Hi, Else here.
And in this video, we'll be exploring the balance sheet.
We've already covered the income statement and the statement
of retained earnings.
But let's just remind ourselves of what they look like
and how they're interconnected.
The single step income statement shows the profitability
of a business over a period of time.
It includes a financial reporting elements, revenues
and expenses.
Both are listed from the largest to the smallest amount.
It's important to note that the income tax expense is
a separate line item.
And it's never included as part of the operating expenses.
The profit at the bottom of the income statement
is then used in the statement of retained earnings.
This statement shows how much of the profit
from the income statement has been retained or kept
by the business for future growth and expansion.
It also shows how much of the profit
has been paid out in dividends to the owners.
The closing retained earnings at the bottom of the statement
is then carried forward to the balance sheet, which
is the subject of this video.
The balance sheet summarizes the assets owned,
the liabilities owed, and the equity which the business owes
to the owners.
This statement shows the financial health
of a business at a specific point in time.
In order to understand the balance sheet,
we really have to understand the elements that
make up this statement, assets, liabilities, and equity.
This has already been covered in a past video
on the financial reporting elements.
But we'll quickly review the concepts.
Remember, that each element has characteristics
that defines them.
When we record the activities of a business,
we use these characteristics to determine if the transaction
will affect the element or not.
Let's start with assets.
Assets have three characteristics.
Assets are owned, meaning the business has possession
of and ownership of the assets.
They provide future economic benefit.
That means the business will use the asset in some way
to help them generate revenue in the future.
And finally, they're due to past events,
meaning the transfer of ownership has already happened.
So to summarize, everything that a business owns
is considered an asset, a resource obtained
through a past transaction that will benefit
the business in the future.
On the balance sheet, assets are grouped into categories.
Why?
Financial statements are all about communicating
useful information to decision makers.
Accounts are already divided into financial reporting
elements, assets, liabilities, equity, revenue, and expenses.
By further subdividing assets and liabilities,
stakeholders who use the financial statements to make
decisions get a better understanding of the business's
financial position and health.
What are the subcategories used for assets?
There are four, current assets, property plant and equipment,
intangible assets, and other assets.
Let's define each subcategory.
Current assets are any asset that
will be converted into cash, sold, used, or consumed
within one year of the balance sheet date.
A few of the more common accounts found in this grouping
are things like cash, accounts receivable, and supplies.
All of them meet the definition of a current asset.
For instance, cash will be used continually, which is certainly
within the one-year time limit.
Accounts receivable will be collected quickly, likely
in the next 30 to 90 days.
So it's being converted into cash within one year.
Supplies are consumed rapidly, so it also
falls under the one-year requirement.
Current assets are any account which
meets the definition of current, converted into cash,
sold, used, or consumed within one year of the balance sheet
date.
If an asset does not meet the definition of a current asset,
then it belongs in one of the other subcategories that
are long term.
These are resources that will be converted into cash,
sold, used, or consumed over more than one year.
Anything that is not current must
belong in one of the other subcategories, property plant
and equipment, intangible assets, or other assets.
Property plant and equipment is exactly what the name suggests,
all the land, building, equipment
that a business owns which the business uses in order
to generate revenue.
You were introduced to this concept in Chapter 3,
long lived assets, which are tangible,
because the asset lasts a long time
and it has physical presence.
That means you can touch it, pick it up, or kick it.
Again, key here is that all property plant and equipment
will be used over the long term, well beyond one year.
This is what makes them long-term assets.
Next are intangible assets.
If tangible assets are physical, then intangible assets
are nonphysical.
They can't be touched, picked up, or kicked.
Instead, intangible assets represent legal rights,
such as a license, trademark, or brand name.
Two examples are the right to use a license
for a period of time or the software
that your business has a right to use for many years.
Finally, other assets are any assets
that last longer than one year but they
don't belong in property plant and equipment or intangible
assets.
This is a catch-all category, including
things such as an accounts receivable that will not
be collected for two years, or the pre-paid insurance
policy that provides protection for the next three years.
How do companies get their assets?
They often use liabilities, the next element
of financial reporting.
They take on debt in order to increase their assets.
Recall that liabilities also have three characteristics that
define them.
Liabilities are owed, generally to a third party
outside of the business.
They will be settled in the future
by either giving up cash, goods, or services.
And finally, liabilities are due to past events,
meaning the obligation already exists now.
So everything that a business owes to a third party
is considered a liability, an obligation
due to a past transaction that the business
will settle in the future.
Like assets, liabilities are divided
into subcategories, current and long term.
This is, again, to provide information to stakeholders so
that they can make decisions.
Current liabilities are obligations
that will be settled within one year from the balance sheet
date.
They include accounts, such as accounts
payable and unearned revenue.
For instance, accounts payable is
likely to be settled with an outflow of cash
in 45 to 90 days, well within the one-year requirement
for a current liability.
Unearned revenue are things like the services
that are due to customers who have paid in advance.
These services are likely to be provided quickly, definitely
within the one year requirement for current liabilities.
Long-term liabilities are debts which
will be settled in the long term,
beyond one year from the current balance sheet date.
The accounts included in long term liabilities
almost always use the word payable as part of the account
name, such as in bank loan payable or note payable.
They will not be settled in the upcoming year,
but instead will be settled far into the future.
That's it for liabilities.
There's only two subcategories.
Let's move onto equity.
We've already defined the element equity
when you completed the statement of retained earnings.
As a reminder, equity is owed to the owners by the business.
Recall that it's made up of two accounts, owner's capital
and retained earnings.
It answers the question, what part of the business
is financed by the owners?
Equity has no subcategories.
Let's do a quick check your understanding.
Remember to pause the video and answer before I answer for you.
The right to receive a service in the future is an?
Current asset called prepaid expense.
It's an asset because in the past,
the business paid for a service but they didn't receive it.
So the business has a legal right
to receive a service in the future.
It's going to benefit the business by helping
them to generate revenue.
It's a current asset because we will likely
receive the benefit within one year of the balance sheet date.
Now that we understand the elements that
make up the balance sheet, we can
look at a sample balance sheet.
That's going to be the topic of my next video.