Hello, I'm professor Brian Bushee,welcome back.In this video we're going to build on ourdiscussion of the balance sheet equationto talk about assets, liabilities, andstockholder's equity in more detail.We're going to provide precise definitionsfor each of them, and we're going to lookat 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 expectedto provide future economic benefits.That means, it's either going togenerate future cash inflows orit's going to reduce future cash outflows.There are two criteria that we use todecide, when to recognize an asset.First, it must be acquiredin a past transaction orexchange, and second,the value of its future benefits can bemeasured with a reasonabledegree of precision.So, for example, if we buy a truck,the truck would be considered an asset.We acquired ownership ofthe truck in an exchange.And the value andthe benefits of the truck are equal tothe 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 thesecriteria to figure out which ofthe following items would be assets.I'm going to give you a number of items,and foreach one, I want you to try to figureout whether it's an asset or not.If it's an asset,try to give me the account name andwhat the dollar amount would be.If it's not an asset,then try to figure out what criteriawould cause it to not be an asset.I'll bring up the pause sign soif you want to pause andtry and answer it yourself you can, butas always you can just roll through andlisten to the answers if you'd like.So lets get started.BOC sells $100,00 of merchandise toa customer that promisesto pay cash within 60 days.This'll be an asset calledaccounts receivable.It's an asset because there wasa transaction where we delivered goods toa customer, and in return we gota promise from them to pay cash.It's an asset, because that can turninto cash within the next 60 days.And the value of the future benefits canbe reasonably estimated because it'sthe amount that customerowes us on the invoice, andthat amount is $100,000, which iswhat 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 becausethere has been no past transactionor exchange.Every exchange of cash, good or services,is going to happen sometime in the future.Nothing has been exchanged yet, sothere can't be an asset for it.>> Excuse me, both of thesetwo sound like promises to me.Why is the first an asset butthe second is not?>> That's a great question and the firstexample the costumers promised topay us cash, but we've acquired thatpromise through delivering them goods.In other words there'sbeen a pass transaction orexchange, which is that first criteria forhim 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 toask the customer to pay us a $100, 000.And, so this first criteria, acquired in apast transaction or exchange, is there toraise our assurance that something thatwe want to call an asset is a legitimateresource that should deliver futurebenefits, as opposed to a simple promisethat could easily be broken, as mightbe the case if there's a contract thatwas signed with no accompanyingexchange of cash, goods or services.B.O.C. buys $100,000 of chemicalsto be used as raw materials.B.O.C. pays in cash atthe time of delivery andreceives a 2% discounton the purchase price.This is an asset andwe'll call this Asset Inventory.Inventory is a term that weare going to use for any product orraw materials that we buy,that we're going toturn into a finished product thatwe're going to sell at a markup.It meets both criteria.We acquired the chemicalsin a market transaction.And the value of the benefits is knownhere because it's what we paid inthe market transaction.And note that the value here is 98,000not 100,000 because we value itat what we actually paid forit, not some kind ofhigher sticker price that wasn't whatthe transactions actually happened at.BOC pays 12 million forthe 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 becausein a market transaction, we paid forthe right to occupy space in thisoffice 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 valueof the benefits is only 11 million.Not the 12 million that we've paid.Because we've already occupied it fora month we've used up onemonth of the future benefits.So at this point in time, there'sonly $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, becausethe land is probably worth $150,000.This is an asset which we'll call Land.Meets the first criteria because therewas a market transaction where weacquired ownership.The value of the benefits are assumed tobe what we paid for it, which is $100,000.Now note, we ignore the last sentenceabout what the broker thinks the land isworth because that's not what we paid forit in a market transaction.And so we're not going to use thatas the value of the benefits.We're going to use the more objectivenumber 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 firmthat its brand name is worth $63 million.This would not be an asset, because wenever acquired it in a past transaction orexchange, and you can argue that the valueof the brand cannot be measured witha reasonable degree of precision, soit doesn't really meet either criteria.>> Are you saying that marketing peopledo not know what they are talking about?