Hi, Else here.
And today, we'll be talking about the elements
of financial reporting.
Let's first have a quick review, so we
understand why the elements are a part of Generally Accepted
Accounting Principles, also called GAAP.
We know that stakeholders are individuals or groups who
either affect the business or are affected
by the actions of the business.
Every stakeholder has an objective-- something
they want from their relationship with the business.
Stakeholders can be either internal or external.
Internal stakeholders work for the business.
Their objectives generally relate to their ability
to do their jobs, keep their jobs,
get promoted, and get paid.
External stakeholders are outside of the business.
And their objectives relate to the decisions
they'll make about providing resources to the business--
generally, money.
This is called resource-allocation decisions.
External stakeholders need a business'
financial information, so they can make decisions
with regards to providing resources-- generally,
money-- to the business.
Businesses are involved in thousands of activities
every single day.
They record their business activities
in the accounting system, an information system that
collects, groups, and communicates a businesses
financial position-- including its financial health
and profitability.
The end result of an accounting system
are the financial statements.
Financial statements tell a business a story-- what they do
and how well they do that.
They provide a business's financial performance--
its current financial position and its cash flows.
External stakeholders use the financial statements
to analyze the business and make resource-allocation decisions--
decisions about whether or not to provide resources, often,
money, to the business.
So how does the accounting system
move from business activities to financial statements?
The accounting system collects and groups the activities,
so it can eventually produce the financial statements.
Who decides how to group business activities?
Generally Accepted Accounting Principles
specify the categories, called financial reporting elements,
that all business activities are divided into.
By grouping the activities into elements,
we can eventually provide financial statements
to external stakeholders that are useful for decision making.
So what are the financial reporting elements
we use to group business activities?
There are five elements-- assets, liabilities, equity,
revenue, and expenses.
Each element has characteristics that define them.
When we record the activities of the business,
we use those characteristics to determine if the transaction
will affect the element or not.
Let's start with assets.
Assets have three characteristics.
Assets are owned, they provide future economic benefit,
and they are due to past events.
Let's go through each of these characteristics
and expand on them.
First, assets are owned.
The concept of owned is pretty straightforward.
For example, my cellphone is an asset because I own it.
Second, assets provide future economic benefit.
That means that assets will be used either directly
or indirectly to help the business.
The concept of future economic benefit is critical to assets.
What are future economic benefits for a business?
Well, an asset might be used to produce a good
or provide a service to customers--
like a machine that's used to manufacture potato chips,
or a lawn mower that's used to provide lawncare services.
It might mean that the asset will
be used to get another asset, like giving up cash
in order to get a machine.
Or the business might be able to use the asset
to get rid of a liability, like paying down a loan with cash.
Assets must have future economic benefit for the business,
or they're not considered assets.
The last characteristic of an asset
is that they're due to past events.
That means that there is an event
in the past that transferred ownership of the asset
to the business.
Why is this last characteristic important?
Because it means that if I plan to purchase
an asset in the future, I can't claim
that it's an asset now because the event has not
as yet happened.
It has to be a done deal.
The transfer of ownership must already have taken place.
So to summarize, everything that a company owns
is considered an asset-- a resource obtained
through a past event that will benefit
the business in the future.
Assets are defined as owned, providing
future economic benefit, and due to a past event.
Stop right now and list all your assets.
Everyone has assets.
Listing yours will help you to better understand
the concept of assets.
Think about what past events caused your assets
to become yours, and also how your assets will benefit you
in the future.
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.
Liabilities also have three characteristics
that define them.
Liabilities are owed to third parties.
They will be settled in the future.
And, finally, liabilities are due to past events.
Again, let's go through each of these characteristics
individually.
First, liabilities are owed-- an obligation or debt.
Important also is that they are owed to third parties--
individuals or groups who are outside of the business.
A personal example of a liability
is a student loan you might owe as a debt to the bank.
Second, liabilities will be settled in the future.
How are they settled?
Through the giving up of either cash, goods, or services.
