accounting 101, accounting overview, basics, and best practices
What. Is accounting, and why, does accounting exist those. Are the two questions of the ages I'm sure you've thought about them for years. Let's, find out what accounting, is and why it exists. First. Exactly. How old is, accounting, well let me tell you it's old. Clay. Tokens have been found in Mesopotamia, dating. Back to 7,000, years ago that are a primitive, form, of accounting, it was simple, a farmer, would say alright let's get some clay tokens to represent how many sheep I have and how much wheat I have and how many goats I have and a big black stone to represent a cow or whatever and, we can keep track of our inventory. Of farm, produce were, these simple tokens and. We can compare what we got this year to what we had last year so we can start to make some simple decisions, and some comparisons, then. Somebody. Came up with the idea rather than have these little rocks and stones to start making notations. On clay tablets or, with chalk on a wall is bookkeeping, the, earliest form of writing I think so, how, crucial, is accounting, accounting we, see here underlies, all of modern civilization. So. What exactly is accounting. Well. First its quantitative, you know this it's numbers, I love, numbers and so do you accounting. Is all about numbers. Second. Accounting, is financial. In nature that means money. Numbers. About, money our two, favorite, things right here they're in accounting, third. Accounting, is meant to be useful, now there's a whole field, of study in accounting, theory and in, another day in another place we could talk about accounting theory but really the fundamental. Purpose of accounting is to be useful it's a very practical field. Of study. Useful. For what that's the fourth aspect of accounting useful, in making decisions, accounting. Helps, you use the past right, now in the present to change the future. Accounting. Is quantitative. Numbers. About, money to, help people you, and me make, better decisions. That's accounting. There. Are four kinds of accounting, or I'll call them flavors, of accounting, first, the most fundamental. Type of accounting is bookkeeping just, the routine, gathering, of the information, making sure that everything, gets recorded because if it doesn't get recorded we'll never know about it so bookkeeping, gathering, the information systematically. The. Second flavor of accounting, is called financial, accounting, this, is reporting. To, people outside your organization, summary. Reports not the details it's not people who are there every day but, it's people who want to know how you're doing so, give them a report of what. Economic. Resources. You have did, you make money last year did you lose money last year just summary, reports, to people outside who might be thinking of loaning you money or might, be thinking of investing in your company that's, called financial, accounting, reporting. To outsiders, the. Third flavor of accounting, is managerial. Accounting, those, are the detailed, secret. Data that, individuals, use inside, their organizations. To make decisions. Detailed. Decisions, should. I raise my prices should I stop selling shirts and start selling shoes instead, should, I build my factory in Wyoming, or should I build it in Alabama, those, detailed, decisions, that business people and people, running organizations make, every, day and this is stuff that just they know they don't reveal this to outsiders it's secret information, that's called managerial, accounting, and finally. The fourth kind of accounting that some of you have an uncomfortable, relationship with, is income. Taxes, the, accounting, that makes sure that you are in compliance with the law and that is the fourth flavor of accounting, bookkeeping. Financial. Accounting, managerial. Accounting and income. Taxes, those are the four flavors. Of accounting. Let's, start with bookkeeping all, accounting, begins with bookkeeping you've, got to get the information down, and then, you can start to organize it to make better decisions, so bookkeeping, is where it all begins, let's. Do a thought experiment, let's. Invent, in our minds a catastrophy, movie the catastrophe movie is this a space. Virus comes, infects. Earth and destroys.
All Novels, that have ever been written Tom, Sawyer gone, gone. With the wind is Gone with the Wind they're all gone, could. You then function, the next morning knowing, that all novels, had disappeared overnight, well, you'd feel horrible. A tragic, cultural, loss but. If you went to the bank to get some cash out okay, fine you've got some cash here if you went to the store to shop everything's working, fine there, everything. Is working perfectly, everyone's, feeling sad because of the cultural loss but society, could continue, to function even, if all novels, ever written disappeared. Overnight all. Right let's roll back the tape and do another thought experiment let's imagine that a space virus comes and destroys all, bookkeeping. Records on earth overnight, everything all, bank. Records, all records, that all companies have of, the inventory, that they have on the shelves of their stores all. Dry-cleaning. Records, everything, all those records, are gone, could. We continue to function as a society, go to the bank and say I would like to withdraw $100. The bank would then tell you well we don't have any records, we don't know whether you've got any money here or not so we're sorry go. To the dry cleaners to pick up your dry cleaning they'll, say well we've. Got a bunch of clothes in the back there and a big pile but we don't have any records on what belongs to whom. Society, would cease to exist, societal, gridlock, we wouldn't be able to do anything his, bookkeeping, more important, than, the collection of novels that have been written no they. Serve different functions but without novels, society, can continue to function without bookkeeping. We're, shut down bookkeeping, underlies. Modern. Society. At. Its heart bookkeeping, is about collecting, information getting, things recorded, because, once events are recorded then we can organize, those, events and start making decisions but. You've got to have a system in place to collect that information that's bookkeeping, for example. Walmart. Has 10 billion. Customer, visits per year 10, billion per year if, Walmart, doesn't have an organized, bookkeeping, system, in place to keep track of what those customers bought, how, much they paid do, they need to order new things what, do they need to do which stores are running out of which things all, Walmart, can no longer function, as a business, with so much activity, 10, billion visits per year Walmart, needs, a good bookkeeping, system, coca-cola. Coca-cola. Is, proud of a claim that they sell. 650. Billion, servings. Of coca-cola per, year that's. 100. Servings, of coca-cola for every man woman and child on, the earth you should ask yourself now did you drink your share last year that's a hundred did you drink a hundred servings, of coca-cola of coca-cola. Is going to have every man woman and child on, earth drinking, a hundred, servings, of coca-cola in a year they, better have a good bookkeeping, system to keep track of what people buy where, they buy it our sales going up our sales going down what, are there different products around the world coca-cola, needs, a sophisticated. Bookkeeping, system to collect information, because, 650. Billion servings you can't keep track of that on the back of an envelope you've got to have an organized, system. Google. Google. Is the most visited. Website. On the internet and they have between one trillion, and two trillion searches. Per year, how. Does Google make money Google, makes money by charging advertisers for.
