Okay, welcome everyone to this lecture on the accounting equation. My name is Justin from think numbers. And in this lecture we're going to be going over the accounting equation and really understanding all of the components in detail. And this will form the basis of all transactional accounting going forward. So the accounting equation is the basis of the double entry bookkeeping system. It's been around for approximately 500 years, and it was developed by a guy by the name of Luca pacioli.
He was a renascence monk who was wanted to drill develop a method of tracking the success and failure of trading ventures. And even till tonight, this formula has remained the same and is used throughout the entire world across every kind of business, and anyone who wants to keep accounting records. And the way that they can equation works is it's the assets of a business, which equals its liabilities plus owner's equity. So let's go through each one in a lot more detail. The assets of an organization have a future economic benefits. They are the things that you can receive either today or in the future that will benefit the organization, the liabilities of the organization, or the future economic sacrifices, these are the things that the business will have to pay back, whether it is today or in the near future, or even over the next 12 plus months.
And then the owner's equity of the owners funds, and any profit or anything left over that is left within the business. So this is where the revenues and expenses form part of the equation. And now we'll get into the debit and credit side of understanding the equation. So it's probably important that you actually just memorize this and you'll understand it as we put this into practice in the future. So any assets, which a future economic benefits of the organization will increase, get debited any future economic benefits that are going to decrease the value to an organization get credited. And it's actually the opposite for the liabilities and owner's equity.
So if you have a future economic sacrifice, that's going to increase, it actually is a credit to the business. And any future economic sacrifice that is going to decrease gets debited to the organization. And likewise, with equity and owner's equity that's going to result in an increase in profit or contribution of funds. It's gets credited to the owner's equity account, as well as revenues which get credited and any reduction of capital losses or expenses get debited to the organization. So, I wouldn't try and analyze this in too much detail about the logic of this Really the only thing you need to know is that debits are on the left, and credits are on the right and not in the sense of the this particular equation. Just remember debit left credit, right?
Because as you'll say, there's going to be transactions that can be on the same side of this equation. Say, for example, on the asset side, or there could be transactions on the left and the right on the asset and say the owner's equity side, or it could be vice versa on the owner's equity side on the liability side. So don't try and analyze the direction of which way this is going. You just have to think debit left credit, right. But let's now go into a lot more detail and understand each of these categories. So you can make it into a bit more practice.
So, assets of the future economic benefits of the organization. Now, there's a number of different assets within all kinds of businesses. If you think about the most liquid form of asset, this is cash, typically known as cash or cash or bank. And it is basically just The cash that is in the bank account, or cash that's in the petty cash, that the business actually has other earn through selling products and services, or has been contributed when the owner initially put the funds into the business. Then if we look at the second most liquid form of asset, this is typically known as accounts receivable or sometimes known as trade debtors. These are actually the customer accounts that actually owe you money.
So, think about think about this, like a big list of customers that form into a total balance that gets reported on your balance sheet. And illness list is a name is a number of different customers, their names and their balances, and all the invoices that make up their account. So, the ledger of accounts receivable is actually an aggregation of all these various different customer accounts rolled into a title. And then the next kind of asset is called inventory. Well, sometimes known as stock, these are actually the products that you buy the are intending to try and sell to your customers. So they are things that you store on the warehouse or the shelf of your store.
And there are items that actually cost you money to purchase, and that you hope to eventually sell to make a profit. Pre payments, these are actually these are actually this is actually cash that you've paid up in advance for something that you intend to expense later in the future. So for example, a very typical kind of prepayment will be rent. And the reason why you might do this you might pre pay your rent, is because there may be an incentive for you to pay this upfront. So for example, your landlord might actually be offering you a discount if you pay three months in events. Other kinds of pre payments that are pretty typical in most organizations are insurance, which you typically pay 12 months in advance with the relate to the upcoming 12 months.
This is normally parked on the balance sheet as an asset. Now, we then move on to some other types of assets. And the next type of asset is an investment. So this is very, very common and very common sense if you think about it, these are the things that you invest in into business. So that could be shares that you actually purchase in another company. On the stock market, for example, or in a private equity business, there could actually be another business's assets that you've actually purchased, that you actually own a part of that business.
