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.