Customer, Views or customer clicks well. How can Google make money how can they charge those advertisers, unless Google has a system in place of keeping track of the number of clicks and what people clicked on just think about it it's a really daunting task, the, Google search engine is awesome. The, Google bookkeeping. System is equally, as awesome without. Bookkeeping, Walmart. Coca-cola. Google, could not continue to function, it, seems mundane, bookkeeping, just collecting, the information but, that's where it all begins with bookkeeping, let's. Make this more personal let's not talk about Google, or coca-cola, or Walmart let's talk about you, think. About you and your personal budget let's, focus in on your, food budget how, much did you spend in the past 12 months on food, now. Let's think about this would you like to know the answer to that question yeah you would because. If you're trying to watch cost and budget a little bit better you'd want to know how much did you spend on food that's, the starting point the. Most honest answer for most of us for me for example is I'm not sure I know how much I spent on food last year I could, use a better bookkeeping, system if I want to start making decisions, and, changing, my behavior with respect to how much money I'm spending on food I first, have to have a system, in place where I keep track of it that's, the starting point of any, kind, of budget. Conscious, behavior with respect to food it starts, with routine, bookkeeping. Basically. Writing, things down. Simply. Stated, bookkeeping. Is the preservation of a systematic, quantitative. Record, of an activity and until. You have a record, of an activity, you really can't make any sophisticated decisions. With respect to that activity you got to get it written down you got to get it recorded once, that happens, now. We can start to make more sophisticated, decisions, we can use the past to help us make better decisions, for the future but it starts with getting things written down that's, bookkeeping. The, second flavor of accounting, is financial. Accounting, reporting. The results of a business, or an, organization to, people outside that organization. Its summary, information given. To outsiders, Financial, Accounting lets, get a sitter the case of a person applying for a loan a mortgage loan, for example you want to buy a house I just went through this, not long ago so. You go to the mortgage company say I'd like to have a mortgage loan so I could buy this house well. Here's what they do they, ask you to verify your, income you got to give them w-2, forms, and all kinds of paperwork to confirm, what. Your income was in the most recent year actually the most recent several years they, also ask you to verify what, things you have accounts, call these things assets, do you have a house do, you have a, checking. Account you have any investments. Let's get those all listed down do, you have any obligations. You have any credit card obligations, do you have any other loan so we want to see all those things the, loan company wants to verify your income they, want to verify the economic. Resources you have and the economic obligations, that you have basically. You are asked, for personal, financial, statements, you're not telling the bank or the lender everything. That you've ever done you're giving them a summary, of what you've done through. A summary of your income, so, many of your assets, some of your obligations, this is, financial accounting, so. What are the benefits to, providing, these personal, financial reports when you're applying for a loan well. The benefits to the lender are obvious, the. Lender wants to know whether you're going to be able to pay them back so, they want to see are you making money have you made money steadily, over the past few years do you have East as do, you have resources do you have an investment account you have cash in the bank do, you not have too many other loans, too much credit card debt so the benefit, to the lender is very clear it helps them to be more able to forecast the, probability. That you're going to be able to repay the loan so, that's great for the lender what, about for me the borrower, well. Imagine. If you weren't allowed to provide financial, information you go into the lender and say I'd like to borrow some money well. We'd like to know not you can't ask anything about me you just have to lend me the money well. That makes it a much more risky, proposition lenders. Are going to be much less like the loan money to anybody, if they, can't verify your income can't, verify your resources, so, by reducing, the, uncertainty, the lender, it makes it easier for me the borrower, to borrow money and, also if, I'm a credit worthy borrower if I've been prudent if I've saved money if I've got some resources, if it gives me an opportunity to reveal, that I want, to reveal that to the lender to make it even more likely that they'll give me a loan, so.
This Process, of providing personal. Financial statements, to a lender when getting a loan benefits. The lender they can make better decisions, benefits, the borrower, because, the borrower can reduce the uncertainty, to the lender and therefore make it more likely that they'll get the loan this, is, financial, accounting, a balance. Sheet is a very, fundamental report. It's a list of an organization's. Resources, accounts. Call those assets, and an organization's, obligations. Accounts, call those liabilities, so. The assets how much cash do you have how much you have in land how much do you have in trucks, and equipment those. Would be a listing of a company's resources. Obligations. How much money have you borrowed, from a bank how much do you owe in taxes, how much do you owe your employees. And wages that you haven't paid yet let's, see all those obligations, so that's a fundamental report. For any business what, do you have and what do you owe we call that a balance, sheet, next. Fundamental, financial report, is called the income, statement, how much money is this company making well. Anybody, wants to know that if I'm thinking of loaning money to your company or investing. In your company I need a report of how much money you're, making the. Balance, sheet and the income statement, are fundamental. Reports that are provided by organizations. By businesses, to people outside the, company so those people outside can, decide should, we loan that company money should we invest in that company it's. Not all the details of the operations, of the company it's a summary, it's a balance sheet it's an income statement. The, third basic. Flavor, of accounting, is managerial, accounting, it, starts with bookkeeping, we have a system in place to gather the raw data sometimes. We need to communicate some. Of those data to people outside the company that's called financial accounting, communicating, with outsiders, more. Frequently, we need to use those data internally. To make internal, decisions, that's, managerial. Accounting the accounting, data, that are used internally, to make daily, decisions, when. I say managerial. Accounting I want you to think details. I want you to think inside, the company I want you to think secret. I want, you to think daily, these, are the data that, people inside an organization are going to be using intensively. On a daily, basis to make those daily, decisions, hey, we're selling blue shoes should we start selling black shoes we're, selling children's clothes should we start selling adult clothes we're selling strawberry, ice cream should we start selling chocolate, ice cream we've. Got a factory, here in Nevada, should we also build one in Illinois those, detailed, daily decisions, that any organization, has to make every, day those, decisions, are made using managerial, accounting data in fact if, you've, ever been, involved in any kind of organization worked, in a company but, involved, with, a charitable, organization, you've, used managerial, accounting data you, might have provided input, into managerial accounting reports you've probably used managerial. Accounting reports it's what people use all the time to make decisions with respect to an organization, and here's the thing these. Data are not things that you're going to share with outsiders, see financial accounting is built to be shared, with outsiders. Managerial. Accounting now inside. Secret. It's stuff that we use, internally, to make decisions, and here's. The interesting thing about managerial. Accounting if done, well, managerial. Accounting can be a competitive, tool it can make your company beat, your competitor, in the marketplace, now. I could tell you're a little skeptical. Accounting. Be a competitive, tool managerial. Accounting can be a competitive tool let's think of an example we got to soup, and salad restaurants, let's put them right across the street from one another one, side we've got soup, and salad restaurant, number one on the other side of the street we've got soup, restaurant number two so these are really competitors, they both serve exactly the, same soup and exactly. The same salad and, they're not competing, based on quality, of food so, how are they going to compete well, accounting. At restaurant. Number one is very traditional they, don't do anything fancy they just want to make sure they get their bills paid they want to make sure that their employees get paid on time they really, even though it's a soup and salad restaurant, they've got a meat and potatoes, accounting, system very, traditional, now. You and I are, over here in restaurant number two we, know that managerial accounting, can be a competitive tool here's, what we do with our accounting, system we, use bookkeeping.
