Hello, I'm professor Brian Bushee, welcome back. In this video we're going to build on our discussion of the balance sheet equation to talk about assets, liabilities, and stockholder's equity in more detail. We're going to provide precise definitions for each of them, and we're going to look at situations where we can record them, and situations where we can't record them. Let's get started. Let's start with assets. An asset is a resource that is expected to provide future economic benefits. That means, it's either going to generate future cash inflows or it's going to reduce future cash outflows. There are two criteria that we use to decide, when to recognize an asset. First, it must be acquired in a past transaction or exchange, and second, the value of its future benefits can be measured with a reasonable degree of precision. So, for example, if we buy a truck, the truck would be considered an asset. We acquired ownership of the truck in an exchange. And the value and the benefits of the truck are equal to the price that we paid to buy the truck. So, both criteria are satisfied, and it would be an asset. Now we're going to practice applying these criteria to figure out which of the following items would be assets. I'm going to give you a number of items, and for each one, I want you to try to figure out whether it's an asset or not. If it's an asset, try to give me the account name and what the dollar amount would be. If it's not an asset, then try to figure out what criteria would cause it to not be an asset. I'll bring up the pause sign so if you want to pause and try and answer it yourself you can, but as always you can just roll through and listen to the answers if you'd like. So lets get started. BOC sells $100,00 of merchandise to a customer that promises to pay cash within 60 days. This'll be an asset called accounts receivable. It's an asset because there was a transaction where we delivered goods to a customer, and in return we got a promise from them to pay cash. It's an asset, because that can turn into cash within the next 60 days. And the value of the future benefits can be reasonably estimated because it's the amount that customer owes us on the invoice, and that amount is $100,000, which is what the value of the asset would be. Next, BOC signs a contract to deliver $100,000 of natural gas to DEF, each month for the next year. This one will not be an asset because there has been no past transaction or exchange. Every exchange of cash, good or services, is going to happen sometime in the future. Nothing has been exchanged yet, so there can't be an asset for it. >> Excuse me, both of these two sound like promises to me. Why is the first an asset but the second is not? >> That's a great question and the first example the costumers promised to pay us cash, but we've acquired that promise through delivering them goods. In other words there's been a pass transaction or exchange, which is that first criteria for him asking asset. In the second case, all we've done is sign a contract. If the contract was broken, it's not clear we'd have any basis to ask the customer to pay us a $100, 000. And, so this first criteria, acquired in a past transaction or exchange, is there to raise our assurance that something that we want to call an asset is a legitimate resource that should deliver future benefits, as opposed to a simple promise that could easily be broken, as might be the case if there's a contract that was signed with no accompanying exchange of cash, goods or services. B.O.C. buys $100,000 of chemicals to be used as raw materials. B.O.C. pays in cash at the time of delivery and receives a 2% discount on the purchase price. This is an asset and we'll call this Asset Inventory. Inventory is a term that we are going to use for any product or raw materials that we buy, that we're going to turn into a finished product that we're going to sell at a markup. It meets both criteria. We acquired the chemicals in a market transaction. And the value of the benefits is known here because it's what we paid in the market transaction. And note that the value here is 98,000 not 100,000 because we value it at what we actually paid for it, not some kind of higher sticker price that wasn't what the transactions actually happened at. BOC pays 12 million for the annual rent on its office building. It has already occupied it for one month. This is an asset. We're going to call it Prepaid Rent. It meets the first criteria because in a market transaction, we paid for the right to occupy space in this office building for 12 months. The value of the benefits are also known. They're what we paid for. But note that, at this point, the value of the benefits is only 11 million. Not the 12 million that we've paid. Because we've already occupied it for a month we've used up one month of the future benefits. So at this point in time, there's only $11 million of future benefits. So we have prepaid rent worth $11 million. BOC buys a piece of land for $100,000. It's broker said this was a steal, because the land is probably worth $150,000. This is an asset which we'll call Land. Meets the first criteria because there was a market transaction where we acquired ownership. The value of the benefits are assumed to be what we paid for it, which is $100,000. Now note, we ignore the last sentence about what the broker thinks the land is worth because that's not what we paid for it in a market transaction. And so we're not going to use that as the value of the benefits. We're going to use the more objective number of what we actually paid for it, so we've got an asset, Land, that's worth $100,000. [SOUND] BOC is advised by a marketing firm that its brand name is worth $63 million. This would not be an asset, because we never acquired it in a past transaction or exchange, and you can argue that the value of the brand cannot be measured with a reasonable degree of precision, so it doesn't really meet either criteria. >> Are you saying that marketing people do not know what