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Lesson 04: Balance Sheets and Cash

Assets and Liabilities

 
Reflections about Assets

Assets are things owned by an organization that have economic value. At the same time there can be questions about whether everything of value should appear on the balance sheet. Consider the following situations. 

Example 1:

If a company purchases a piece of equipment used to manufacture widgets, is that an asset on the balance sheet or does it belong in the P&L as part of cost of goods sold (direct expense) or an operating expense (indirect expense)? Like all expenses, we did have to purchase the equipment; however, the machine allows us to create value well beyond the interval of time the P&L statement represents.

The answer is that it belongs on the balance sheet as an asset. What has occurred with this transaction is that we have decreased one asset (cash) to acquire another asset of economic value (equipment). 

Example 2:

An organization is required to purchase a large amount of paper from Staples to support its duplication services. Further, in order to take advantage of bulk purchase discounts, it orders large quantities of paper and stores it as inventory. Is the paper an asset (inventory) on the balance sheet or does it belong in the P&L as part of cost of goods sold (direct expense) or an operating expense (indirect expense)? 

The answer is that it is an operating expense because paper is part of office supplies used for the purpose of supporting the operations of the company (not adding economic value). 

 
Liabilities

Liabilities on the balance sheet are debts and obligations of an organization. The text doesn't have extensive discussions about liabilities because it is fairly straightforward. At the same time we want to caution students to avoid confusing a balance sheet liability with some underperforming element within an organization. Consider the following situation. 

Example:  

A local CPA firm was performing  year-end accounting services for a company that had a P&L with a net loss. The primary owner/operator of the company was quite troubled because he had a group of investors who were going to be upset about the loss. When the accountant sat down to discuss the company's performance, she asked why the company sustained a loss for the year. The owner said there was a group of employees who didn't perform up to expectations and as a result, the company was not profitable. He went on to state that as far as he was concerned, they were all liabilities!  The owner went on to say that he felt it was appropriate to move the costs related to these underperforming employees from the P&L to the balance sheet and classify them as liabilities because that is what they were. The accountant explained that she couldn't do that. Although the owner might view them as “liabilities”, they were, in reality, expenses which belonged on the P&L.

In order to provide additional instruction on the construction and use of the Balance Sheet, please review the following Khan video, Introduction to Balance Sheets (visual starts at about 00:01:04).

Video #.#, Length: 00:09:53, Introduction to Balance Sheets Transcript

SALMAN KHAN: Welcome. Well, there's been a lot of news lately about what's going with the Bear Stearns and Carlyle Capital. And I go to these parties, and I start explaining to people, because it's very exciting, and it's actually very important to all of our collective futures, and the whole health of the financial system, and I feel like people's eyes start to glaze over.

So with that in mind, I've decided to take a little bit of a hiatus from kind of the core math and physics videos and actually do some accounting and finance videos, because I think what's happening in the world right now is extremely, extremely important. And I'm not just going to go straight into what's going into Carlyle and Thornburg and all of these characters because I think the newspapers do that.

But a lot of people don't understand kind of the based accounting. What is a write down? What does it mean when you don't have liquidity? And really tangible ways. So I'm going to use kind of the same Khan Academy techniques to hopefully explain some of this.

So I'm going to start with just a vary basic accounting concept of the balance sheet. And you might have a sense of what it is. So let's take a scenario.

Let's say I want to buy a house. Let me draw a house. So let's say this is the house I want to buy. And the owner of this house is asking for $1 million for this house. And I like the house, and I think that's a fair price. Other houses in the neighborhood also went for $1 million, whatever. Maybe they went for more, so I think it's actually a good deal.

But all I have is $250,000. So I have $250,000. So what I'm going to do is I'm going to create my balance sheet before I do anything, before I go to try to get the house. So what is my before house balance sheet? Well, what are my assets? So let's say I'll write down assets. Assets.