To Gather the data and then we organize, the data that's what managerial, accounting is organizing. All these data we've got in our company we know for example item. By item how, much each item, on our menu costs, you, come on to our soup and salad restaurant, and order, tomato basil soup we know exactly how much it costs us to prepare that the raw materials, and to, cook it and serve it we know all the costs and if. We know all our costs, we, know whether we can afford to give customers a 20%, off coupon or a 30, percent off coupon or a two-for-one, we, know exactly, how low we can go with our prices and how big, our discounts, can be because we know what our costs, are we. Know by. Our by, minute, inside our business, what, people are buying and when they're buying it we know how much tomato basil soup, is sold, between 11:00, and 12:00 every day and how much is sold between 6:00 and 7:00 in the evening every, night we, know that that makes it easier, for us to target, our promotions, to our customers, we also know when do we need to have more staff here and when can we afford to have fewer staff because we know exactly by. The minute, inside our business when people are there we. Know our customer, demographics, we've probably got a system set up where customers, can get points by registering, with us and providing us their address and, our email address, so we know a little bit about our customers, and we keep track of what they buy so. Since we've got their email address and we know what they like to buy we can send them little email coupons, hey come in we're running a special on your favorite, tomato basil soup. 60%. Off bring a friend and your friend will also get 60%, off we can target our sales. Efforts, and individual. Customers based, on their individual preferences now you say wait stop this is marketing, this is advertising, no it's, marketing, or advertising, standing. On the back of a good managerial, accounting system, it's the managerial accounting, system and the data involved, with it that make it possible to. Target our individual, customers, you. Know the frequently ordered combinations. You. Know that when somebody comes in and orders tomato basil soup they're probably, gonna, have for dessert that's strawberry cheesecake, so. Package those together give people the discount for ordering both of them at the same time you. Know all this stuff meanwhile, the, poor person trying to run restaurant, number one across the street all their internal, accounting system tell them it is how much they're supposed to pay their employees this week and how much they're supposed to pay for their supplies, when they received them that's all they know who's. Gonna win in the long term in this, competition, between soup, and salad restaurant, number one and soup and salad restaurant, number two the. One with, the better internal. Managerial. Accounting system good managerial, accounting can be a competitive, tool. So. How are managerial. Accounting data use these internal, data inside, a company well, first product, costs let's say I've got a wood furniture business somebody, comes in and orders and custom-made oak table well, in order to make an intelligent decision about, whether I should sell that table or not and at what price I need to know how much it cost me to make that table so product, costing, is part of managerial accounting. Breakeven. Analysis let's. Say I'm considering, opening up a scuba, shop at the local mall well. That's a risky, thing to do but okay, go ahead think about it and one of the first things you should do is this figure. Out how much you're going to have to pay your manager figure out how much you're going to have to pay for rent and then figure out how many customers, are, gonna have to come into my scuba shop each, month for me to break even to avoid losing, money that's, an important, part of managerial accounting, analysis, budgeting. Many. Startup, businesses have been killed because they just haven't sat down and made, a budget a numerical. Plan on paper. Budgeting. Is part of managerial. Accounting. Performance. Evaluation, some. Employees, are doing their jobs very well some, employees are not doing so well we want to reward the, one and not, reward, the other so, we need a system in place to gather the data to, evaluate different parts, of our company, let's. Say I want to invest in a long term project I want. To build a new factory, facility, in Rock Springs Wyoming it's. Going to last for 20 years well, that's, a decision that's going to require the use of managerial, accounting information how much is it going to cost to buy the land how much is going to cost to buy the building and the machines and what are the profits we're going to make and how long is it going to last all those, data would, be brought to bear in making that decision to invest, in a long term project, what about outsourcing, production.
