Hello, I'm Professor Brian Bushee,and welcome back.In this video, we'll take a lookat the one rule of grammar inthe accounting language,the balance sheet equation.We'll see how the balance sheetequation makes all the financialstatements fit together.We'll also use the balance sheet equationto solve some problems where we'remissing one piece of information,but we can fill in everything thatwe do know into the balance sheetequation and solve for what we need.Hope you enjoy the video.So if you've ever tried to learna foreign language, you know that one ofthe most difficult things is learning allthe rules of grammar, all the cases anddeclensions and the changes inverb endings and all that stuff.Well, the good news about learningthe language of accounting is that there'sonly one rule of grammar, the balancesheet equation or the accounting identity.This is that assets equal liabilitiesplus stockholder's equity at allpoints in time.Another way to say this,as we've talked about,is that the resources of the company,equal the claims on those resourcesby the outsiders, and by the owners.>> Can you give me an example ofwhen this is used in the real world?>> A good example to think about howwe use the balance sheet equation inreal life, is when we buy somethingbig like a house, or a car.So, let's us say we wantedto buy a $500,000 house butwe only had $50,000 of cash whilewe would need to go out andborrow $450,000 from the bank ina mortgage in order to buy the house.Then after we bought it we'dhave 500,000 in assets,the house, which is equal to the 450,000of liabilities, the mortgage.Plus 50,000 in equity,which is how much cash we put in andwhich represents our claim on that house.The most important feature ofthe balance sheet equation is that itmust always balance.And that's why we're going totalk about something theycall double entry book keeping.If you increase something on one side ofthe equation, you have to increase ordecrease something elseto stay in balance.So, there has to be at leasttwo entries any time youtinker with the balance sheet equation.And as we'll see, the changes betweentwo Balance Sheets are going to besummarized in the Income Statement,the Statement of Stockholders' Equity, andthe Statement of Cash Flows.So let me show you this graphically.So let's say we have a balance sheetat the end of December 31, 2014.Assets equal liabilitiesplus stockholders' equity.We'll split the assets into cash andnon-cash assets, andwe'll split stockholders' equityinto contributed capital andretained earnings, which are conceptswe'll talk more about in later videos.Then we have a balance sheetat the end of the year, sowe've got one at the beginning of 2015,at the end of 2015.The difference in the retained earningsis going to be explained in the incomestatement forthe year end at December 31, 2015.And the difference in cash, is going tobe explained in the statement ofcash flows forthe year ended December 31, 2015.>> Here you go again withthe difference between income and cash.Remind me, why are they different?>> Okay,let's go back to the house example.So, let's say on your first balancesheet at the beginning of the year youhave a $500,000 house,which is your asset,$450,000 mortgage which is your liability,and $50,000 of equity.Now let's say that during the yearthe value of your house increases toa $1 million, now you can't actuallydo this in practice, but forthe sake of the example, let's assumeyou could write up the value ofthe house from 500,000 toa million at the end of the year.So, your balance sheet at the end of theyear would have a million dollar asset,the house, 450,000 of liabilitiesbecause the mortgage doesn't change, butyour equity would go upfrom 50,000 to 550,000.Now, if you look atthe statement that explainsthe changes in two balance sheets.None of this affects the cashflow statement because there's nocash impact of yourhouse going up in value.In fact, your cash up should probably wentdown as you were paying the mortgage.But your income statement would showa gain of $500,000 from the increase inyour equity due to yourownership claim of the house.>> Housing prices going up?Can you give us a morecontemporary example?>> Okay, so let's talk about what happenedduring the financial crisis of 2007,2008 and 2009.There were banks out there that had assetscalled mortgaged-backed securities.These are assets because they'reclaims on collecting cashpayments from people thattook out sub-prime mortgages.So let's say a bank had 10 billion ofthese mortgage-backed securities asassets.And let's say they had 9.5billion of liabilities.And half a billion of equity.Financial crisis hits, these home ownersno longer make their mortgage payments.Which means, these assets drop in value.So now they have to be writtendown in value from 10 billion to,let's say 1 billion.Now the liabilities don't change.In fact, that's why youneed a government bailout becauseyou're liabilities don't change.But what does change is the equity.The equity drops by 9 billion as well.And so it's another example where there'sno cash flow impact of the change inthese two balance sheets, butwe end up showing a $9 billion loss onour income statement due to the dropin our equity claims on those assets.Of course, we also have to mentionthe statement of stockholders' equity,which explains the changes instockholders' equity between twobalance sheets, which we will talkabout more later in the course.What I want to do next is show you howeverything that we're going to talkabout fits into thisbalance sheet equation.So, we talked about how stockholders'equity is two components,contributed capital, which is the moneythat we raised from shareholders, andretained earnings, which is what wecreate by operating the business.Retained earning is going to equalwhatever retained earnings were atthe beginning of the periodplus any net income,earned during the period minus anydividends paid out to shareholders.That's why it's called retained earnings,because it's the earnings ornet income less any dividends paid out.And then net income, as we talked about ina prior video, is revenues minus expenses.So, if we put all of this intothe balance sheet equation weget one big complete balance sheetequation, which is assets equalliabilities plus contributed capital,plus your prior retained earnings,plus revenues, minus expenses, minusdividends that you pay during the period.