Foundations of Finance and Accounting

Okay. So now we’re gonna talk about accounting and finance. These terms are often used interchangeably.

But we’re talking about two completely different things as I’m gonna show you. Accounting and finance. Now when I was doing my MBA, my finance professor came into the room, and he asked us what’s the difference. Between accounting and finance.

Well nobody really had a, a, a good answer for him. He went over to the board and he drew one dollar on the board, and he said in accounting this is one dollar. In finance, this is one dollar.

Now he was a funny guy and we all chuckle. But over the years as I’ve considered that and I’ve pondered it I start to realize wow that’s really true.

There’s actually a lot in that. Accounting, as we are about to see from the accounting equation, accounting deals with. The tracking of money. Where did money go? How has it been used, right. If you write that you’ve got $5 in accounting, you’ve got $5. Finance is really in the actual usage of money that you have. You see in accounting, you can have negative a million dollars.

In accounting you just minus one million and there you go, negative a million dollars. You see, I can’t as a person, actually have negative money in my pocket.

The lowest amount of money I can have in my pocket is nothing. I can’t have less than nothing. If I had negative a dollar in my pocket and I put a dollar in my pocket, by definition that dollar would just disappear. All right, and that as we know doesn’t happen. And here’s the great thing. Accounting-wise, I can actually owe $1,000,000. God forbid. But I can actually owe $1,000,000, and yet still be walking around with $100 in my pocket.

Right? In accounting, what am I worth? I’m worth negative a million dollars, minus the $100 I’ve got in my pocket, right? In terms of finance, I’ve got $100. Right? This is the basic difference. Let me show you that academically. We’re gonna go to what we call the accounting equation. The accounting equation is the basic equation that defines all of accounting, and this accounting is assets equal liabilities plus equity.

Assets equal liabilities plus equity. That’s it. Now, what this really refers to is shown on what we call the balance sheet. The balance sheet is one of the four financial statements. We’re gonna start there. Most people do. Because this is the, the manifestation of the accounting equation. Traditionally, the balance sheet was done with two sides, right? You had the left hand side, assets, and on the right hand side you’d have liabilities and equity. Now, if you go Google a company and you look at their financial statements, you look at their balance sheet, a lot of times today that’s not the way it’s done. They’re gonna do the straight line format, or what’s called the common format. Okay, they’re gonna have assets, liabilities, equity. But traditionally, this was left and right, and when you’re an accounting student, you actually start that way, because it’s important for us to see that left and right, because that left and right, it, it has other imp, implications for us. So what we have is a left-hand side, Assets, equal the liabilities. What I owe and the equity, what I own.

So think of it this way. Assets, what I have.

Liabilities, what I owe, and equity, what I own.

Now at first, you think, wait a second, how does what I have equal what I owe plus what I own.

Let me explain this, and make it a little bit easier.

I have a car. Okay? I have a car. You go out to the parking lot out here, you’ll see my car parked in the parking lot. I have that car. Now, that car is worth $50,000, so I have a $50,000 car. Right? But I haven’t paid the full $50,000 on that car, yet. Right? I have a loan for that car. And I’ve paid some of that car, in fact, I’ve paid $30,000 of that car.

Now, I don’t just drive around the $30,000 part, I have the whole car. Top to bottom. All right? So I have a car. I own equity, $30,000 of it. So where’s the other $20,000? It’s in my liabilities. It’s what I owe. So I have a $50,000 car. I owe 20, I own 30, that’s 50. 50 equals 50. Assets equal liabilities and equity. That is the accounting equation. Okay?