I've, Got a production facility right, now in the Central Valley of California we'll, say what, should I stop. Producing, my product here, in California, and outsourcing. Maybe it can be made in Brazil maybe it can be made in Ethiopia. There are all kinds, of possibilities. Managerial. Accounting data are used to, make those kind of decisions outsourcing. Production, now, finally add a product, line I've got a nice line, of children's, clothing here, should I start selling adult clothing in my store as well let me run the numbers on that watch numbers, these, are the kind of decisions, that are made using, managerial. Accounting. Data. The. Fourth basic. Flavor of accounting, is income, tax accounting, bookkeeping. Gather. The raw data financial. Reporting, or reporting, to people outside our, company, who might want to loan us money or might, want to invest in our company managerial. Accounting it's the detailed stuff that we use in our company every day to make decisions, income. Tax reporting, that's, accounting. Done, to, satisfy our, legal, obligations, so let's talk about income. Tax accounting. You. May have heard before people talking about big, companies while they keep two sets of books or they keep five sets of books well how many sets of books does a large u.s. corporation keep, and, we're not talking about doing anything shady here legitimately. How, many sets of books does a large company, keep. Any. Large company, in the world keeps, three, sets, of books of course, there's one underlying bookkeeping, system that generates all the data but, then different, reports, are prepared. For different purposes, first. They're the financial, set of books if you will those. Are the reports that are provided to outsiders, banks, potential, investors the financial, reports so that's one set of books, next. There are the managerial, accounting that we use every single day those detailed, data that we use to make decisions you can call that another set, of books two. Different ways to use that same underlying bookkeeping. Database, used. By insiders, the managerial, reports. Third. We, use the same raw bookkeeping, data to, fill out the tax reports, into being compliance with the law of our local, governments, that can be said to be a third, set, of books and I. Hope it doesn't surprise you to learn that the Financial, Accounting income, that you're going to report on your financial, reports to your banks and your shareholders is not necessarily. The same number as the tax income that you report to the government you say oh I'm shocked to hear such a thing no the. Financial, reports are prepared, to give economic. Information, to potential lenders and potential investors that's the purpose of those the tax reports, are merely, designed, to satisfy the law, there. Are two different, purposes two, different, sets of books and we, add the third set of books those detailed, internal, management reports. Companies, keep three, sets, of books. Let. Me give you the conceptual. Idea, around, and about income, tax reporting, at. One end of the spectrum we have economic. Income, economic. Income is based on value, changes, what am i worth how much is my house worth how much are my investments. Worth economic. Income measures the ebbs in the flows in the worth of an, individual, the worth of a company that's one extreme but that's kind of subjective I mean what am i worth well that's an interesting question to ask, that's, economic, income at, the other end of the spectrum is cash flow, how much cash that I collect how much cash should I spend, there's no subjectivity, there that's very objective.
Cash Flow those, are the two extremes of, measuring. The performance of, a, company during year the subjective, value, changes, of economic, income and the objective, cash flows, well. Accounting, income and taxable. Income, fall somewhere in between accounting. Income is an attempt to get as close to economic, income as we can given, the practical, constraints that, subjectivity, has. To be constrained. A little bit we, call it accrual, accounting let. Me give you an example of this idea of accrual, accounting that's, used, in measuring accounting income let's. Say I earn. $20,000. This year but, I'm not going to collect that 20,000. In cash until, next year I earned, it this year I did the work this year I'm gonna collect it next year well. Do I report the income this year or next year this. Year when I did the work or next. Year when I collect the cash well. The idea of accounting, income accrual, income is now don't follow the cash don't follow the money follow the, effort, follow, the creation, of the economic, value so for your accounting, records for financial, accounting for example you'd report the income this, year when you actually did the work see. That's more towards the economic side, of thing let's report the economics, did you create the value this year that's when you're gonna report the income, taxable. Income on the other hand is towards. The cash flow end of things. Taxable. Income is when you collect the cash that's when you report the income you've experienced, that as you filled out your own tax return, now why would taxable income be closer to the cash flow objective. End of the spectrum rather than the economic income. Subjective, end of the spectrum, well because taxable, income it's a legal report and I, want to be able to tell whether I've obeyed the law or not and if we're measuring subjective. Economic, values it's hard to tell who's, right and who's wrong where if it's just cash flow that's very straightforward so it reduces, arguments, it. Makes it so people can tell whether they're obeying the law or not also, there's. The idea of the ability to pay I should, pay tax when I have the cash to pay the tax yes, I earned the income this year but, I can't pay the tax this year because I haven't collected the cash yet wait, until next year when I collect the cash then I can pay the tax so that's another idea, behind taxable, income, the, third thing and I. Won't say anything more about this than this brief statement, the thing that makes the tax rules complex. In any country in the world is the social tinkering, that legislatures, do, through, the tax code we, want people to own their own homes in the United States so, Congress, has said you can deduct the, interest you, pay on a mortgage loan on your own home that encourages, people to buy their own home so we want people to donate to charities, we give them a tax deduction if they donate to charities, these, are good things and the, tax code is an interesting way to tinker, with what happens in our society but that's what makes the tax code complicated. So. Here you see the, simple difference between accounting, income and taxable. Income, accounting. Income is a little, bit more of an economic, measure taxable.
Income, Is a little more objective towards. A cash-flow measure, taxes. Are enforced. Exactions. Not, voluntary. Contributions. That's. A very oft, cited, quote, there and there's, a key point income. Tax accounting, is all about obeying the law one. Of the laws say about how much tax I owe let's, make sure I pay that tax I'm not obligated to pay more than that and it would be illegal, to pay less than that so let's pay exactly, that so income, tax accounting. All swirls. Around making sure we understand, the rules in a world Bay the law. You. Let's, dig into a little bit more detail, about financial. Accounting but first a quiz. Financial. Accounting are those. Reports, directed, to people outside the business or are those reports, directed the people inside, the business you're, thinking yeah you got it Financial Accounting is directed towards people outside. The business so let's talk more about financial, accounting, these reports, directed, to outsiders. The. Key external. Users of financial accounting data are lenders, and investors. The. People who provide, the capital to, a business, so that you can turn your dreams into reality. I need a hundred million dollars well I'm gonna have to borrow it or I'm gonna have to get new investors, in my business, those, are the key users, of financial accounting data, without financial. Accounting data it would be impossible for, companies. To raise money from strangers, the financial accounting data provide that environment. Of trust where. Lenders and investors feel, comfortable, giving, money to an entrepreneur to, start a business or expand a business so lenders what a lenders, want to know well, it's a loan gonna be repaid it's early that simple, if I loan you one hundred million dollars are you gonna pay me back and. What data can I use to assess whether you gonna be able to pay me back well tell me how much money you're making now tell me how much money you made for the last three years I want to see that that's going to help me forecast, how much money you're gonna make in the future tell, me what existing, obligations you already, have because. If you're already loaded, up with obligations I'm, not sure I want to be one more person to loan you money I might not get paid back also, tell me what resources if you got your assets, tell. Me what those are and all. Those things will help me assess, whether you're gonna be able to pay back alone, investors. What do investors, want to know so investors, they're, becoming your partners they're not part owners in the company they. Want to know is this profitable, business have, you made money the past few years so they want to know the same thing that the lenders do because. Really, this is a very important point when you're an investor in a business you're not buying the past of the business you're, buying the future, of the business how's it going to do in the future so, what you use the financial accounting reports for is to, tell you the past so, you can use that information now to help you forecast, better what's going to happen in the future because, the potential, for the future is really what you're buying when you're an investor, lenders.