Well, before we know what my assets are, let me tell you what an asset is. An asset is something that's going to give you some future economic benefit. So, for example, cash is an asset. Why is cash an asset? Because in the future, you can use that cash to get stuff from people or make them do things or buy stuff.

A month from now you can use your cash, and you can make someone dance for you, or you can buy a car, or you can go on vacation. So there's all sorts of things you can do. I don't know if someone dancing for is an actual economic benefit, but you get the idea.

So cash could be an asset. A house could be an asset because the economic benefit you get in the future is you get to live in it and not freeze when it's freezing outside. So that's what an asset is. So what are my assets before I buy the house or get a loan or all of the things are about to happen? Well, I have cash, and I have $250,000 worth of cash.

Now what are my liabilities? Liabilities. I'm going to write the liabilities on the left-hand side. I think that's the convention, but I forget. But it doesn't matter. What are my liabilities? Well, a liability is something that-- it's an obligation to someone else, kind of an economic obligation to someone else.

So if I take a loan from someone, I owe them interest, or I have to pay them back the actual value of the loan one day. Say I have an IOU where I promise to dance for someone in the future. That could be a liability. It would be hard to value, but that's something that I have to do in the future.

But what are my liabilities here? Well, the example I gave, I'm just Sal. I have no debt. I've paid off my college loans and everything, and I have $250,000 in cash.

So what are my liabilities before I buy the house? Well, nothing. I don't have any liabilities. I don't owe anybody anything. And that to me is the definition of freedom. So I have zero liabilities.

So what is my equity? My equity. And you've probably heard this word, people borrowing their equity and all of these things. So I'm going to give you a little equation actually, just to take a little bit of a tangent, that assets-- assets, A for assets, is equal to liabilities plus equity, right? So in this case, our assets are $250,000.

My liabilities are what? I owe nothing to nobody. I don't know if that was correct. But anyway, I owe nothing to anyone. So my liabilities are zero. So my equity must be $250,000, right? My equity is also $250,000.

So in this case, if I made a balance sheet before I enter into any transactions-- and let me make it look a little bit like a balance sheet. My assets are $250,000. I have no liabilities. And then my equity would be $250,000.

And if I were to draw this graphically, actually you could probably draw it like this. I have no liability, so let me draw another little mini balance sheet here. Let me draw it as a neat square. You probably can't see that square. Let me switch colors. So I put my assets on the right-hand side, and I'll say I have $250,000 of cash. And on the left-hand side, I have no liabilities, and I will just say I have equity of $250,000.

Now, equity might not make a lot of sense to you right now because I'm kind of saying, well, my equity is equal to my cash. In general, equity is just what you own. After all of your assets and liabilities are kind of resolved or they're cleared up, what do you have left over? That's equity.

So in this situation, after I pay off all of my debts, what do I have left over? Well, I have no debts. So I have $250,000 in cash left over. This will start to make sense when I go to the bank now to get a loan to buy this house.

So this house is $1 million house, right? So how much of a loan do I need? Well, I have $250,000 cash. So I'll go to the bank for a loan for the remainder, for $750,000.

So let me draw the bank. This is the bank with a big dollar sign. It's made out of granite to show you that it can never fail. It's going to be there forever, even if they do silly things like-- well, I won't go into all of the silly things that they do, but they do many silly things. We'll go into that later.

But the bank is going to give me another $750,000 in cash, right? And in return, I'm giving them essentially an IOU. An IOU. And I'm going to pay interest, right? So they're going to hold this little security that says "Sal owes me $750,000, and he has to give me 10% interest every year." So $75,000 a year or something like that. And in return, I get $750,000 of cash.

So what does my balance sheet look like now? Well, let me draw it. Let me make sure my balance sheet now looks-- let me draw it like a square because I think the visual representation is helpful. And then I will split it.

So what are all my assets now? I had $250,000, and now I got another $750,000, right? I got another $750,000 from the bank. So now what are my assets?


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