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2.4 Four Essential Terms Encountered in Financial Accounting
At the end of this section, students should be able to meet the following objectives:
- Define “asset” and provide examples found in financial reporting.
- Define “liability” and provide examples found in financial reporting.
- Define “revenue” and provide examples found in financial reporting.
- Define “expense” and provide examples found in financial reporting.
Assets, Liabilities, Revenues, and Expenses
Question: Attaining a thorough understanding of financial accounting and its underlying standards is a worthwhile endeavor especially if a person hopes to become successful at making decisions about businesses or other organizations. Where should the journey to gain knowledge of financial accounting and its principles begin?
Answer: The study of a language usually starts with basic terminology. That is also an appropriate point of entry for an exploration into financial accounting. Consequently, four fundamental terms are introduced here in this section. Knowledge of these words is essential in gaining an understanding of accounting because they serve as the foundation for a significant portion of the financial information provided by any organization.
To illustrate, when examining the financial statements presented by Sears (formally known as Sears Holdings Corporation) for January 29, 2011, and the year then ended, four monetary balances immediately stand out because of their enormous size. On this date, the corporation reported $24.3 billion in assetsProbable future economic benefits owned or controlled by an organization. along with $15.6 billion in liabilitiesProbable future sacrifices of economic benefits arising from present obligations; the debts of an organization.. During that year, Sears generated revenuesMeasures of the increases in or inflows of net assets (assets minus liabilities) resulting from the sale of goods and services. of $43.3 billion and incurred expensesMeasures of decreases in or outflows of net assets (assets minus liabilities) incurred in connection with the generation of revenues. of $43.2 billion.
There are thousands of words and concepts found in accounting. No terms are more crucial to a comprehensive understanding of the reporting process than these four. Almost all discussions concerning financial information, whether practical or theoretical, come back to one or more of these words.
Definition of the Term “Asset”
Question: The first essential term presented here is “asset.” Is an asset a complicated accounting concept? What general information is conveyed to a decision maker by the term “asset”?
Answer: Simply put, an asset is a probable future economic benefit that an organization either owns or controls.This is one of the opening chapters in an introductory financial accounting textbook. Definitions are somewhat simplified here so that they will be more understandable to students who are just beginning their exploration of accounting. Many terms and definitions will be expanded in later chapters of this textbook or in upper-level financial accounting courses. On January 29, 2011, Sears reported holding over $24.3 billion of these economic benefits. If a customer walks into one of the company’s retail stores, many of these assets are easy to spot. The building itself may well be owned by Sears and certainly provides a probable future economic benefit by allowing the company to display merchandise and make sales. Other visible assets are likely to include cash registers, the cash held in those machines, available merchandise from jewelry to car tires to children’s clothing (usually referred to as inventoryA current asset bought or manufactured for the purpose of selling in order to generate revenue. in financial accounting), shopping carts, delivery trucks, and the shelves and display cases. Each of those assets is acquired with the hope that it will help Sears prosper in the future.
Examples of Typical Assets
Question: All decision makers who evaluate the financial health and future prospects of an organization should be interested in learning about its assets because those balances reflect the economic resources held at the present time. This is valuable information. What are some of the largest asset balances that a business like Sears is likely to report?
Answer: Every business has its own particular mix of assets. Virtually all have cash and accounts receivable (money due from customers). Many also have inventory (merchandise held for resale). The size and type of other assets will vary significantly based on the company and the industry in which it operates.
However, as a result of financial reporting and the existence of the Internet, such information is readily available to anyone wanting to learn about virtually any business. The assets are reported in the financial statements. As of January 29, 2011, the following four assets were reported by Sears as having the highest dollar amounts. Each of these asset categories will be discussed in detail later in this textbook.
|Merchandise inventories||$9.1 billion|
|Buildings and improvements||$6.3 billion|
|Trade names and other intangible assets||$3.1 billion|
|Furniture, fixtures, and equipment||$2.9 billion|
Alice Roanoke has decided to start an Internet business to provide expert financial advice to customers who sign up and pay a monthly fee. She hires Matt Showalter, a renowned expert in setting up investment strategies. She rents a building, paying for the next two years in advance. She also buys several large computers and a small library of books on investing and providing financial advice. Which of the following is not an asset to her new company?