They could be a joint venture arrangement where there's not actually a legal entity, but a joint arrangement, and so on and so forth. And so this is actually represents the actual cost that you've actually purchased into one of these other types of investments. Then if we think about the tangible types of items and assets, these are cool property, plant and equipment, and what I mean tangible I mean the physical things that you can see in a business So if you think about any kind of property that you can actually physically see, any kind of plant, any kind of equipment, any kind of vehicles, these are all the items that have tangible assets. And so the property plant equipment is typically long term assets, the purchase for a period that you would intend to use for greater than 12 month period. And they get depreciated over time as well.
And we'll go into depreciation in the future in a bit more data. And then, intangibles are the intangible kind of assets. So they're they're non physical assets that you can't see. So typical examples of intangibles will be things like patents, trademarks, and rights to use certain products, goodwill, and these items sit on the balance sheet, and they get amortized over a period of time as opposed to depreciate it. It's a very similar concept, amortization to depreciation. But again, we'll be going through this concept in In the future in a bit more detail.
So what's important to understand these are the typical types of assets that you'll find in any type of business. It doesn't matter what industry you're in, or what type of business you're you are, these are the typical kinds of assets that you will find. Now, liabilities, these are future economic sacrifices, remember, remember, these are the things that you will have to pay back in the future. So if we look at accounts payable, sometimes known as trade creditors, these are the suppliers that you've actually purchased from and that you're, you've got terms with that you're happy paying them back over a period of time. accrued costs, remember how we talked about the accrual basis of accounting and costs that have been incurred? Well, this is where on the balance sheet, the accrual side sits and what it actually is, it's the costs and what this actually is, these are the costs where a cost has been incurred.
You have not received an invoice. And you've had to make some kind of estimate in order to put on the balance sheet. Some of the other known names of accrued costs could be something like for example, wages payable, dividends payable, rent payable. accrued wages. There's lots of different ways to say this. But if you think of the terms accrued or payable, this is typically the categories to be the accrued costs that sit on the balance sheet.
The third category that is a liability is called revenue paid in events, or sometimes known as unearned revenue. And what this actually is, if you think about this, this is the opposite side on the other person's box of what a prepayment is. So if you've received money in advance for a product or service, and you haven't yet delivered or performed the service, the actual revenue hasn't been earned. So it actually sits on earned as a, as a as a liability until such time as you've actually earned the revenue in which case will be transferred from a liability to revenue. And then if we think about the non current or long term types of debt, these are typically known as borrowings, which is like a loan with a bank, or it could be alone with a private private lender, or it could be a director or shareholder loan.
And also leases where you lease equipment, typically on a finance lease that has a longer period than 12 months. owner's equity. So this is really the owners funds and the profits that sit within an organization. So the first item is share capital. This is this, the shareholders initial funds that they put into a business. This could be a single individual shareholder who's put cash into a business, and this is his actual shareholding.
Or it could be an IPO situation where you've raised a heap of capital. And then this is actually the the registry of shares that sits within your organization and it could be the unit holders. Share of They funds and so on and so forth. It's always called share capital or sometimes capital or contributed capital is another term sometimes used, then reserves, reserves are actually used to actually revalue assets such as property plant equipment. So for example, let's say that you've purchased some property plant equipment for $100,000. And the market value this property plant and equipment is actually now worth $500,000 and you actually revalued on your balance sheet your property plant equipment to the $500,000.
So where do you actually increase the value of this asset is you increase the property plant and equipment account in assets by debiting it and you actually put the the remainder of it into a reserve account such as an asset revaluation reserve and that gets credited. Then the third category of owner's equity is called retained earnings. We'll be going over this in a bit more detail in a future lecture. However, it's a Important to note, the retained earnings is all the accumulated profit that is earned in a business since the beginning of time that the business started less any dividends that have actually been taken out over time. So this is really a cumulative balance of profit since day one. So, for all these categories, the way that they broken up on a balance sheet is typically into a current and non current category.
The current category represents a less than 12 month period to be converted to cash. And when you think about it, if we think about the current assets, we have cash, which is already cash, accounts receivable, typically customers would have terms anywhere from a day up to anytime under 12 months typically, in which case it will be converted to cash stock or inventory typically should be turned over within a short period of time less than 12 months and if it's not, then you would typically have to discount or sale that inventory. Then prepayments. Typically you wouldn't prepay things for greater than 12 months. So generally rent or prepaid insurance is for a 12 month or less period. And then when we looked at the liability side, accounts payable is typically for supplier accounts that needs to be paid within a 12 month period.