>> [FOREIGN] Are you going to makeus do some mathematics with this?>> Why, yes.I am going to ask you to do some math.Now I'm going to give you some problems,give you a chance to try toanswer the problems, andthen we'll talk through the answers.After I read the problem, you'll seea little pause icon on the screen.If you want to try to answer the problembefore I give you the answer,pause the video at this point,try to come up with the answer andthen resume the video.But, if you want to just roll through andhear the answer right away,then it's okay to keep the video going.This is going to be the procedure thatwe follow any time that I give yousome questions that I wanted to, want youto try to answer during the video lecture.Okay, here is the first one.Assets equal 100, liabilities equal 50.What is stockholders' equity?We can solve this one witha balance sheet equation.We know that assets are 100.Liabilities are 50.The only thing that's missing isstockholder's equity, which has to be 50.So that we have 100 on the left hand side,and 100 on the right hand side.Next, liabilities increase by 100 andstockholders' equity is unchanged.What is the change in assets?Again, we can use the balancesheet equation to answer this, butnow we're looking atchanges in the numbers.So, stockholders' equity is unchanged,liabilities go up by 100, the only way forthe equation to stay in balance is forassets to also go up by 100.Next, all non-cash assets are 70,total liabilities are 60,total stockholders' equity is 30.What is cash?We can use the Balance Sheet equation forthis one if we separate assetsinto Cash and Noncash assets.So we have Liabilities of 60 andStockerholders' Equity of 30,that's 90 on the right-hand side.Noncash assets are 70.The only thing missing is Cash,which has to equal 20,so that we have 90 on each side.Next, cash decreases by 10 andall non-cash assets increase by 15.What is the change in liabilities?We can use the same equation butwe have to be a little bit careful.We have cash going down by ten, noncashassets going up by 15, we're looking forliabilities, but we don't know whathappened with stockholders' equity andbecause we don't know what happenedwith stockholders' equity,we actually don't have enoughinformation to solve this.Now, if we knew that stockholders'equity had not changed,then liabilities would havehad to go up by five, sothat we have an increase in fiveon both sides of the equation.But without knowing whathappened to stockholders' equity,we technically don't have enoughinformation to answer this one.>> Oh, come on, a trick question, really?>> Sorry about the trick question.But, I promise that it won't be the last.Next, we have Retained Earningsincreasing by 100, dividends are 50.What is net income?Earlier in the video, we looked atthe equation for retained earnings,where retained earnings is equal to priorretained earnings, what they were atthe beginning of the year, plus net incomeduring the period, minus dividends.So we know that the change in net income.Change in retained earnings,retained earnings minus priorretained earnings is 100.We know that dividends is 50,so the only thing missing is net income,which has to be 150 for this to balance.Next we have revenue increasing by 100,all other categoriesare unchanged except assets.What is the change in assets?We have to use the complete balancesheet equation to solve this one, sothat we break Stockler's equityinto contributed capital,prior retained earnings,revenues, expenses and dividends.So, we know that revenuesare going up by 100.Everything else is unchanged but assets,which means that assets also have togo up by 100 so that both sidesof the equation increase by 100.Finally, expenses increase by 60 andall other categoriesare unchanged except cash.What's the change in cash?We'll again use the completebalance sheet equation, butnow we'll split assets into cash andnon-cash assets.So we know that expenses went up by 60,everything else is unchanged except forcash.Now notice on the right-handside of the equation,expenses going up by 60 meansthe right-hand side goes down by 60,which means the cash also has to godown by 60 for us to stay in balance.>> I think I can do this.Can we do more maths problems.>> Finally some positive feedback.The purpose of this exercisewas to preview the type ofproblem that you are going tobe doing a lot in this course.There's going to be a certain piece ofinformation that you need that you'renot given.But, you can take all the otherinformation that you're given,and a set of equations, that willusually be in the form of T accounts, orjournal entries, fill in everything youknow, and then solve for that one piece ofinformation that you need, that youcan't find in the financial statements.Wow, has it been twelve minutes already?Time sure flies when you're doingthe balance sheet equation.So I'm going to go ahead and wrap up thisvideo, and we'll come back next time andtalk in more detail about assets,liabilities and shareholder's equity.I'll see you then!>> See you next video.