In this video, we're going to go into more depth with regard to the balance sheet. What are assets? What are liabilities, and what are stockholders' equity accounts? What goes on the balance sheet? What doesn't? How do we value them? Remember, the balance sheet equation is a snapshot at a point in time. Assets are the resources, liabilities are claims on the resources held by outside parties, creditors, and stockholders' equity are the claims on the resources not claimed by anybody else. The balance sheet equation, assets equals liabilities plus owner's equity, a very important part of what goes on in accounting, but what's an asset? How do we value it? What's a liability? How do we value it? Et cetera. So, some issues that we're going to run into is, what goes on the balance sheet and what doesn't? If something is going to go on the balance sheet, how do we value it? Everything on the balance sheet is expressed in monetary terms, so we have to express it in terms of dollars if it's a US company. What number do we put on the balance sheet when we put an asset, say, on the books? Do we leave it there forever or how do we adjust it over time, and when do we take it off? In terms of valuation, we'll see that there are two common ways that financial statements value things. One is referred to as the historical cost. The historical cost is essentially, what did it cost you to acquire the asset? The good thing about historical cost is, it's easy to figure out what it is, it's objective. The bad thing is, it can get out of date and it can get out of date quickly if markets are volatile. An alternative is something called fair value. You might hear the term mark to market accounting here. Here, the issue is, what's the asset worth today? This is potentially a much more relevant piece of information but it's a much more subjective, too. So, as we'll see, some types of assets are valued with one, sometimes the other. There's a relevance reliability trade-off that we're going to make. Now, what is an asset? An asset is a resource that's expected to provide future economic benefits, generate a future cash inflow or save a future cash outflow. A key word here is future. Assets are a forward-looking concept. We often think about accounting as being backwards but the very first definition has a forward-looking aspect to it, okay? Assets have future benefits. Now, there's lots of things that have future benefits that still don't actually show up on balance sheets. So, accounting rules provide some constraints on what you can show. One constraint is, it has to be acquired as a result of a past transaction or an exchange. In addition, the value has got to be reasonably precisely measurable. So, let's take a couple of examples. Coca-Cola, what's its most valuable asset? Well, probably, it's its brand. But if you look on Coca-Cola's balance sheet, you don't see a line item that says brand value. And the reason is, Coca-Cola didn't acquire it in a past transaction or exchange. In some sense, it developed it over time as a result of every exchange it had with customers over time. And it's a hard thing to measure. So it doesn't show up on the balance sheet. If on the other hand, Pepsi bought Coca-Cola and kept the Coca-Cola brand, there actually would be an exchange that would show up and they could show the asset on the balance sheet. So, internally developed assets might show up on the balance sheet differently than externally acquired ones. Another thing that you'll often hear companies say, "Our most valuable asset is our people." But you're never going to see people as a line item on a balance sheet as well. So accounting tends to be better at bricks-and-mortar type assets than more intangible type assets. Types of assets that you'll see. Some are financial, some are physical like property, plant, equipment, and inventory. Often with financial assets, we mark them to market, but physical assets, we keep at historical cost. So not all assets are shown in the same way. This means, when we add up assets, we're not necessarily adding up apples to apples. You want to be careful about that. When intangible assets are shown on the balance sheet, they're usually shown at historical cost. Intangible assets include things like patents or other kinds of contractual assets, things like brand name, if you've acquired them from another company, or something called good will which only shows up as part of an acquisition as well. As I mentioned, accounting rules tend to be reluctant to recognize internally developed intangible assets. R&D costs aren't viewed as assets. They're viewed as expenses. Advertising, expense as well. IFRS rules tend to be more likely to be willing to recognize some of these softer assets. And so, this is going to be a big difference between US rules and international rules. So, here's some examples. Do these show up on balance sheets as assets? Cash, well, obviously, and cash is an easy one to measure. Receivables, also an asset, but not as easy to measure. We know how much people owe us, but the benefit is, how much are they going to pay us? So, we're going to have to estimate how much of our receivables are going to be collected here. Customers' promises to buy products from us in the future. That's not an asset because there's no exchange that's happened. It might be useful to know. The stock market might react to it, okay? But you can't put it on your books. Prepaid insurance, well, that would be an asset because you're saving having to pay the premiums in the future. Inventory, clearly an asset. Brand name, well, as we said, it depends. If you've acquired it from somebody else, it's on your balance sheet. If you've developed it yourself, not. Discovering a new medicine, well, that could be a tremendously important activity but it's not going to be on the balance sheet because the benefits of it are going to be to imprecisely determinable. A competitor goes bankrupt, you