- Having Showalter as an employee
- Owning the investment books
- Paying the rent on the building for the subsequent two-year period
- Acquiring the computers
The correct answer is choice a: Having Showalter as an employee.
An asset is a future economic benefit that an organization owns or controls. A person cannot be owned or controlled and therefore is not deemed an asset for reporting purposes regardless of how smart or helpful the person is. Showalter could quit tomorrow. Company officials cannot force him to work for them; slavery was outlawed approximately 150 years ago. The books, the building, and the computers all have future economic benefit, and the company does have ownership or control.
Definition of the Term “Liability”
Question: As of January 29, 2011, Sears also reports owing more than $15.6 billion in liabilities. Does this figure reflect the total amount that the reporting company will eventually have to pay to outside parties? What does the balance reported as liabilities represent?
Answer: A more formal definition of a liability is that it is a probable future sacrifice of economic benefits arising from present obligations, but, for coverage here at the introductory level, liabilities can be viewed as the debts of the organization.
The $15.6 billion liability total disclosed by Sears most likely includes (1) amounts owed to the vendors who supply merchandise to the company’s stores, (2) notes due to banks as a result of loans, (3) income tax obligations, and (4) balances to be paid to employees, utility companies, advertising agencies, and the like. The amount of such liabilities owed by many businesses can be staggering. Walmart, for example, disclosed approximately $109 billion in liabilities as of January 31, 2011. Even that amount pales in comparison to the $627 billion liability total reported by General Electric at the end of 2010. To ensure that a fairly presented portrait is shown to decision makers, businesses such as Sears, Walmart, and General Electric must make certain that the reported data contain no material misstatements. Thus, all the information that is provided about liabilities should be based on the rules and principles to be found in U.S. GAAP.
Another term that is often encountered in financial reporting is “net assets.” The net asset total for an organization is simply its assets (future benefits) less its liabilities (debts). This balance is also known as “equity” in reference to the owners’ rights to all assets in excess of the amount owed on liabilities. A business’s net assets will increase if assets go up or if liabilities decrease. Changes in net assets show growth (or shrinkage) in the size of the organization over time. For example, IBM reported net assets of $22.7 billion at the end of 2009 (assets of $109.0 billion and liabilities of $86.3 billion). That number had risen to $23.2 billion by the end of 2010 (assets of $113.5 billion and liabilities of $90.3 billion). The ability of this business to increase its net assets by $500 million ($33.2 billion less $32.7 billion) during 2010 is certainly of interest to every decision maker analyzing the financial health and future prospects of IBM.
The Jackson Corporation is a women’s clothing store located in Upper Lakeview. On Friday, the company’s accountant is looking at four recent events so that the amount of liabilities can be reported as of the end of this week. Which of the following is not a liability for reporting purposes?
- A new sales person was hired this morning, will begin work on the following Monday, and will be paid $600 per week.
- Twenty dresses were received three days ago at a cost of $80 each, but they will not be sold until next week and payment will be made then.
- The cost of renting the company’s sales room is $1,300 per week, but the amount for this week will not be paid until next week.
- The company borrowed $900,000 to build a new store, but construction will not start until next week.
The correct answer is choice a: A new sales person was hired this morning, will begin work on the following Monday, and will be paid $600 per week.
With the dresses, the rent, and the loan, an event has already occurred that created an obligation. The dresses have been received, the room has been used, and money from the loan has been collected. In each case, the company has a debt. The new employee has not yet begun the job, so no debt has accrued. A commitment has been made to pay this person, but only if work is done. At that time, as the sales person works, the company does begin to have a debt (or liability) that must be reported.
Definition of the Term “Revenue”
Question: In financial accounting, a business or other organization reports its assets, which are probable future economic benefits, such as buildings, equipment, and cash. Liabilities (debts) are also included in the financial information being disclosed. Both of these terms seem relatively straightforward. The third essential term to be discussed at this time—revenue—is one that initially appears to be a bit less clear. Sears reported that its stores generated revenues of $43.3 billion in 2010 alone. What does that tell a decision maker about Sears? What information is conveyed by the reporting of a revenue balance?
