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Accounting Basics Explained Through a Story - YouTube
Channel: Leila Gharani
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In this video, I'll give you
an introduction to accounting
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by telling you a story.
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It's a story about Claudio,
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and how he runs his business in Italy.
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Before we start, let's just get
clear on what accounting is.
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Accounting makes it possible
to systematically record,
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analyze, and report important
financial information,
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and communicate the financial
health of a business
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to all interested parties.
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It's called the language of business,
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and it's the backbone of any company
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because every business needs reliable data
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to make informed decisions.
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But what does that really mean?
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Let's just take a moment
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to make this a bit more transparent,
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and understand the basics of accounting.
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So, let me tell you about Claudio.
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(bright music)
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Imagine we're in Italy,
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which is also one of my favorite places,
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a nice beach city, where
a man called Claudio
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is selling souvenirs to tourists.
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He only sells one item,
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a beautiful plate made
from colorful glass.
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In the morning, he leaves
his home with 100 euros,
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and goes to the manufacturer
of the souvenir.
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Each plate costs one euro,
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so Claudio buys 100
pieces with his 100 euros.
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He walks to the beach and
sells the plates to tourists
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for five euros a piece,
and by noon, he sold out.
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He goes home happily,
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and repeats the same process the next day.
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After a month, he wants to know
how much the business made.
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What if he sold more than one item?
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Which one was more profitable?
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Would it make sense to
expand his business,
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like rent a fixed stand at the beach?
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Without a way of recording
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the daily activities of his business,
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he's not going to be able
to answer these questions.
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Accounting makes this possible.
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Not only will each financial
transaction be recorded,
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but Claudio will also
get detailed reports,
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summarizing his financial performance.
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We call these reports
financial statements.
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Let's start with Claudio's profitability.
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If you want to find out about
a business's profitability,
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you go to their income statement.
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This is one of the main
financial statements.
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There you can find out how
much sales a business had
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in a certain period, which costs,
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and what was the resulting profit or loss.
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There is another name you may
hear for the income statement.
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Do you know what it is?
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P&L, for profit and loss.
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It's a fairly simple business model,
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and the P&L for Claudio's
business would look like this.
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He sold 100 plates for five euros each.
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That's what we call sales or
revenue, which were 500 euros.
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The plates he sold, he
didn't get for free, right?
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He incurred costs to buy them.
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Each plate cost him one euro.
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Therefore, in total, his
costs were 100 euros.
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We call this the cost of goods,
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which we need to deduct from revenue.
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To keep it simple,
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we don't consider any other costs for now,
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like fees and taxes.
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If we add this up, we can see
that Claudio made a profit,
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or a net income of 400 euros.
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That's how a simple income
statement would look like.
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Next, we're going to take a quick look
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at the second main financial
statement, the balance sheet.
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The balance sheet shows which
assets the company owns,
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the liabilities it owes to others,
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and the equity that belongs to the owners.
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Assets are usually things of value,
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or resources the company owns and uses.
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For instance, land and
buildings, office equipment,
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inventory, or cash, just to name a few.
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Liabilities are what you owe to others.
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For example, a bank loan,
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or what you owe to your
suppliers for goods,
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or to the IRS in taxes.
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The third component is equity.
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This is a bit more abstract.
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It's the residual amount
that would be left
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if the company sold all its assets
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and paid off all its liabilities.
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In other words, it's the
difference between total assets
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and total liabilities.
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This leftover money belongs
to the owners of the company.
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In the balance sheet, the
assets are on one side,
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and equity and liabilities
are on the other side.
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If you draw a line between
the two, and one on top,
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it looks like a T.
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This is what accountants use to
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visualize accounting transactions.
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It's a very helpful tool,
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and we're going to come back to
these T accounts all the time.
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You can see that the left side of the T
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is just as big as the right side.
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That's because everything the
company owns, so its assets,
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was purchased either from
debt, so somebody else's money,
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or its own money, meaning equity.
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For money to go to one account,
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it has to come out of another.
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We call this a flow of economic benefit
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from a source to a destination.
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We already said that assets
minus liabilities equals equity.
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If we rearrange this, like this,
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we we get assets equal
liabilities plus equity.
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Both sides are always in balance,
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hence the name balance sheet.
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And that is the foundation
for any accounting system,
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the accounting equation.
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The total amount of assets equals
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total liabilities plus equity.
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Both sides are in balance.
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With that in mind,
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let's see how the balance
sheet looks like for Claudio.
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A balance sheet is always created
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at a certain point in time,
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like at the end of the business year,
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or at the end of a quarter.
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In our example, it's the end
of Claudio's business day.
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Claudio started out
with 100 euros in cash,
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which is also the money, or equity,
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he put into the business.
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The cash on the left side
equals equity on the right side.
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The balance sheet, at
this point, is in balance.
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Then, he spent the cash in the morning,
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to buy the colorful plates.
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The plates are what we call his inventory.
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In the process, his cash
got reduced to zero,
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but in exchange, he received
another asset, inventory.
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He didn't get richer or
poorer by that, right?
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The total amount of assets is still 100,
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but of course, his equities too.
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After he sold the plates five euros each,
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he ended up with 500 euros in his pocket
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at the end of the day.
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His inventory is gone
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because he sold all the
plates to the tourists.
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At the end of the day,
his inventory value,
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therefore, is zero.
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He doesn't have any more plates.
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If we look at Claudio's balance
sheet at the end of the day,
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we can see that the total value of assets,
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the left side, is 500 euros.
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That's the cash he came home with.
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On the credit side, we
only have 100 euros.
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The balance sheet is out of balance.
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As we know, this can't be.
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Both sides always need to be in balance.
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So, what's wrong here?
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The missing component is the
profit he made during the day.
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If you go back to the income statement,
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we see that Claudio's
net income was 400 euros.
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This will be added to equity, why?
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Because due to his successful business,
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he made the business more valuable.
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When he started out the day,
it was worth only 100 euros,
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which was the money he
put into the business
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when he walked out the door.
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When he came home, he
had sold all his plates
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with a profit of 400 euros.
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So, his business is now worth more,
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which is reflected in a higher equity.
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Net income is the link
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between the income statement
and the balance sheet.
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So, when we add the profit
of 400 euros he achieved
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to equity, also the right side
gets to a total of 500 euros,
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and the balance sheet
balances like it should.
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So, that's how it would
look like for Claudio
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at the end of his
successful day at the beach.
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I hope this video was helpful for you
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to get familiar with accounting basics.
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I'm planning to add more
videos for accounting
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in the coming weeks.
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Let me know in the comments below
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if you want me to cover a specific topic.
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Now, the videos that are coming,
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just to give you a heads up,
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what they're about is going
to be on debits and credits,
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and more details on the balance sheet.
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If you enjoyed this video,
give it a thumbs up,
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and if you want to improve your
skills, consider subscribing.
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And don't forget to hit that bell
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so you don't miss out any new videos.
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Thank you for watching,
see you in the next video.
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(upbeat music)
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