Chapter 2 – Financial Reporting Elements, INTRODUCTION

hi else here and today we’ll be talking about the elements of financial reporting let’s first have a quick review so we understand why the elements are a part of generally accepted accounting principles also called GAAP we know that stakeholders are individuals or groups who either affect the business or are affected by the actions of the business every stakeholder has an objective something and they want from their relationship with the business stakeholders can be either internal or external internal stakeholders work for the business their objectives.

Generally relate to their ability to do their jobs keep their jobs get promoted and get paid external stakeholders are outside of the business and their objectives relate to the decisions they’ll make about providing resources to the business generally money this is called resource allocation decisions external stakeholders need a business’s financial information so they can make decisions with regards to providing resources generally money to the business businesses are involved in thousands of activities every single day.

They record their business activities in the accounting system an information system that collects groups and communicates a business’s financial position including its financial health and profitability the end result of an accounting system are the financial statements financial statements tell a business’s story what they do.

Business’s Financial Performance

How well they do it they provide a business’s financial performance its current financial position and its cash flows external stakeholders use the financial statements to analyze a business and make resource allocation decisions decisions about whether or not to provide resources often money to the business so how does the accounting system move from business activities to financial statements the accounting system collects in groups the activities.

It can eventually produce the financial statements who decides how to group business activities generally accepted accounting principles specify the categories called financial reporting elements that all business activities are divided into by grouping the activities into elements we can eventually provide financial statements to external stakeholders that are useful for decision making so what are the financial reporting elements.

Five Elements Assets Liabilities Equity

We use to group business activities there are five elements assets liabilities equity revenue and expenses each element has characteristics that define them when we record the activities of a business we use those characteristics to determine if the transaction will affect the element or not let’s start with assets assets have three characteristics assets are owned they provide future economic benefit.

They are due to past events let’s go through each of these characteristics and expand on them first assets are owned the concept of owned is pretty straightforward for example my cell phone is an asset because I own it second assets provide future economic benefit that means that assets will be used either directly or indirectly to help the business the concept of future economic benefit is critical to assets what are future economic benefits for a business well.

Asset And liability

It might be used to produce a good or provide a service to customers like a machine that’s used to manufacture potato chips or a lawn mower that’s used to provide lawn care services it might mean that the asset will be used to get another asset like giving up cash in order to get a machine or the business might be able to use the asset to get rid of a liability like paying down alone with cash assets must have future economic benefit for the business or they’re not considered assets the last characteristic an asset is that they’re due to past events that means that there is an event in the past that transferred ownership of the asset to the business.

Characteristic Important

Why is this last characteristic important because it means that if I plan to purchase an asset in the future I can’t claim that it’s an asset now because the event has not as yet happened it has to be a done deal the transfer of ownership must already have taken place so to summarize everything that a company owns is considered an asset a resource obtained through a past event that will benefit the business in the future assets are defined as owned providing future economic benefit and due to a past event stop right now and list all your assets everyone has assets listing yours will help you to better understand the concept of assets think about what past events caused your assets to become yours and also how your assets will benefit you in the future.

Element of Financial Reporting

How companies get their assets they often use liabilities the next element of financial reporting they take on debt in order to increase their assets liabilities also have three characteristics that define them liabilities are owed to third parties they will be settled in the future and finally liabilities are due to past events again let’s go through each of these characteristics individually first liabilities are owed and obligation or debt important also is that.

they are owed to third parties individuals or groups who are outside of the business a personal example of a liability is the student loan you might owed as a debt to the bank second liabilities will be settled in the future how are they settled through the giving up of either cash goods or services for instance a student loan will be settled through the payment of cash in the future.

Good Third Liabilities

Other obligations might be settled by providing a service or delivering a good third liabilities are due to past events again why is this important because if you plan to borrow money next year that’s not a liability yet and therefore you can’t record it as a liability the event borrowing money has not yet happened a liability will only exist after you get the money so to summarize everything that a company owes to a third party is considered a liability an obligation due to a past event that the business will settle in the future liabilities are defined as owed to third parties to be settled in the future due to a past event stop again and list all your liabilities some students don’t think they have any but if you use a credit card and have not as yet paid your bill or you have a cellphone bill you probably have liabilities let’s move on to equity equity is a difficult concept to grasp.

Business generates Profit/Retained earnings

We’re going to keep it simple right now equity is equal to the wealth that is due to the owners of the business and it is made up of two items first equity is the capital provided by the owners for instance if you start a business with $20,000 of your own money then you have $20,000 of capital in the business which is recorded as an equity second equity is the profit that the business generates and keeps in the business for instance if the business has profit of $10,000 during the year then the equity would go up by $10,000 if portion of that profit was paid out to the owners in the form of dividends then equity would go off by the amount of the profit less the amount of the dividends for instance if the business has a profit of ten thousand dollars but it paid out dividends of two thousand dollars then equity would increase by eight thousand dollars.

Which is the profit that the business kept this is called retained earnings meaning the profit kept or retained in the business for future expansion so to summarize equity is the capital invested by the owners plus the profit less dividends retained by the business equity is owed to the owners of a business by the business equity capital plus retained earnings owed to the owners so what is your equity or wealth position it’s easy to calculate your equity all you do is take the value of your assets and deduct the value of your liabilities what is left over is equal to your equity or your wealth.

Definition Revenue

Let’s move on to the element revenue and it’s definition revenue is the income a business earns there are only two ways to earn revenue businesses either provide a service or a good the key to revenue is that it must be earned what does that mean it means that the business has done their job past tense for example if a lawn care business plans to MOA customers along tomorrow that is not earned revenue today because they have not done their job yet after they finish mowing the customers lawn.

Revenue of retail Store

They’ll have earned their revenue if a retail store plans to sell a product to a customer tomorrow revenue is not earned because again the business has not as yet done their job revenues can only be recognized when the business has finished your job provided the service or delivered the good notice the past tense that’s very important with regards to the element revenue to summarize revenues income earned through the day-to-day activities of a business when a service or a good is provided revenue earned by providing services or goods your revenues should be easy to figure out.

Last financial reporting element

If you have a job that earns you income then you know what your revenue is the last financial reporting element to define is expense expenses are the cost of the resources that are used consumed or incurred to help generate revenue expenses are best described through an example if you use gas in a lawnmower when you mow a customers lawn then the gas that was consumed during the mowing of the lawn would be an expense a cost of earning revenue.

Why because the gas was consumed in order to help generate the revenue note that the concept of use consumed or incurred is important but so is the fact that these things must have happened to help earn revenue costs or expenses must be matched to the revenue they help to generate expenses costs of what is used consumed or incurred to help generate revenue so what expenses do you use consume or incur to generate the income from your job.

It includes transportation to and from work because that would be the cost of generating your income we just defined all the elements used in financial reporting these elements are used when recording business activities business activities are groups so that we can eventually produce financial statements that will be used by external stakeholders to make resource allocation decisions in the next video we’ll be talking about combining the definitions with the accounting equation you