And Investors, the. Providers, of financing, to a business to turn dreams into reality, those, are the key external. Users of financial accounting, data, lenders. Investors aren't the only external, users of financial data lots, of people you and me for example we use financial accounting, data at least we do now, so, who some, categories, suppliers, if. I'm gonna sell to you on credit then, I want to know if you're gonna be able to pay me it's just like loaning, somebody money if you sell, those people on credit it's the same as loaning them money you want to know if they're gonna be able to pay you so if you're considering, entering into a long term, significant. Business, relationship, where you're selling on credit to, another company the first thing you're going to do is get, their financial statements have, a little analysis, done to see if they're going to be able to pay you back so suppliers, are important, users of financial. Accounting data, customers. Anybody. Who enters into a long-term, relationship with a business wants to know if they're going to be around in the future so if I'm gonna be one of your customers, and I'm gonna start to rely on you, and maybe you're giving me a warranty. Employees. Employees. Have long term relationships, with companies an employee. Too, often they don't but employees should, look at the financial reports of a company's it's a strong company, do they have a strong track record can I count on them because I'm going to give them my blood sweat and tears are they gonna be here in the long term, are they financially, viable, competitors. This kind of the other side of it because, I provide, these financial accounting data and they're available to people outside my company it's often the case that my competitors, get their hands on them do. You think that Coke wants. To see the financial accounting reports of Pepsi of course they do do, you think that Walmart, wants, to see the financial accounting. Reports of Target of course they do of course they look at those things so, competitors, want to see where your strengths are where you know weaknesses, are they can do that by, looking at these financial, accounting reports government, agencies, there, are some industries banking. Industry, the, insurance, industry, the. Utilities. Industry companies. That sell natural gas electricity all of those are regulated, by government agencies, so they have to provide financial. Accounting reports to the government agencies, in addition. Sometimes. In, some industries, people, in general want to know hey you're, health insurance company are you price gouging, are you making profits, that are too large you're an oil and gas company we're, all paying a lot of money for, gas at the pump are, you making obscene, profits we want to see those financial, reports so government, agencies, and people with, interest, in the, public responsibility, of companies they'll look at the financial, reports politicians. Are also, looking at financial reports if I want to make a political argument, against, for example the oil and gas industry, and I want to show that they're profiteering, I pull, out Exhibit, A in their financial reports or if, I'm. A politician. Who wants to protect say. The textile, industry in my state I pull, out the, financial reports of some major textile, businesses, show that their profits are going down so politicians.
Can, Make a political point using the financial statements, of companies, and finally the press, the. Press commonly. Use financial reports first just, simple background information if I'm writing a story about Apple, I ought, to tell my readers okay here's how much money Apple, made last year here's, how many assets they have here's how much cash they have in the bank you can actually go into the details of their financial reports and find out where their income was generated, how much in the United States how much in Europe yeah I want to want to use the financial reports for background. But, also the, press often, use financial, reports to trigger investigations. I'll give you an example let's. Say a company just announced that their profits have gone down, by, 70%. That's a financial accounting, report but, that could trigger an investigation by. An enterprising, reporter who'd say well why did their profits go down by 70% so it's an investigation, trigger, lots, of people use, external. Financial accounting, data include, I hope from now on you, so we could write your name right down at the bottom of this screen. Financial. Accounting, is based on these three, primary. Financial statements, the, balance sheet and income statement you've, already seen, so let's talk about those the balance sheet is the listing of a company's assets and, its, liabilities. Its economic, resources, the assets, and its, economic obligations. The liabilities, it's a basic, financial, report the, income statement how much money did you make last year how much money did you make last quarter, how much money have you made each year for the past ten, years that's, the income statement that's also important, information, provided, to people outside the company a statement of cash flows, we, haven't talked about yet but it's the third primary, financial, statement it's a report of the cash that came in to a company, and a report of the cash that went out of the company a pretty basic thing but we're gonna find out soon, that the statement of cash flows is an awesome, piece of work these, three primary financial statements the balance sheet in the income statement the statement of cash flows they summarized.
The Financial, position, and health, of a company really, three, sheets, of paper summarize. A lot, of information, about a company that's, financial, accounting. Let's. Talk about the balance sheet in a little bit more detail the, balance, sheet is build, around one, of the, most awesome creations. Of the human mind the accounting, equation there. It is assets. Equal liabilities plus, equity now. I can tell your underwhelm, you thought I was expecting, a little bit more of something like a equals mc-squared well this is just as great as e equals mc-squared, let, me tell you where this accounting equation comes from first the asset side well you know what that is list of assets here's the thing people, have been listing assets, for, thousands, of years I told you that there's evidence that, farmers. Were keeping lists of assets, 7,000. Years ago in ancient, Mesopotamia. There's no great insight, there how many cows do I have how many goats do I have how much wheat do I have a list of my assets the, insight. Behind, this accounting, equation was, created. A little bit over 500, years ago in Italy, the traders, in Venice, and then other traders in Italy they, had this insight, listen, let's. Keep it a list of our assets like we've always been doing but let's also every, time we get an asset let's write down where. We got the money to buy that asset, we. Write down the asset and we write down the source of the financing, to buy that asset, did I borrow the money to buy the asset, was it invested, by the owners if I borrow the money then, liabilities. Is the name I give to the source of the financing, to buy that asset if the, money was invested by owners, I say equity, was the source of the money to buy the asset, so we got the two sides of the Italian equation the, first side, the asset said that's the real world there you can go touch a company's, assets that's. The real part of a company the, other half of the accounting equation just says where did you get the money to, buy those assets, it's the discipline, of the accounting equation it seems so simple but this discipline, is the foundation. Of all the sophisticated, financial reporting, that we now have in the world and we've, been using this for 500 years it's, an awesome invention. I tip, my hat to those, medieval accounts, in Italy who invented the accounting equation assets, equal, liabilities plus, equity assets.
