I hope you had a chance to watch my first video on the accounting equation. This is a follow-up video to include how revenues
and expenses affect the equation.
The accounting equation states that assets always equal liabilities plus equity
such as in this balance sheet where we see that total assets equal the total
of the liabilities plus the equity. In the first video we saw how the accounting equation
changed when a business gets a bank loan.
We also saw how the equation is affected when a business purchases equipment. We also saw how the equation stays in
balance when an owner contributes cash and this was because both cash and equity increased. This video
will focus on how revenues and expenses affect equity
and we're going to show how this shows up on the accounting equation. Let's start with revenues.
Let's say we have a store and it had $1,000,000 in sales last year and all
its customers paid in cash. Assets increased because cash increased.
Liabilities were not affected. Equity increased because an increase in revenue
increases equity. Our accounting equation balances. Now, you may not understand this at first but
when business closes out its books, the accounts will be adjusted at the end of the year.
This business will take out the $1,000,000 from the revenue account and put it
into equity. Revenues will start at
$0 for the new year and equity will increase on the balance sheet by $1,000,000.
Now let's look at expenses. Let's say the store had $900,000
during the year in expenses and paid these expenses in cash. Cash will decrease
by $900,000,
liabilities were not affected, equity decreased because expenses decrease equity.
And our accounting equation balances. We could have said that net income was
$100,000 for the year instead of taking revenues and expenses separately. We would
have said that assets increased by $100,000
because cash increased by $100,000, liabilities were not affected and equity increased because
net income increased by $100,000. And our accounting equation balances again.
Another possible situation that we could have said was that our store did not receive any payment from its customers and that it is still waiting to be paid and
and that the store has not paid any of its expenses but will pay them in the future. In that case, we would have said
that assets increased by $1,000,000 because accounts receivable increased by $1,000,000, that liabilities
increased by $900,000 because accounts payable increased
by $900,000, and that equity increased by $100,000 because net income increased by
$100,000.
The $900,000 increase in liabilities and the $100,000 increase in equity come out to
$1,000,000 increase and once again our accounting equation balances.
Always remember that the accounting equation, assets equals liabilities plus equity, is the basis of double-entry
accounting which states that every transaction affects at least two accounts. The accounting equation and
double-entry accounting, along with this system of debits and credits, is the foundation for
writing journal entries. If you would like to see Part 1 of my video or my video on
writing journal entries, just click below. I hope you enjoyed the video! Thanks for watching!