Accounting Fundamentals | Transactions – Part 2 of 2

Mark Farber: Today what we’re going to do
is take a look at some actual transactions that a company might go through and how we
could record them. Not the way that they’re actually recorded
in a normal accounting system, but just sort of back of the envelope or in a very simplistic
way how we could keep track of it and get a sense of what’s going on vis-à-vis actual
transactions and the accounting equation. Here’s a few very simple transactions that
a company might go through. What we’re doing here is we’re setting up
a brand new consulting company. The first transaction is the owner’s invested
$5,000 of cash into his company. He’s taken $5,000 of his own money out of
his bank account and put it into the company’s bank account. The second one is he’s gone and he’s purchased
a new computer for the business and he paid $2,000 cash for the computer. In the third one, he’s rented some office
space and he paid rent. Also $2,000. Rent is always paid in cash we assume, so
I didn’t bother writing in cash. In the fourth one, he’s completed a job for
somebody. He’s gone and done some consulting work for
somebody. He’s completed the work and he sent them an
invoice saying that they owe him $3,000. He hasn’t received the money yet, but remember
what we said previously. That would be an account receivable. And then in the last one, he’s withdrawn $500
of cash to go and buy whatever he wants for himself personally. Those are our transactions. Let’s take a look at how they might get recorded
very simply just by looking at assets and liabilities. In the first one, we said he’s going to invest
$5,000 of cash. That means that the company is going to have
$5,000 of cash, and that investment is going to get recorded as capital in the business,
or his equity. Our capital is going to increase by $5,000. Cash, being an asset, we can just very quickly
go up here and say plus $5,000. Capital is equity, so we’ll put plus $5,000
here. You can see we have $5,000 on this side of
the equation, on this side of the equation. It’s in balance, so that one’s okay. Next, he purchases a computer. The computer, we’re going to call it equipment. We’ll put that in our equipment account over
here and then we’re going to increase that by $2,000 for the purchase of a computer. Because he paid cash, his cash balance is
going to go down and I’m actually going to put that in brackets. In accounting, we tend to use brackets to
denote a negative number, just because it’s very easy to miss out on little minus signs,
whereas brackets, you never miss out on, so there’s no confusion. So our cash has gone down by 2,000, equipment’s
gone up. Cash is an asset, so minus 2,000. The computer is equipment, so it will have
increased by 2,000. We’ll put in plus 2,000. We have a minus 2,000 and a plus 2,000 on
the same side of the equation. It’s in balance. Keep going. He pays rent. Rent is an expense. It’s a cost that he has to incur in order
to run the business. So his rent expense is going to increase. We’re going to keep track of that over here. He paid cash again, so, again, minus $2,000
of cash. If we go up here, minus 2,000 in the assets. If you recall, we said that expenses are a
form of equity. They’re actually negative equity. The reduce equity. The rent expense is going to reduce equity
by $2,000. Minus 2,000, minus 2,000, we’re in balance. Next, he completes a job. That’s going to be revenue. Well, he’s going to have revenue of $3,000
for completing the job and we can put that right up here. Revenue is equity, so $3,000. He didn’t receive the cash yet, but instead
he received an account receive … Or he sets up an account receivable, meaning that he’s
owed $3,000. We’ll put that under accounts receivable and
that’s an asset. Claims that the company has are assets. Plus 3,000, plus 3,000. Finally, he withdraws $500. We’re going to keep track of that in our withdrawal
account. $500. That’s cash that was taken out of the business,
so we’ll reduce cash by $500. Finally, we’ll just go up here and we’ll put
in we’ve reduced cash by 500. A withdrawal we said is negative equity again
it’s a reduction in the company’s equity, minus 500. Once again, we’re in balance. Now, that actually works and you can see that
we can add this up and figure out that he’s got $500 left of cash from the original $5,000. He’s got $5,000 of capital, so AR, some equipment,
so on and so forth. We’ve checked each of these against the accounting
equation to make sure that everything stays in balance. This system of keeping track of our accounts
could work, but imagine if you were a massive company. Imagine if you were General Motors or Apple,
and you had to keep track of every single transaction this way. It would be nearly impossible to keep track
of what was going on, and also nearly impossible to make sure that you didn’t, at some point,
go out of balance. It’s not a very effective way of working on
sort of a macro scale. What we’re going to do now is we’re going
to start to look at how we actually use the accounting system, along with the accounting
equation, to come up with a simplified way of keeping track of what’s in all of the accounts,
and also making sure that our accounting equation always remains in balance and that we’re recording
things properly. So stay tuned for that in the upcoming video.

Leave a Reply

Your email address will not be published. Required fields are marked *