And We're also going to keep track of the sources of financing to buy those assets, so. What are assets, we kind of have an intuitive sense of this they're resources, owned, or controlled by a company little provide probable, future benefit, so. Let's take the simplest example, if you look at the balance sheet of Apple, you, see they got lots of cash a lot of billions, of dollars of cash is, that a resource, that will provide probable future benefit yeah cash is a good asset that's, not the only asset, if. You're a financial institution like, MasterCard. Like, Wells Fargo, Bank like Bank of America your. Biggest asset, is an asset we call accounts, receivable, or loans, receivable. The asset, you're, going to collect money from people in the future based on contracts, that exist in place right now so if I have a piece of paper that, somebody has signed or they promise to pay me back, $10,000. In the future is that, a valuable, thing is that an asset sure it is the, primary, asset. Of any bank is. Accounts. Or loans, receivable. Master car as an example, Citibank. They, have over a trillion, dollars in, accounts. Or loans receivable that's trillion, with a, t huge. Asset. Money that they expect to collect in the future from, the people who've borrowed it from them in the first place how, about Walmart let's do a little mental, trip into a walmart, location. So close, your eyes drive. Into the Walmart parking lot and get out of your car you're, walking across the parking lot you're walking, on one of Walmart's assets. They own that land it's a Walmart asset you walk into the building they're you know in that building that's another Walmart asset, stand, in the middle of the store and look around at all the stuff on the shelves that's called the inventory the stuff that you can buy from Walmart those are all very important, assets, for Walmart, Delta. Airplanes. FedEx. Airplanes, United, Airlines airplanes. These, are resources, owned or controlled by the company that provide probable, future benefit, the things that a company uses to provide services, to its customers so that their customers will pay them these. Are all assets, the. Balance sheet also lists the liabilities. Of a company the obligations. That will require the probable, future sacrifice, either, by paying assets, or by delivering. Some service, I'll explain what I mean so. Let's talk about some examples Walmart accounts. Payable payable. As a hint they're an obligation, to pay in the future when. Walmart buys, inventory. They, promised their suppliers, Procter, & Gamble or Black, & Decker or whoever will pay in the future we're not got to pay a cash now we'll pay in the future well, that's an obligation now. Walmart better write that down Walmart, better not just write down hey we just bought some inventory from Procter & Gamble they better also write down oh yeah, and we owe them for it we got to pay them later you got it right down the asset you write down how, you bought the asset in this case should promise to pay it later accounts payable is one liability, Home, Depot and Target. And Walmart, and almost, every other business in the world has, the employees worked for a few weeks and then they pay them Home Depot doesn't, gather all the employees together at the end of a day and say ok we're, gonna pay you cash for whatever you earn today no thanks. For working for us today, we'll pay in a couple of weeks when it's payday, so, if Home Depot or Walmart or, Target we're, to do a balance sheet at the end of any given day they, would be required to write down ok wages, payable how much of our employees, earned that, we haven't paid them yet another liability, same thing works for taxes. Taxes. Build up slowly over time and if you're to do a balance sheet you better write down ok as of today here's how much tax we owe though we haven't paid yet exxon mobil does a lot of accounting for taxes they pay taxes, of all sorts around the world they pay property, taxes, they pay income taxes, they pay sales taxes. They, pay, import-export. Fees all kinds, of taxes, and they don't pay them up in cash at the end of every day so, when they do a balance sheet they have to list down here the taxes, that we are, gonna pay them next, month there are a couple of months or now sometime in the future, long, term borrowing, Disney. Has some long term debt on their balance sheet that means money that, they have borrowed that they're gonna pay back sometime. Far in the future five years from now 10 years from now 20 years from now the.
Reason I've got Disney here is they're interesting, because a number of years ago they, got some really long, term. Debt they borrowed some money and promised. To pay it back in not one year not, five years a hundred. Years, would. You loan money to somebody on a promise that they'll pay you back in a hundred years well you would do that for many companies but you do it for Disney, there. Are only a few companies in the United States who have borrowed money on such a long-term, basis, but it's listed in Disney's balance, sheet long-term debt a hundred years from now we got to pay this back a little, bit different liabilities this last one on the list United, Airlines unearned revenue, throughout. The last time he rode on United, Airlines or Delta Airlines or American. Airlines there any other airline did, you pay for your flight before. You flew or after. You flew, before. They always make you pay before all. Right well they then have an obligation if, you've paid for a flight and they haven't given it to you yet they have an obligation, to give you a ride on an airplane that's, what this unearned revenue, is there are two ways to get the money to buy assets borrow. It in which case we call it liabilities, or have, it invested, by the owners, then we call it owner's equity owner's, equity is the amount that owners. Have invested, in a company for the company then to use to buy assets, there. Are two ways for owners to invest in a business one the simplest way to visualize. Is the owners just say okay my business needs some, money to buy assets I'm just going to pull it out of my personal pocket for my personal, savings I've, done some work elsewhere, I've been prudent I've saved my money I'm not gonna pull it out of my pocket and put it into my business and the business will then use those, assets to buy, assets we, call that paid in capital the, amount that owners take out of their personal savings and invest in their business or capital. Stock or capital, contributions. They all mean the same thing so that's one way that owners, invest, in a business not. A way that owners invest in a business is this the. Business generates. Some income who owns the income, generated, by a business well the owners do it's theirs it's their business they own the profits well, the owners can choose what to do with those profits sometimes the owners will say okay my business generated some profits I'm gonna take those out or some of those out to, use for, personal uses to pay tuition to, buy a boat to do whatever we, call those dividends, when owners pull profits, out of the business but. More often than not owners. Will say okay my business generated, profits I take, out a little bit of dividends but most of it I'm gonna put back in the business for expansion use, these profits to buy more buildings to buy more equipment to buy more inventory if, the. Profits are kept in the business then, the label we give to that source of owner's equity is retained, earnings, owners. Can invest directly, we call that paid in capital owners, could say let's keep the profits in the business that's another way that owners invest into business both, those two things together paid, in capital and retain earnings the sum of those two is equal to owner's, equity another. Source, of financing. To buy assets. Alright, I'm a little embarrassed to, tell you this but, I got to tell you the whole truth the. Balance sheet is not perfect, there are some limitations, so, I better tell you what those are you better that you hear from me than from somebody else first. When. You look at a balance sheet most, of the numbers that you see are not market, values, there, are costs, you, say well what's the big deal well it can be a huge, deal let's say you've got a company that has some land, that it bought 50. Years ago for five thousand, dollars all. Right and the land now 50, years later is worth two, million dollars, well. What's, gonna be reported on the balance sheet the amount reported on the balance sheet is the original, cost the five thousand, dollars fifty years ago not, the current market value this, often misleads, people because then when they look at the balance sheet they trust the balance sheet they love the balance sheet they're looking at they, have to remind themselves this is not the current values, these are the costs if I want to know the current value of all the assets I need to do some other investigations.