>> No, no, no.I definitely respect marketing people.Some of my best friendsare marketing professors.It's simply a case whereaccounts have decided to err onthe side of reliability or objectivity.Without a market transaction wherethe company has acquired the brand,we can't be sure of how much it's worth.And so we err on the side of leavingit off the financial statements.For this reason, you often see the valueof the company in the stock market tobe greater than the value onthe financial statements,because investors would considerthis to be an economic asset,whereas the accounting system is going toignore this asset as not reliable enough.Now, we're going to turn to liabilities.A liability is a claim on assetsby creditors or non-owners, thatrepresent an obligation to make futurepayment of cash, goods, or services.>> My former boss called mea liability to the organization.Is this what he meant?>> No, you're probablya liability in a different sense.Let's go on.Just like assets, there are two criteriafor when we recognize a liability.First the obligation is based on benefitsor services received currently orin the past and second the amount andtiming of payment is reasonably certain.And even though the words are different,these are essentially the sametwo criterias for the assets.The first one says there has tobe some kind of transaction orexchange where you've received somethingthat creates an obligation andthe second criteria says you can measurethe amount of what the obligation is.So for an example, let's say we borrowmoney from a bank, we have an obligationto repay the bank based on receivingthe benefit of getting the money now.The amount and the timing of the paymentis reasonably certain, and if there wasany question, I'm sure the bank couldclarify how much we exactly owe them.So, borrowing money from a backwould meet both criteria.And it would be a liability calledsomething like notes payable ormortgage payable.We're going to do the sameexercise now with liabilities.I'll give you a number of items.I'll give you chance with the pause signto try to answer them if you'd like andthen we'll talk about what the answer is.First item, BOC receives $300,000 ofraw materials from a supplier andpromises to pay within 60 days.This will be a liability.We're going to call thisliability accounts payable.We use that term anytimewe owe money to a supplier.It meets the first criteria because wegot the benefit of raw materials ina transaction, which now createsthe obligation to pay our supplier andthe amount of the obligationis reasonably certain.It's the $300,000 which is on the invoice.So we're going to have an accountspayable liability for $300,000.Based on this quarter's operations,BOC estimates that it owesthe IRS $3 million in taxes.This will be a liability, we'll callthis liability Income Tax Payable.So a little bit hard to seethe first criteria here,because there was no explicit transaction.But essentially what happened is,the government allowed us to operate ourbusiness so that, so we got the benefitof being able to operate our business inthis country, and in return it createdan obligation to pay them taxes.Based on the right tooperate the business.We have to then estimate the amount of theliability even though when we don't knowexactly what the taxes are at this point,we can estimate them with recent knowablecertainty, we come up with $3 million as our estimate, sowe would have a liability calledincome tax payable for $3 million.>> You said that the amount andtiming of payment has to be reasonablycertain for there to be a liability.Why is an estimated amountconsidered to be reasonably certain?>> We're going to have to makea lot of estimates in accounting.As long as we're reasonably certainabout the number, we should go ahead andbook the liability.For something like taxes,there are tax forms available on the web.We have a rough idea of how much taxableincome will be during the period,and sowe can estimate what our tax liability is.Now, it may not be 100% correctwhen we eventually file the form.But whatever our best estimate is,is a much better estimatethan ignoring it completely.So, we go ahead and put our bestestimate 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 andit's not a liability because we have,there's no obligation based on benefitsthat have been received currently orin the past which is the first criteria.Until Dakota actually works forus, and works forus without getting paid,there cannot be a liability.And even then the liabilitywould only be forthe time that he orshe has worked without pay.We wouldn't book a liability forthe entire three year contractbecause we haven't received.The, benefits for that yet.Plus, there's too much uncertainty withthat because Dakota could quit tomorrow,we could fire Dakota, our lawyers, his orher lawyers could finda way out of the contract.There's too much uncertainty over thedollar amount for the three year contract.So we only are going torecord a liability forthe amount of time the Dakota's worked forus.Since he or she hasn't worked forus yet, there would be no liability.BOC has not yetpaid employees who earned salaries of $1million during the most recent pay period.This would be a liability which we'regoing to call salaries payable.It does meet the first criteriabecause there's an obligation based onthe benefits we've, we've received.The employees have worked for us, we'vegotten the benefit of their services, andnow we have an obligation to pay them forthose services.The amount we owe is