it yet but we will now actually because you've ended a finan

final year so we need to post some adjusting entries adjusting entries are journal entries that bring your books in

line with something called the acral 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 princip principles IFRS or Gap these two Rule books 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 GAP

have one major thing in common they both want you to follow the acrel 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 subscription starting on April 1st you collected $440,000 in 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 a c Accounting in cash

accounting you recognize your Revenue as you receive cash and record your expenses as you pay it out but receiving

cash is not the same as earning Revenue let me show you you received $40,000 of cash during March but you actually earn

that Revenue over the next 12 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 12 months of income this financial year but

you haven't earned 3 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 the acrel method

we can fix this situation by reversing three out of the 12 months of your subscription Revenue which is

$110,000 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 posted your adjusting entries we can see that your subscription Revenue has gone

down by $10,000 and your liabilities have gone up by $10,000 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 acrel method of accounting nice one now we can create your financial statements financial

statements are accounting reports that summarize your business's 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 acrel method so profit and cash flow aren't the same thing you keep track of your cash flow 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 stockage change 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 will look something like this youd debit your Revenue accounts

and You' credit your expense accounts to clear them down to zero the balance of $26,400 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 wellow 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 more

leisurely pace and we'll begin with the accounting equation the key principle behind the accounting equation is that

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 $5 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 and that depends 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 hey

so that $5 that my popcorn business now has is called an asset and that $5 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 and buildings Investments and Goodwill whereas liabilities can be made up of accounts payable loans

payable wages payable and taxes payable amongst other things the most common forms of equity are stockholders or

owners equity and retained earnings I will cover retained earnings in detailed 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 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 $5

on Corin then I no longer have $5 in cash but I now have $5 of inventory the categories have now changed but my total

assets stay the same my balance sheet is imbalance now I need to pot this cor but I don't have enough money to go and buy

a pot so I go to one of my friends and I ask them if I can borrow $10 the business's cash increases by $10 and

Loans payable go up by $10 as well total assets are now $15 and my liabilities plus My Equity are now also $15 we're

still in Balance I then go and spend this $10 on a pot my cash goes down by $10 and my equipment goes up by $10

let's say I go and sell this first batch of popcorn at a 60% markup on cost so I've made sales of $8 all my inventory

has now gone however I now have $8 in cash and I've made a small profit of $3 my profit is $3 because my sales were $8

and my corn cost me $5 to buy 8 less5 is $3 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 $3 because my business has made a profit of $3 my

total assets have now increased from $15 to $18 so to recap in this video we have learned that 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 to a business's assets liabilities and Equity at a single point in time H 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 sub Contracting 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 uh 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 flow of economic benefit from a source to a destination well credits represent

the source and debits represent the destination destinations that econom 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 owners Equity where business's owners give their cash

to the business liabilities such as amounts owed to a bank in exchange for a loan or to supply 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 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 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 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 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 d e a l e r dealer if you are ever in doubt 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 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 are

equal to liabilities plus owner's equity paid in plus Revenue an easy way to remember this is dealer before we move

on I'd 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 is 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 go and pay for something they debit my account which

decreases my balance we appear to have 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

want we can 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 customers 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 te account is a visual representation of an account it is called a te 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 tea accounts in its most

simple form a te 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 D 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 de EA l e r dealer dividends expenses and assets go on the left these

increase when debited and decrease when credited whereas liabilities owner 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 let's say your business has a cash account with a $100 in it that's your opening balance you take out $40 to pay

a bill and then you decide to take out $25 more to buy some new supplies so you are left with $35 in the account which

we will call your closing balance balance by the way is another way of saying total at 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're doing a calculation you might choose to lay it out like we have done here however when

you using te 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 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 $5 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 cow that I did there well this is a simple example for

demonstration purposes in reality te 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 te account

accounts as 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 cuz 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 te accounts this means that to record a transaction you will need to write down both sides

of it in at least two tier counts 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 te 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 $100 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 $30 in cash on window cleaning equipment next it spent a further $50 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 $150 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 te accounts for both of these categories cash is an

asset like I mentioned earlier it's the a in dealer so debits increase it I therefore need to put $100 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 dealer so credits increase it credits always go on the right so we will need to put $100 on the right hand

side of our new stock te account moving on in the second transaction a business takes out a $200 loan from the bank to

fund its activities this transaction affects cash and Loans payable which both need to increase by