For instance, a student loan will
be settled through the payment of cash in the future.
But other obligations might be settled by providing a service
or delivering a good.
Third, liabilities are due to past events.
Again, why is this important?
Because if you plan to borrow money next year,
that's not a liability yet.
And, therefore, you can't record it as a liability.
The event-- borrowing money-- has not yet happened.
A liability will only exist after you get the money.
So to summarize, everything that a company owes to a third party
is considered a liability-- an obligation due to a past event
that the business will settle in the future.
Liabilities are defined as owed to third parties,
to be settled in the future, due to a past event.
Stop again and list all your liabilities.
Some students don't think they have any,
but if you use a credit card, and have not as yet paid
your bill, or you have a cell phone bill,
you probably have liabilities.
Let's move on to equity.
Equity is a difficult concept to grasp,
so we're going to keep it simple right now.
Equity is equal to the wealth that
is due to the owners of the business.
And it is made up of two items.
First, equity is the capital provided by the owners.
For instance, if you start a business
with $20,000 of your own money, then you
have $20,000 of capital in the business,
which is recorded as an equity.
Second, equity is the profit that the business generates
and keeps in the business.
For instance, if the business has
profit of $10,000 during the year,
then the equity would go up by $10,000.
If a portion of that profit was paid out to the owners
in the form of dividends, then equity
would go up by the amount of the profit,
less the amount of the dividends.
For instance, if the business has a profit of $10,000,
but it paid out dividends of $2,000,
then equity would increase by $8,000, which is the profit
that the business kept.
This is called retained earnings,
meaning the profit kept or retained
in the business for future expansion.
So, to summarize, equity is the capital invested by the owners,
plus the profit, less dividends retained by the business.
Equity is owed to the owners of a business by the business.
Equity-- capital plus retained earnings owed to the owners.
So what is your equity or wealth position?
It's easy to calculate your equity.
All you do is take the value of your assets,
and deduct the value of your liabilities.
What is left over is equal to your equity or your wealth.
Let's move on to the element revenue and its definition.
Revenue is the income a business earns.
There are only two ways to earn revenue.
Businesses either provide a service or a good.
The key to revenue is that it must be earned.
What does that mean?
It means that the business has done their job-- past tense.
For example, if a lawn care business
plans to mow a customer's lawn tomorrow,
that is not earned revenue today because they have not
done their job yet.
After they finish mowing the customer's lawn,
they'll have to earn their revenue.
If a retail store plans to sell a product to a customer
tomorrow, revenue is not earned because, again, the business
has not as yet done their job.
Revenues can only be recognized when the business has
finished their job, provided the service, or delivered the good.
Notice the past tense.
That's very important with regards to the element revenue.
To summarize, revenue is income earned
through the day-to-day activities of the business
when a service or a good is provided.
Revenue-- earned by providing services or goods.
Your revenue should be easy to figure out.
If you have a job that earns you income,
then you know what your revenue is.
The last financial reporting element to define is expense.
Expenses are the cost of the resources
that are used, consumed, or incurred
to help generate revenue.
Expenses are best described through an example.
If you use gas in a lawn mower when you mow a customer's lawn,
then the gas that was consumed during the mowing of the lawn
would be an expense, a cost of earning revenue.
Why?
Because the gas was consumed in order to help
generate the revenue.
Note that the concept of used, consumed, or incurred
is important.
But so is the fact that these things must have
happened to help earn revenue.
Costs or expenses must be matched to the revenue
they help to generate.
Expenses-- costs of what is used, consumed, or incurred
to help generate revenue.
So, what expenses do you use, consume,
or incur to generate the income from your job?
Likely, it includes transportation
to and from work.
Because that would be the cost of generating your income.
We just defined all the elements used in financial reporting.
These elements are used when recording business activities.
Business activities are grouped, so that we can eventually
produce financial statements that
will be used by external stakeholders
to make resource-allocation decisions.
In the next video, we'll be talking
about combining the definitions with the accounting equation.