reasonably certain,and again, if there were any questions,the employees would surely letus know how much we owe them.So we'd have an obligationbased on past benefits for$1 million, and we'd book a liabilitycalled 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 onepertains to an executive,whilst the second onepertains 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 onbenefits or services received in the past.Employees that have worked for us withoutbeing paid, creates a liability for us.Employees that have not yet worked forus, cannot create a liability.BOC borrows $500,000from a bank on a one-yearnote with a 10% interest rate.We so,I talked about this example earlier.This would be a liability called notespayable, meets the first criteria becausewe have an obligation based on receivingthe benefit of the $500,000 from the bank.The amount that we owe is reasonable cert,that's $500,000 soit meets the second criteria.So we have the liability callednotes payable for $500,000.>> What about the interest,we will owe the interest on the loan.Shouldn't there bean interest payable as well?>> Great question,interest is not a liability atthis point because we justtook out the loan, andwe can presumably pay a back ratenow without owing any interest.Interest only becomes a liability asthe money is outstanding over time.And to the extent that we haven't paid it,the amount of interest that we owe buthaven't paid becomes a liability.Finally, BOC is sued by a group ofcustomers who claim their productswere 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 basedon a benefit received in the past.The benefit was we sold productswhich turned out to be defective.Doesn't meet the second criteria though,because we can claim that the amountof the payment is still uncertain.Until we have a settlement orwe got to trial we don't knowthat we have to pay anything, sobecause of that uncertainty, we don'thave to record a liability in this case.Finally, we have stockholders' equity.Stockholders equity is the residualclaim on assets after settling claimsof 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 orliabilities, there are not two criteriafor how to measure stockholders' equity.Because if you measure all your assetscorrectly and you measure all of yourliabilities correctly then stockholders'equity is whatever is left over.But there are two sourcesof stockholders' equity.The first source is what wecall contributed capital,which arises from sellingshares of stock to the public.So we'll talk about common stock andadditional paid in capital.That's what you record when youissue new shares to the public.Common stock is for the par value,additional paid-in-capital if foreverything you receiveabove the par value.And then treasury stock is what we call itwhen the company re-purchasesit's own stock from investors.>> Wait,what is this thing called par value?Is this why there are so many accountanton the golf course during the day.>> I'm not sure why you're seeing somany accountants on the golf course, butit has nothing to do with par value.Par value is this archaichistorical concept.There used to be laws which said thatcompanies couldn't issue new equity ifthe value of their stockwas below the par value.Where they couldn't pay dividends ifthe value was below the par value.Most of those laws are gone now.And, par value's main implication isthat when we issue equity, we putthe par value amount of the proceedsinto an account called common stock.We put the rest intoadditional paid in capital.You'll see this more in subsequent videos.The other source Stockholder's Equityis Retained earnings whicharise from operating the business.Retained earnings is the cumulation ofmain income which is revenues minusexpenses less any dividends that have beenpaid out since the start of the business.So what are dividends?Dividends are distributions ofretained earnings to shareholders.They're not considered an expense andwe record them as a reduction ofretained earnings on the datethe 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 willcreate a liability to our shareholders,until we actually paythe 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 consideredan expense because they'renot considered a costof generating revenue.Instead dividends are a discretionarydecision by the board ofdirectors to return some funds back toshareholders that's presumably somewhatindependent of the company'sperformance or sales during the period.Second, we created dividends payable,because once the boarddeclares a dividend, it's essentiallyholding the shareholders' money until itsends the check, making the shareholderscreditors of the company.Now, I admit that this one seems weird,because usually liabilities are fornon-owners, where as here wehave a liability to our owners.But we consider them creditorsin this one specific case.Best thing at this pointis just to memorize it.Dividends are not an expense andwhen the board declares butdoesnt' pay a dividend,we create a dividend payable liability.And that wraps up our discussionsof assets, liabilities, andstockholders' equity.Now we have to figure outhow to keep track of them.Well the good news is in the next video,we'll talk about those magicalthings called debits andcredits which will help us keep track ofeverything in the financial statements.I'll see you then.>> See you next video.