That's Outside. The financial accounting process, so that's the first limitation so, I'm embarrassed, about that second. Probably, worse, some. Very valuable, economic. Assets are not reported, at all, in the. Balance sheet especially, intangible, assets what, are the most important, economic assets. Of Apple, think, about this well first the logo itself the. Name think, how much would you have to pay to. Buy the worldwide. Rights to use that name Apple, it would be tens of billions of dollars same, thing with the logo and even. More an, intangible asset are the relationships. That, Apple, has with all of its customers around the world if you're an Apple user you, are loyal and, if they come out with a new product you're gonna buy the thing that's valuable, for a company to have an existing, base of loyal users that's, an asset then if Apple wanted to sell its customer, list they could do that again for tens of billions, of dollars. How. Much of those crucial. Economic assets, the logo the name those relationships, how much are they recorded out in the balance sheet zero. Because. Apple, never had to pay to buy those Apple. Never had to pay anybody else to buy its name it just developed, that name, didn't have to pay anybody else to buy its logo it created, the value that logo it didn't have to buy its relationships, with customers its created, those relationships. Itself, so, the intangible, assets that a company, grows, itself. Creates, itself, organically. Homegrown. Intangibles. I call them are recorded, at zero, on, a balance, sheet and for, many companies these, assets, are the most important ones they've got the name Apple the name Microsoft. The name IBM, the name McDonald's or, coca-cola all, of those names, are, worth tens, of billions, of dollars and yet they're all recorded, at zero, on the, balance sheets of the respective, companies, so accounting, doesn't account for intangible, assets very well at, all I'm ashamed the. Combination, of these two things means this the, value, of a company on its books the book value we can say is often. Not equal to the market value of a company, those, are. Limitations. Of the balance sheet now you know the truth the valid she's great I love, it you, love it but, it's not perfect.
As, We know there are three primary financial, statements the balance sheet the income statement, and the statement of cash flows about. Sheet in the income statement have been around for over 500, years. Statement, of cash flows only been around for 25 years so we'll leave that one to the side let's just talk about a comparison, between the balance sheet and the income statement, those stately, old financial. Statements that have been our friends for over 500 years, about sheet listing, of assets, and liabilities as, of. Right now what, do you have and what do you owe as of today. So you could theoretically do a balance sheet any old day let's do it at the end of today let's do it at the end of the next day it's, as of a point in time it's often spoken of as being a snapshot, the, balance sheet is a snapshot as. Of, right now what. Do you have and what do you owe the. Income statement on the other hand tells, you how much you made and. If you think about that for a second, you realize okay how, much I made what this, week this. Month this year you, have to define a period. Of time so the balance sheet is as of a point, in time the. Income statement is for a period, of time for. Large companies, in the United States they are required, to report an income statement every, three months every quarter. In addition, at the end of every year they're required to report an income statement for the entire year so those are the periods, of time that, income statements are required for large companies United States so, let's see if we've got this let's review, close. Your eyes I don't want you looking at anything just close your eyes which. One of these two a balance, sheet income statement is, for, a period, of time yeah. You got it the income statement which. One is as of a certain point, in time that's. The balance sheet balance, sheet as of a certain date what. Do I have and what do I owe income. Statement for some period, a quarter. A year a, month, how, much did I make that's, the difference between a balance, sheet and an, income statement. The. Income statement contains two items, revenues. And expenses. Revenues. Minus expenses, equal. The net income that's it that's the income statement now. You shouldn't be seeing yourself okay that's not that bad you're right accounting, is not that bad in fact we can make a stronger, statement a County's great, now. What does the word revenue. Mean it's, kind of subtle but important, remember. Revenues. Are the amount of assets, created, from the sale of goods or services so, how do companies generate, assets through, profitable, business, operations, well depends. On what the business is Microsoft. For example generates. Assets, by collecting it from you and me through, selling software and hardware we call that Microsoft's, revenues, how, does Walmart generate, assets through doing business well they sell products, to you and me and they sell us memberships, in their Sam's Club so. That's the way Walmart, generates, assets, through doing business so those are Walmart's, revenues. Disney. Disney. Has five, major. Business. Segments, they're media networks they're, cable TV and television networks Parks and Resorts Disneyland. Studio. Entertainment, Pixar. Marvel. The, Disney Studios themselves, Lucas films Star, Wars Disney, has all those consumer. Products, yeah you still got that lunchbox, that you bought when you were a kid that's got the Disney logo on that and they make money from that and the fifth one not listed on the slide here they're interactive. Division, so, Disney, generates. Assets. Through doing business in many different ways they're all called revenues, revenues, are, a ways that, companies, generate. Assets through, doing business and, whatever your company is that's. The way you're going to generate revenue differs, depending on what industry you're in well. There are revenues but they're also expenses. Like. What well, Microsoft, in order to generate those revenues, by selling, software and hardware to you and me they got to pay programmers, they got to buy equipment there are all kinds, of things that they have to pay for they got to pay for electricity, they've. Got to pay for maintenance on all. Their facilities that they have those, are expenses, Walmart.