they are talking about? >> No, no, no. I definitely respect marketing people. Some of my best friends are marketing professors. It's simply a case where accounts have decided to err on the side of reliability or objectivity. Without a market transaction where the company has acquired the brand, we can't be sure of how much it's worth. And so we err on the side of leaving it off the financial statements. For this reason, you often see the value of the company in the stock market to be greater than the value on the financial statements, because investors would consider this to be an economic asset, whereas the accounting system is going to ignore this asset as not reliable enough. Now, we're going to turn to liabilities. A liability is a claim on assets by creditors or non-owners, that represent an obligation to make future payment of cash, goods, or services. >> My former boss called me a liability to the organization. Is this what he meant? >> No, you're probably a liability in a different sense. Let's go on. Just like assets, there are two criteria for when we recognize a liability. First the obligation is based on benefits or services received currently or in the past and second the amount and timing of payment is reasonably certain. And even though the words are different, these are essentially the same two criterias for the assets. The first one says there has to be some kind of transaction or exchange where you've received something that creates an obligation and the second criteria says you can measure the amount of what the obligation is. So for an example, let's say we borrow money from a bank, we have an obligation to repay the bank based on receiving the benefit of getting the money now. The amount and the timing of the payment is reasonably certain, and if there was any question, I'm sure the bank could clarify how much we exactly owe them. So, borrowing money from a back would meet both criteria. And it would be a liability called something like notes payable or mortgage payable. We're going to do the same exercise now with liabilities. I'll give you a number of items. I'll give you chance with the pause sign to try to answer them if you'd like and then we'll talk about what the answer is. First item, BOC receives $300,000 of raw materials from a supplier and promises to pay within 60 days. This will be a liability. We're going to call this liability accounts payable. We use that term anytime we owe money to a supplier. It meets the first criteria because we got the benefit of raw materials in a transaction, which now creates the obligation to pay our supplier and the amount of the obligation is reasonably certain. It's the $300,000 which is on the invoice. So we're going to have an accounts payable liability for $300,000. Based on this quarter's operations, BOC estimates that it owes the IRS $3 million in taxes. This will be a liability, we'll call this liability Income Tax Payable. So a little bit hard to see the first criteria here, because there was no explicit transaction. But essentially what happened is, the government allowed us to operate our business so that, so we got the benefit of being able to operate our business in this country, and in return it created an obligation to pay them taxes. Based on the right to operate the business. We have to then estimate the amount of the liability even though when we don't know exactly what the taxes are at this point, we can estimate them with recent knowable certainty, we come up with $ 3 million as our estimate, so we would have a liability called income tax payable for $3 million. >> You said that the amount and timing of payment has to be reasonably certain for there to be a liability. Why is an estimated amount considered to be reasonably certain? >> We're going to have to make a lot of estimates in accounting. As long as we're reasonably certain about the number, we should go ahead and book the liability. For something like taxes, there are tax forms available on the web. We have a rough idea of how much taxable income will be during the period, and so we can estimate what our tax liability is. Now, it may not be 100% correct when we eventually file the form. But whatever our best estimate is, is a much better estimate than ignoring it completely. So, we go ahead and put our best estimate on the financial statements. Next, BOC signs a three-year $120 million contract, to hire Dakota Dokes as its new CEO, starting next month. This one is not a liability and it's not a liability because we have, there's no obligation based on benefits that have been received currently or in the past which is the first criteria. Until Dakota actually works for us, and works for us without getting paid, there cannot be a liability. And even then the liability would only be for the time that he or she has worked without pay. We wouldn't book a liability for the entire three year contract because we haven't received. The, benefits for that yet. Plus, there's too much uncertainty with that because Dakota could quit tomorrow, we could fire Dakota, our lawyers, his or her lawyers could find a way out of the contract. There's too much uncertainty over the dollar amount for the three year contract. So we only are going to record a liability for the amount of time the Dakota's worked for us. Since he or she hasn't worked for us yet, there would be no liability. BOC has not yet paid employees who earned salaries of $1 million during the most recent pay period. This would be a liability which we're going to call salaries payable. It does meet the first criteria because there's an obligation based on the benefits we've, we've received. The employees have worked for us, we've gotten the benefit of their services, and now we have an obligation to pay them for those services. The amount we owe is reasonably certain, and again, if there were any questions, the employees would surely let us know how much we owe them. So we'd have an obligation based on past benefits for $1 million, and we'd book a liability