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.

• Assets
• Liabilities
• Revenues
• Expenses

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.

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.

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.

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.

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?

Answer:

• 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.