What. Is their major expense, their major expenses, the cost of, the goods that they sell to you me on. Average, if they, sell something to you and me for a dollar that thing cost them about 75, cents so that's an expense, that's assets, consumed, in generating. Revenues, they. Also have buildings, that they build and slowly wear out over time those are all assets, being consumed, in generating, revenues. McDonald's. What. Are their expenses, well they have to buy the food that they sell to you and me they have to buy the paper that they sell to you and me they got to pay the employees, that are working behind the counter there are also all expenses. Involved. In generating the revenues so expenses. Are technically defined as the amount of assets, consumed, in generating, revenues, now. Another way that expenses. Are created, is by. Generating. Liabilities. For, example, let's, say I've got employees that work for me for the year I pay them their wages that's fine those are expenses, that's easy but what if I also promised. Them, a pension, 30, or 40 years from now when they retire and they also earn those pension, benefits this year that's. Also, an expense, even though I'm not going to pay them for 30 or 40 years they earned the, benefits, this year and so, I'm going to report as an expense this year the definition, of expense in that case is when, I create, liabilities. Through doing business, another, common, and unfortunate, liability, is environmental. Liability. If, I'm ExxonMobil, through, sucking oil and gas out of the ground and transporting. It around the earth I'm gonna do some damage to the environment every year I don't necessarily have to pay to clean it up this year but, I did the damage this year those. Are also business, expenses, recorded. This year, expenses. Consuming. Assets or creating. Liabilities, through, doing business those are expenses. So. The income statement revenues. Minus, expenses equals. Net income it's as simple as that now this net income, is the. Overall measure of a company's economic, performance during, the period that's the one number that, summarizes. All the economic, things that the company did it's an economic, measure accounting. Net income we've been working for over 500 years to. Fine-tune. The accounting rules to, properly measure revenues, and expenses so that number net, income the difference between revenues, and expenses, for the year is the, economic performance for. The year it's a good measure of a company's economic, performance. A statement. Of cash flows, statement, of cash flows is the baby of, the financial, statements the balance sheet income statement have been around for over 500 years. Statement. Of cash flows is just this let's take all the cash flows cash. Collected cash, paid by, a company and again that's a pretty easy concept cash. We'll just focus on cash how much cash did you collect how much did you pay and we're gonna separate, those into three categories, operating. Activities, investing activities. And, financing, activities. And let me tell you what those three activities, are and then we'll look at examples of each one operating, activities are the things that you do every single, day your. Operations. So. When would you collect cash, from operating activities, if you sell some goods if I'm Walmart I sell you something if, you provide some services, if I'm a consulting, company I provide consulting services to you and you give me cash so, those are cash inflows, from operating, activities cash, outflows, from operating activities, you pay wages you pay your chilies you pay your taxes, you pay your interest those, are all things that you do every single day so operating activities, it's just the routine stuff that you do hundreds, of times a day. Investing. Activities, hear. The word investing, means investing. In the productive capacity, of the business so. Cash, outflows. From investing, activities down at the bottom here is buy, new buildings, buy, new land, investing. Spending, cash to, enhance, the productive capacity of the business, those are cash outflows. From investing, activities cash, inflows from investing, activities well when I'm done with a truck when I'm done using some land I sell them I don't need them anymore so I'm gonna sell them for some cash supposed, to be cash inflows, from investing activities how, often do i do investing, activities well occasionally, but not every day these are not routine things I don't go out and buy a building for my business every, single day so. Investing activities, happen occasionally, and it's investing, in the productive capacity of the business and I'm generally spending.
Money To enhance the productive capacity of my business, the. Third category of cash flows financing. Activities. Financing. Activities it's just what it sounds like, I'm getting, the cash to, do what I want to do in my business I'm borrowing, some money I'm, getting, new investment, from owners those are cash inflows. From financing. Activity, cash, outflows, well, I'm repaying, those loans I am, paying dividends, to my owners, those are cash outflows, from financing, activities and, how, often do I do those things occasionally, not, very often so. Operating, activities, those are the things that I do every, single day repetitively. Over and over it's what I exist, for, investing. Activities, I want to expand, the productive capacity of my business I'm spending, money to enhance that productive, activity. Financing. Activities I'm getting. The, cash to do what I need to do I'm borrowing money and I'm repaying it back I'm getting cash from shareholders and I'm paying dividends, to them that. Is the statement of cash flows it's only been around for 25 years, but, it's been 25, awesome. Years. Financial. Accounting focus. On communicating. To people outside the company primarily. Lenders. And investors, who. Are providing money to the company to buy its assets, that's, the primary audience, so remember financial, reporting people, outside the company really, these financial reports can be thought of as three, pieces, of paper the, balance sheet report the. Income statement report and the statement of cash flows report, it's amazing. How, much information can be summarized, about, a company, on just, three, pieces, of paper think, about Walmart and their ten billion customer visits per year the results of all of that can be summarized in boom-boom-boom. Three. Pieces, of paper the summary reports to people outside the company so let's remind ourselves let's, review what's, on the balance sheet three. Things structured. Around our favorite, equation, it wasn't our favorite equation before today maybe but it is now the accounting, equation assets. Equal. Liabilities plus, equity if. I've got assets, I had to get the money to buy those assets from somewhere I either borrowed, it liabilities. Or owe is provided, to the company by shareholders, equity, assets. Equals, liabilities plus, equity, that's the balance sheet the income statement, revenues. Minus expenses is, net income revenue. Is the amount of assets generated, for doing business expenses. The amount of assets consumed, in doing business and what we would hope in a company is that you generate, more assets than you consume in your business operations, that's the income sta