Answer: “Revenue” is a measure of the financial impact on an organization that results from a particular process. This process is a sale. A customer enters a Sears store at the local mall and pays $100 to purchase several items, such as hammers, shirts, socks, and scarves. Sears receives an asset—possibly $100 in cash. This asset inflow into the business results from a sale and is called revenue. Revenue is not an asset; it is a measure of the increase in net assets created by the sale of inventory and services. Thus, for The Coca-Cola Company, revenues are derived (net assets are increased) from the sale of soft drinks. For The Hershey Company, revenues come from sales of chocolate whereas The Walt Disney Company generates revenue by selling admission to its amusement parks and movies.
For timing purposes, as will be discussed in a later chapter, revenue is recognized when the earning process takes place. That is normally when the goods or services are delivered. Therefore, throughout each day of the year, Sears makes sales to customers and accepts cash, checks, or credit card payments. The reported revenue figure is merely a total of all sales made during the period, clearly relevant information to any decision maker attempting to determine the financial prospects of this company. During 2010, the multitude of Sears stores located both inside and outside the United States sold inventory and services and received $43.3 billion in assets in exchange. That is the information communicated by the reported revenue balance. To reiterate, this figure is not exact, precise, accurate, or correct. However, according to Sears, $43.3 billion is a fairly presented total determined according to the rules of U.S. GAAP so that it contains no material misstatement. Any outside party analyzing Sears should be able to rely on this number with confidence in making possible finanical decisions about this business as a whole.
The Rowe Company is a restaurant in a remote area of Tennessee. The owner buys a steak from a local farmer for $7. The chef is paid $2 to cook this meat. A waitress is paid $1 to deliver the steak to a customer. The customer is charged $18, which is paid in cash. The customer leaves a tip for the waitress of $3. According to U.S. GAAP, what amount of revenue should the Rowe Company report in connection with this series of events?
The correct answer is choice d: $18.
The term “revenue” refers to the increase in net assets brought into an organization as a result of a sale. There is a lot of interesting and relevant information here. However, only the payment made by the customer to the business is reported as revenue because that is the increase in net assets brought into the company by the sale.
The McCutcheon Company is a restaurant in a remote area of Montana. The owner buys a steak from a local farmer for $7. On Tuesday, the chef is paid $2 to cook this meat. A waitress is paid $1 to deliver the steak to a customer. The customer is charged $18. The customer does not have any money with him and tells the owner that he will pay the amount in the following week. The owner knows the customer and allows the payment to be delayed. According to U.S. GAAP, what amount of revenue should the McCutcheon Company report on Tuesday when the sale is made?
The correct answer is choice d: $18.
The term “revenue” refers to the increase in net assets as a result of the sale of a good or service. Here, the business received a promise to pay that is viewed as an asset because it has future economic benefit. Although no cash was collected, the business did gain an $18 asset (a receivable) as a result of the sale. Revenue was $18. Some very small organizations use cash systems that only recognize revenues when cash is received, but they are not reporting according to the rules of U.S. GAAP.
Definition of the Term “Expense”
Question: That leaves “expense” as the last of the four essential accounting terms introduced at this point. Sears reported $43.2 billion in total expenses during 2010. This figure apparently is important information that helps paint a proper portrait of the company, a portrait that can be used by decision makers. What is an expense?
Answer: An expense is an outflow or reduction in net assetsAn expense often causes an immediate reduction in assets, especially if cash is paid. Frequently, though, an expense creates an increase in liabilities instead of a reduction in assets. That happens if the cost is incurred but payment is delayed until a later date. In either case—the reduction of an asset or the creation of a liability—the amount of net assets held by the organization decreases as a result of the expense. that was incurred by an organization in hopes of generating revenue. To illustrate, assume that—at the end of a week—a local business pays its employees $12,000 for the work performed during the previous few days. A $12,000 salary expense must be reported. Cash (an asset) was reduced by that amount, and this cost was incurred because the company employed those individuals to help generate revenues. That is an expense. The same general logic can be applied in recording insurance expense, rent expense, advertising expense, utility expense (such as for electricity and water), and many other similar costs. For each, net assets are reduced (assets go down or liabilities go up) to help create sales.
In some ways, expenses are the opposite of revenues that measure the inflows or increases in net assets that are created by sales. Expense figures reflect outflows or decreases in net assets incurred in hopes of generating revenues.
The Hathaway Corporation started business on January 1, Year One, as a restaurant in Toledo, Ohio. During Year One, the company paid $10,000 each month to rent a building to serve as its kitchen and dining room. Because operations were so successful, on the final day of Year One, the company paid $150,000 to buy a new building for the restaurant. The company hopes to move over the New Year’s Day holiday from the old rental facility to the newly acquired one. In connection with these events, how much should Hathaway report as its total expenses for Year One?