can't call that an asset even though it's might be something is good for your company. Hire a new CEO, not an asset. You don't own the CEO, and until they've actually provided some employment services or you've paid them something, nothing's going to get recorded. Now, let's shift to liabilities. Liabilities are a claim on the assets by an outside party, a creditor. Usually, we're going to pay the liability holder in cash but not always. Sometimes, we're going to provide goods and services to the liability holder instead. Similar to assets, not all liabilities are going to show up on the balance sheet. We only do it if it's a result of a past transaction or exchange and we can reasonably precisely estimate what the liability is. So, a good example of something that's not going to show up on a balance sheet would be something like lawsuit exposure. When it's early in the process, whether we're going to lose or not and how much we're going to lose is very difficult to determine, plus our lawyers are not going to really want us to put something on the balance sheet as a liability in case it's viewed as an admission of guilt. If a liability is way in the future, we're going to take what's called the present value of the cash flows as opposed to the actual cash flow itself. So, some examples. Accounts payable, it's a liability. It's an amount that we owe to somebody. A new customer signs a contract to buy a product in the future, well just like we can't record an asset for the money we're going to get from this customer yet, we also don't have to record a liability as an obligation to provide the product yet because they haven't paid us anything. Signing a contract is not enough. How about if we get a payment? Well, now we have a liability. Now, we've got an obligation to either pay the money back or provide the actual product or the service. Long term debt, a contractual requirement. So, that's going to be a liability. Product warranties, a tougher one to estimate because you've got to estimate how many of our products are going to break down and what is it going to cost us to fix them but still, it's a liability. Penchants, often a big liability for many companies far out into the future, but still, we have to estimate what the cost is going to be. A lawsuit filed against the company, probably not. Simply filing is not going to be enough to require us to put down a liability. But at some point in the process, if it looks bad, then we are going to have to put a liability down. Stockholders' equity is the last category. This is all of the claims on the assets not held by somebody else. Different types of stockholders' equity accounts. The first type is, money that shareholders actually put into the firm when we sell them shares. We call this contributed capital. In the US, you'll see the terms common stock and additional paid in capital. IFRS accounting, you're going to see something called share capital and share premium. Another thing that's going to happen is, profits that we've made for investors get reinvested in the firm on their behalf. We call this retained earnings. This is where the balance sheet links to the income statement. The retained earnings account at the end of the year is the beginning balance plus this year's income, minus whatever amount of this year's income wasn't retained, namely paid out in the form of a dividend. And then the last big category you'll see within shareholders equity is something called treasury stock. This is actually a subtraction from stockholders equity and this is recorded when a company buys back its own shares. So, when they issue shares, stockholders equity goes up. When they buy back shares, it's going to go back down. Assets are fairly intuitive. The distinction between liabilities and owner's equity is less intuitive. This is referred to as the capital structure of the company. How have the assets been financed? How much debt versus equity does a company have? Debt and equity are both important but it's important to understand how they're different, and they're different in a number of different ways. First, it's contractual. Payments the debt holders usually contractually specified how much interest and principal you have to pay and when, whereas equity holders are more hoping to get something, dividends and capital gains. Typically, equity holders get to vote, whereas debt holders don't. Debt holders also get paid first but their return is capped. Equity holders get paid last but their return is uncapped, unlimited. Anything that the firm makes over and above what the debt holders are owed, the equity holders get. You also see differences on the financial statements themselves. Interest is subtracted in the calculation of income, dividends aren't. Interest is tax deductible, dividends aren't. So, in fact, dividends are taxed twice. When a firm makes income, the firm gets taxed, and when they pay out the income to shareholders as a dividend, the shareholders get taxed. So there's advantages to issuing debt versus equity at least from a tax perspective. Leverage is an important concept in accounting. Leverage is the relative amount of debt and equity you have in the capital structure. The more debt you have, the riskier a firm is viewed to be because you've got all these payments that you need to make in order to stay alive. How we value things and what shows up on the balance sheet are important parts of the accounting process, and understanding what's on and what's not is very useful. Not all assets are valued the same way. Yet, we add them up. It's important to understand that that sum doesn't necessarily represent the real value of all those assets, and if assets equals liabilities plus owners equity, if the assets aren't valued correctly, neither is the owner's equity as well. This doesn't mean accounting is useless. It just means you have to be careful about how you're going to operate with the numbers.