$200 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 $200 loans payable is a form of

liability the L in dealer so credits increase it the $200 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 $30 of its cash on

window cleaning equipment so we need to credit cash by $30 to decrease it and debit our new equipment te account by

$30 we record the credit to cash by adding $30 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 further $50 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 te account for supplies and debit the left hand side of it by $50 we owe $50 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 t account by $50 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 $150 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 $150 cleaning the client's windows so

Revenue needs to go up by $150 and so does our cash revenue is the r in dealer so credits increase it we

need to make a new Revenue te account and credit it by $150 on the right hand side the cash we

have made is recorded as $150 debit to the left hand side of the cash te 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 $50 on supplies so if we have used half then

we need to credit supplies by $25 to decrease them and debit our brand new cost of sales te account by $25 to

increase it there we have it our first month of transactions all laid out visually in front of us in tea 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 dos 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 te account is a visual

representation of an account and how to record transactions using them however in day-to-day life te 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 and 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 te 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 J when abbreviated is a record of a financial

transaction and 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 while 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 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 man 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 $20 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 dealer so debits increase it they charged me $20 so I need to put this number in the debit

column cash is an asset that's the a in dealer 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 there 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 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 transactions 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 we' got to feel for what invoices are 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 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 so they 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 authorities 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

but if you want to be more organized and have the ability to track payments and make reports then I recommend use some

sort of cloud accounting software like QuickBooks Online zero or fresh books 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's 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 Jan this is the day that the invoice was created and it's critical to include it because it starts the

countdown from when the payment is due from the buyer and how long have they got well that's 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's a common

weight time but terms can vary depending on what's been agreed 30 days after the 17th of Jan is the 16th of Feb 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 for 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 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 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 a taxable service has been provided that comes out at $28 and that leads us with an invoice total

inclusive of tax of $378 before we wrap up this video I'd like to answer for 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 produced by the seller and given to the buyer

however the key difference is that an invoice is a request for a payment so it's issued before the payments been

made whereas a receipt that's 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 Le 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 fing 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 in email or better yet in a signed contract you

don't want to be that person that gets in 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 mean 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 through some of the common types that exist in most businesses we accountants we like to split our sets

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 assets are probable future economic benefits obtained or controlled by a particular

entity as a result of past transactions or events uh say what 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 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 back

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 on to the next part of the

definition assets are 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 benefit

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 will that same laptop carry the same future

economic benefit in 5 years time probably not it might well have cacked it 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 5 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 to an asset's actual life because useful economic life is an

estimate so if that laptop cost you $1,000 today and we assumed a useful economic life of 5 years then we would

depreciate or reduce its value by $200 a year for the next 5 years until it's worth nothing at all is this 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 is considered a l e and technically

doesn't own the building the economic reality of the situation is that basically they do make 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 that has big

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 you 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 and 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 asset 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 when your business sells inventory your customers owe you money which we call accounts receivable and

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 in 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 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 shortterm 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

than a year they become non-current assets instead 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 asset the first which we touched on a moment ago are long-term Investments these are the 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 the ones that have an actual physical presence you can actually touch

them the most common types are land and buildings or PPE which stand 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 to

recognize your work so this intellectual property that you own is bringing you probable future economic benefits it

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 brought Instagram back in 2012 for something stupid like a bilon

ion dollar were Instagram's net assets at the time worth that much not for a long shot the majority of that purchase

was for Goodwill that's the premium that Facebook were 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 and it ain't pretty liabilities are probable future sacrifices of economic benefits arising

from present obligations of particular entity to transfer assets or provide services to 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 situation to estimate future outcomes this is especially the case with the crws 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

and what are we going to give up economic benefits which relates to the things that have value or more

specifically assets and services and 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 the 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 simple 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 are what we account as like to call current liabilities are a

business's obligations that 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 that we get sent when buying something from the

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 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 run out of carrots a vital ingredient of their award-winning Minon 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 DARS 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- Monon 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 account's 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 employee 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 acrs or acur expenses or adjusting

journal entries typically posted by accountants a 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 month of course are there any acrs that I need to post hm 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 the 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 post and a Cel in the books

to recognize an aced 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 craws of 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 jez we 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 un earned 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