Accrued costs are typically for a particular month or maybe a couple month period. Revenue paid in advance again, it's similar to a prepayment where it's, it's going to be converted once you've actually performed the service or deal with the product. And so that's all current. Now we don't use this current category or non current category within the owner's equity section at all. And then non current is then long term greater than 12 months. So anything that would typically last greater than 12 months and you think about investments, typically.
Now, yes, you could sell shares pretty quickly. But typically when we think of investments, we think of long term investments such as acquisitions in other businesses, in which case, it's not always easy to sell them within a short period of time, it could typically take greater than 12 months. Property plant equipment, you generally would make capital purchases within an organization to last more than 12 months and, and depreciate over a period of time. And likewise, if you're going to take out a patent or trademark or some kind of instrument to actually as an intangible, again, you'd expect it to be lasting more than 12 months of time. And also then with borrowings borrowings, also typically non current because the term of a loan would typically be greater than 12 months, as long as also as well as the lease you typically take a lease out for for a number of years.
So that's the theory behind how the cat equation works. Just the other thing to note is that the retained earnings balance is accumulation of profit, which is actually accumulation of profit over time, less any dividends that have been paid for the character. Period plus the current periods profits. And one important thing to note is that profits is actually made up of revenue, less expenses. So therefore, whenever you think of owner's equity increasing revenues drive up owner's equity and expenses, drive down owner's equity. So, another thing to actually understand about assets is another category, which is actually called a contra asset.
And what these are, is they don't actually have future economic benefits, they actually have negative future economic benefits. And what they're actually useful is to offset different asset accounts to actually represent the true book value. So for example, the first one is called allowance for doubtful debts. If you have an accounts receivable balance, just remember this is a list of all your customers and the aesthetic balance at any point in time, which could have a number of invoices. Say for example, some of these invoices you actually believe are not going to be collectible for whatever reason. Maybe the customer Most having cashflow problems, maybe they potentially there's potential that business could go out of business.
This is what the allowance for doubtful debt account is. And what it actually does, it's a credit balance, that actually offsets the balance of the accounts receivable. And what it actually does is it actually almost like reverses the effect, that that customer would be paying you money. So if for example, the accounts receivable balance was $100, for that customer's invoice, and you took up into lots of doubtful debts for negative 100, your balance sheet position of assets would be zero, because you've actually offset the effect of that customer paying you and what you're representing is that you don't believe you're going to actually receive that invoice as payment in cash. The second category is known as the provision for stock obsolescence. And what this is, is for to offset the account for inventory.
And so for example, if you purchase a bunch of stock, however, there could be a reason why you can't sell that stock. For example, it could be damaged, or it could be out of date or its shelf life is over, or some something of that nature. The provision for stock obsolescence is actually used to actually offset the cost balance on the balance sheet. So if you had again, if you have inventory, you've purchased $1,000 worth of inventory. However, 20% of that inventory is actually ruined, destroyed or copy sold, you could then take a balance for $200 of provision for stock obsolescence as a credit balance as a negative future benefit, in which case you've got an $800 book value of assets for that inventory count. And finally, accumulated depreciation.
And also there's also accumulated amortization for intangibles is used to offset the property, plant equipment account and the intangibles accounts. And what this does. depreciation of non current assets happens over a period of time. And what the reason for this is actually represent its true book value. The fact that these assets were weren't here. And so every month, or every period of time, you'll take up a cost, which will actually hit your p&l.
So an expense will go for depreciation. And the other side of this will be sitting on the balance sheet. And it's kept separately from the property, plant and equipment account. And what actually we'll be doing is it will actually slowly over time reduced what that property plant and equipment value is to represent the book value. So say for example, you bought a motor vehicle $50,000 you put the cost as a non current asset into property plant equipment. And over time, that vehicle is not going to be worth as much and the reason why you depreciate it, so when you sell the vehicle eventually will dispose of it.
You're not going to be running off that balance sheet account into your cost. And so you're slowly releasing the cost of it over time into your profit and loss. And so every month, that $50,000 a month, let's say for example, it's got a five year life for that vehicle and 10,000 Every single year we'll be hitting that accumulated depreciation account. So after 12 months that contra asset accumulated depreciation, accumulated depreciation will have $10,000 sitting in it, the cost will still be sitting at $50,000 in property plant equipment and the net book value will be $40,000. Okay, so, this now ends our lecture on the accounting equation. Feel free to go over this again if you'd like to absorb this in a bit more detail.
However, we in the next section we'll be going over understanding accounting transactions. And there's four steps that we're going to be going through to actually understand how to think about things transactionally