The correct answer is choice b: $120,000.
The company’s net assets decreased by $10,000 per month as a result of renting the first space. The benefit from that rental has passed because the restaurant was used at that time to generate revenue. That is an expense. In contrast, the new building is an asset. In acquiring the building, one asset (cash) was exchanged for another (building). Net assets did not change; one asset went up and one went down. Thus, no expense resulted. The expense for Year One is $120,000 in rent.
Four Essential Terms Encountered in Financial Accounting
Question: To reiterate, four terms are basic to an understanding of financial accounting. Almost any coverage of accounting starts with these four. What is the meaning of asset, liability, revenue, and expense?
- Asset. A probable future economic benefit owned or controlled by the reporting company, such as inventory, land, or equipment.
- Liability. A probable future economic sacrifice or, in simple terms, a debt.
- Revenue. A measure of the inflow or increase in net assets generated by the sales made by a business. It is a reflection of the amounts brought in by the sales process during a specified period of time.
- Expense. A measure of the outflow or reduction in net assets caused by a business’s attempt to generate revenue and includes many common costs, such as rent expense, salary expense, and insurance expense.
A strong knowledge of basic accounting terminology is essential for successful communication to take place in the reporting of financial information. Four terms provide a foundational core around which much of the accounting process is constructed. Assets are probable future economic benefits owned or controlled by an organization. Assets typically include cash, inventory, land, buildings, and equipment. Liabilities are the debts of the reporting entity, such as salary payable, rent payable, and notes payable. Revenue figures indicate the increase in a company’s net assets (its assets minus its liabilities) created by the sale of goods or services. Revenues are the lifeblood of any organization. Without the inflow of cash or receivables that comes from generating sales, a business cannot exist for long. Expenses are decreases in net assets that are incurred in hopes of generating revenues. Expenses incurred by most companies run a full gamut from rent and salary to insurance and electricity.
Talking with a Real Investing Pro (Continued)
Following is a continuation of our interview with Kevin G. Burns.
Question: Financial accountants tend to place a heavy emphasis on the importance of generally accepted accounting principles (U.S. GAAP) to the world of business. After nearly three decades as an investment advisor, what is your opinion of the relevance of U.S. GAAP?
Kevin Burns: Before the accounting scandals of the late 1990s—such as Enron and WorldCom—financial information that adhered to U.S. GAAP was trusted worldwide. Investors around the globe took comfort in a standard that had such a great reputation for integrity. In the 1990s, though, I felt that U.S. GAAP become somewhat muddied because investors wanted to depend too heavily on one or two figures rather than judging the company as a whole. In the last several years, FASB has moved back to stressing clearer transparency for reported information. That objective enables investors to better see and understand the organization standing behind those statements. That is very important in order to maintain investor confidence.
As for the current state of the U.S. GAAP, it is certainly superior to the majority of the world’s standards. Unfortunately, it is getting more complicated every year, which is not always a good goal.
Question: Your answer is quite interesting because of the push in recent years toward International Financial Reporting Standards as a single global set of standards for all businesses. Some people love the idea of the same accounting rules for everyone. Others hate the idea that IFRS could replace U.S. GAAP. What is your feeling?
KB: For an investor, that is a very interesting question. Given that we truly are a global economy I would love a worldwide standard but only if it was equal to or more transparent than the current U.S. standards. As an investment advisor, I would love to be able to compare business valuations here and in China (for example) side by side and have confidence that I am truly comparing apples to apples.
Question: When you begin to study the financial data reported by a company that you are analyzing as an investment possibility, which do you look at first: revenues, expenses, assets, or liabilities?
KB: For me, assets have always been the most important determination in the investments that I have chosen. However, that is because I have always been strictly a value investor. There are many different styles of investing. Value investors look at the value of a company’s assets and then look for bargains based on current stock market prices. In comparison, growth investors look at earnings momentum and don’t care too much about asset values. They like to see a consistent rise in profitability each year. Over the years, being a value investor has worked well for my clients and me.
Professor Joe Hoyle talks about the five most important points in Chapter 2 "What Should Decision Makers Know in Order to Make Good Decisions about an Organization?".