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 instead 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 guess a loan from A bank the flip side however is the bonds

are less flexible other non-current liabilities that I think we've all heard of are mortgages on properties and

employee pensions and a lesser known one is deferred income tax which is definitely for another day but you can

think of it as a by product of the timing differences between your accounting and taxable profits that

wraps up current and non-current liabilities but I mentioned earlier that there's a third category contingent

liabilities these are less common than the other two but nevertheless is 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 disclose at all

management need 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 OD ball in

the accounting equation and there are so many different terms and joggers 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 the 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 you 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 Equity represents the net assets of a business simp 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 the broadest 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 achieves 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 have a claim on all of its net assets and we call this equity

make sense 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 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 will 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 Feb movement on the internet and you've come across

this video 90% of all gross 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 Ed to describe these three things changes 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 Ed to

describe what is essentially the same thing let me show you the first thing that makes up Equity is capital

contributions Capital relates to the funds raate to support a business and contributions simply mean that these are

given to the business so Capital contributions is the money that the 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're a sole proprietor then there's only one owner you so you'd call the money that

came out of your own pocket owners Equity however if you were part of a partnership then the owners of the

business would be the partners so you You' 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 $11,000 in the form of cash and you the owner have a claim of

$11,000 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 will 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 profit 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 over

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 on to and set aside your retained earnings within a year your business 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

there your accumulated profits held for future youths so a big chunk your retained earnings is your accumulated

profits which are your revenues less your expenses which come 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 but retained

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 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 sheet the balance

sheet is made up of three things assets liabilities and equity and we know that Equity is made up of capital

contributions from the business's owners and retained earnings which are its accumulated profits held for future use

retained earnings break down further still into accumulated profits less withdrawals and 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 a

business's 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 acral 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 $10 to buy and you are selling it at a$ 150% markup on cost so the customer pays you

$25 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 $10 to increase them and you credit your cash

by $10 to reduce your cash balance you then need to recognize your Revenue which is the $25 that the customer pays

you you debit your cash by $25 to increase it and you credit your Revenue by $25 to increase it as well if you're

new to debit 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 7-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 that makes it cheap to maintain and you might be able to get away without paying for more pricey

accounting software and finally many countries accept this method of accounting for tax purposes so long as

your earnings are below a certain threshold so this could be 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 profit 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 Gap or IFRS so if you follow either of these principles or standards then no

dice 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 that you don't have a reliable way of recording your profit if

that's you then you'll need to use the acr's 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 is the acrel 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 acr's basis of accounting the acr's basis of

accounting is considered to be a much better method to follow than the cash bases because there's so much

information you can extract from it I'm going to explain why most businesses is when they're starting out 10 to cash

account because it's easy but have you ever wondered how the big companies like apple Amazon and Google do their books

or pretty much any household name they all have one thing in common they use the acrs 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 a 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 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 across 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 much easier way to record the

performance of your business over a specific period in 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 $10 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 7day 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 first first of

November because that's when we receive the cash however under the acrs 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 cash for the ingredients however using the acrs 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 ACR 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 acr's 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 a cruel methods of accounting

the matching principle makes it easier for us to objectively analyze results because you can can accurately measure

your profit over time now that we've clarified the acrel 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 a business's 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 Gap and IFRS so it's possible to produce financial statements

under these principles and standards on the the other on the other hand however the acrs 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 knowe that whichever method you choose could impact your tax

payments by bringing them forwards or backwards depending on your situation however in the long run both the cash

and acrs methods tend to produce the same result most startups and small businesses tend to start off with a 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 acrs basis of

accounting instead what is the revenue recognition principle to keepi 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 [Music] principle 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 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 acred revenue because the service was provided in

advance of the payment now it's important to know that acrw and deferred revenue don't exist under the cash basis

of accounting 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 business that it intends to sell 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 a good 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 sell what hats actually since

I'm in Canada and Winter's just around the corner let's do tkes instead so you've run a merchandising

business that sells tkes you buy your tkes from your local manufact facturer at $4 a touque which you pay for in cash

and you sell these tkes on to your end customers at $7 a toque 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 tuon 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 $4 so you need to debit your inventory account to increase

it by $4 you debit inventory because inventory is a type of asset the a in dealer which makes it a normal debit

account so 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 de debit and credit accounts I've made a video explaining what it is in more detail