called salaries payable for $1 million. >> In both of these last two examples, we have not yet paid our employees. Why is this one a liability, but not the previous one? Is it because the first one pertains to an executive, whilst the second one pertains to lowly employees? >> No, no, no. It has nothing to do with status. It's simply a matter of, for a liability to exist, there must be some obligation based on benefits or services received in the past. Employees that have worked for us without being paid, creates a liability for us. Employees that have not yet worked for us, cannot create a liability. BOC borrows $500,000 from a bank on a one-year note with a 10% interest rate. We so, I talked about this example earlier. This would be a liability called notes payable, meets the first criteria because we have an obligation based on receiving the benefit of the $500,000 from the bank. The amount that we owe is reasonable cert, that's $500,000 so it meets the second criteria. So we have the liability called notes payable for $500,000. >> What about the interest, we will owe the interest on the loan. Shouldn't there be an interest payable as well? >> Great question, interest is not a liability at this point because we just took out the loan, and we can presumably pay a back rate now without owing any interest. Interest only becomes a liability as the money is outstanding over time. And to the extent that we haven't paid it, the amount of interest that we owe but haven't paid becomes a liability. Finally, BOC is sued by a group of customers who claim their products were defective. The suit claims damages of $6 million. This would not be a liability. It does meet the first criteria. There's a potential obligation based on a benefit received in the past. The benefit was we sold products which turned out to be defective. Doesn't meet the second criteria though, because we can claim that the amount of the payment is still uncertain. Until we have a settlement or we got to trial we don't know that we have to pay anything, so because of that uncertainty, we don't have to record a liability in this case. Finally, we have stockholders' equity. Stockholders equity is the residual claim on assets after settling claims of creditors. In other words, it's assets minus liabilities. A lot if synonyms for this, It's also called, shareholders' equity, owners' equity, net worth, net assets, net book value. Unlike assets or liabilities, there are not two criteria for how to measure stockholders' equity. Because if you measure all your assets correctly and you measure all of your liabilities correctly then stockholders' equity is whatever is left over. But there are two sources of stockholders' equity. The first source is what we call contributed capital, which arises from selling shares of stock to the public. So we'll talk about common stock and additional paid in capital. That's what you record when you issue new shares to the public. Common stock is for the par value, additional paid-in-capital if for everything you receive above the par value. And then treasury stock is what we call it when the company re-purchases it's own stock from investors. >> Wait, what is this thing called par value? Is this why there are so many accountant on the golf course during the day. >> I'm not sure why you're seeing so many accountants on the golf course, but it has nothing to do with par value. Par value is this archaic historical concept. There used to be laws which said that companies couldn't issue new equity if the value of their stock was below the par value. Where they couldn't pay dividends if the value was below the par value. Most of those laws are gone now. And, par value's main implication is that when we issue equity, we put the par value amount of the proceeds into an account called common stock. We put the rest into additional paid in capital. You'll see this more in subsequent videos. The other source Stockholder's Equity is Retained earnings which arise from operating the business. Retained earnings is the cumulation of main income which is revenues minus expenses less any dividends that have been paid out since the start of the business. So what are dividends? Dividends are distributions of retained earnings to shareholders. They're not considered an expense and we record them as a reduction of retained earnings on the date the board declares the dividend, which is called the declaration date. If we don't pay in cash on that date, which is what usually happens, it will create a liability to our shareholders, until we actually pay the dividend on the payment date. >> Excuse me, please explain that again, why are dividends not an expense? They are paid in cash like other expenses, and why are they a liability? >> Both great questions. First, dividends are not considered an expense because they're not considered a cost of generating revenue. Instead dividends are a discretionary decision by the board of directors to return some funds back to shareholders that's presumably somewhat independent of the company's performance or sales during the period. Second, we created dividends payable, because once the board declares a dividend, it's essentially holding the shareholders' money until it sends the check, making the shareholders creditors of the company. Now, I admit that this one seems weird, because usually liabilities are for non-owners, where as here we have a liability to our owners. But we consider them creditors in this one specific case. Best thing at this point is just to memorize it. Dividends are not an expense and when the board declares but doesnt' pay a dividend, we create a dividend payable liability. And that wraps up our discussions of assets, liabilities, and stockholders' equity. Now we have to figure out how to keep track of them. Well the good news is in the next video, we'll talk about those magical things called debits and credits which will help us keep track of everything in the financial statements. I'll see you then. >> See you next video.