WEBVTT NOTE Before the entry: event, element, and account 1 00:00:00.000 --> 00:00:05.327 Every day, something happens. For most organizations, many things happen. 2 00:00:05.327 --> 00:00:18.461 Regardless of their industry, employees, customers, investors, counterparties, and various other parties generate an overwhelming amount of activity when viewed under a microscope. 3 00:00:18.461 --> 00:00:30.064 Clearly, not all of this activity "matters" for modeling the financial condition of an organization, even if some of it does. So how do we decide what matters? 4 00:00:30.064 --> 00:00:46.044 And relatedly, how do we answer the rest of the Five W's we learned in grade school? Taken together, financial reporting boils down to answering the who, what, when, where, why of an organization's financial activities. 5 00:00:46.044 --> 00:00:53.998 For better or worse, in the United States and most of the world, we are not making up the rules from scratch. 6 00:00:53.998 --> 00:01:07.497 While financial reporting has and likely will always continue to leave broad discretion to the parties preparing a report, there are still clearly marked boundaries we must stay within. 7 00:01:07.497 --> 00:01:19.464 And these boundaries begin with the basics - what are the types of events we must record? Let's start with the most basic version of the rule: The rule, first pass. 8 00:01:19.464 --> 00:01:32.015 An event belongs in the records when it changes what the organization owns or what it owes. That test is clean enough, and it holds until we try it on an ordinary purchase. 9 00:01:32.015 --> 00:01:45.149 A single purchase can carry three dates, and somebody inside the company will call each of them the real one. Beacon Design is a small architecture studio invented for this course. 10 00:01:45.149 --> 00:01:48.360 It needs 3,000 dollars of drafting supplies. 11 00:01:48.360 --> 00:01:56.242 Its office manager signs a purchase order on Monday. The order says Beacon pays within 30 days of delivery. 12 00:01:56.242 --> 00:02:09.649 The vendor delivers on Wednesday and invoices Beacon, and Beacon pays 1,000 dollars on Friday against the 3,000 dollars it now owes. So which of those three dates does Beacon record? 13 00:02:09.649 --> 00:02:20.624 Beacon's financial statements change on Wednesday and on Friday. Monday changes nothing in them, though it changes plenty in the records behind them. 14 00:02:20.624 --> 00:02:27.696 Monday is also the date most of us would pick, which is why it is the one to work through first. 15 00:02:27.696 --> 00:02:40.476 Why Monday looks like the right date. There are good reasons to think Monday counts. The order is signed, and on these terms the vendor could enforce it if Beacon backed out. 16 00:02:40.476 --> 00:02:49.143 Inside the company the 3,000 dollars is already spent in every practical sense, and Beacon's books say so from Monday. 17 00:02:49.143 --> 00:02:59.133 The order is on file, the amount is committed against a budget, and no other manager can spend the same 3,000 dollars on something else. 18 00:02:59.133 --> 00:03:08.828 Bookkeeping is doing its job here, and a treasurer forecasting cash will count that 3,000 dollars weeks before any invoice shows up. 19 00:03:08.828 --> 00:03:24.840 So a rule suggests itself: a signed obligation is an obligation, so put the signed contract in the liabilities. That rule isn't naive. If what we want to know is what Beacon has promised, Monday is the date to look at. 20 00:03:24.840 --> 00:03:37.620 Here is where we have to be careful, because two different questions are hiding in one word. An accounting system records far more than a set of financial statements reports. 21 00:03:37.620 --> 00:03:53.486 Beacon's records track the order, the budget, the vendor, and eventually the invoice number. The financial statements report a much smaller set: what Beacon owns, what it owes, and what happened to the owners' claim. 22 00:03:53.486 --> 00:04:05.752 Recognition is the narrower question, and it is the one the first pass is really asking. Everything in this course sits on top of an assumption we should say out loud. 23 00:04:05.752 --> 00:04:10.673 The records have to be complete, and each event has to appear once. 24 00:04:10.673 --> 00:04:26.832 Get recognition perfectly right on top of books that double-count a sale or lose a payable, and the report is still wrong, because no rule about when to record something repairs a record of something that never happened. 25 00:04:26.832 --> 00:04:37.947 The SEC's allegations in HealthSouth describe thousands of small false entries, each sized to stay under the threshold where anyone would look. 26 00:04:37.947 --> 00:04:51.704 The law agrees: the Foreign Corrupt Practices Act requires issuers to keep accurate books and adequate internal accounting controls, separately from anything to do with bribery. 27 00:04:51.704 --> 00:04:58.855 Recognition asks a narrower question than whether something happened that matters to Beacon. 28 00:04:58.855 --> 00:05:09.192 The Financial Accounting Standards Board (FASB) defines the two elements we need here, and both definitions turn on the word present. 29 00:05:09.192 --> 00:05:18.672 Quoting FASB Concepts Statement No. 8, Chapter 4, paragraphs E16 and E37. 30 00:05:19.272 --> 00:05:35.976 An asset is a present right of an entity to an economic benefit. A liability is a present obligation of an entity to transfer an economic benefit. 31 00:05:36.776 --> 00:05:42.172 Let's put those words into the first pass: The rule, tightened. 32 00:05:42.172 --> 00:05:55.704 An event belongs in the records when it gives the organization a present right to an economic benefit, or leaves it with a present obligation to transfer one. 33 00:05:55.704 --> 00:06:11.120 Owning has become a present right, owing has become a present obligation, and present is the word Monday fails, because on Monday Beacon holds neither the right nor the obligation. 34 00:06:11.120 --> 00:06:21.373 What is missing on Monday. Neither side has performed on Monday. Beacon's duty to pay doesn't mature until the supplies arrive, and they haven't arrived. 35 00:06:21.373 --> 00:06:28.409 The vendor's duty to deliver is outstanding too, so each side is holding nothing but the other's promise. 36 00:06:28.409 --> 00:06:37.388 An exchange in that state, where both promises are outstanding and each is the price of the other, is what accountants call executory. 37 00:06:37.388 --> 00:06:50.455 The same state shows up whenever any of us orders a couch for delivery next month, since the store still has the couch and we still have the cash. Notice how much work the payment terms just did. 38 00:06:50.455 --> 00:06:57.692 We concluded that Beacon's duty had not matured because the order says payment comes 30 days after delivery. 39 00:06:57.692 --> 00:07:08.079 Change that clause to payment on signing and the analysis changes, because Beacon would owe the 3,000 dollars on Monday no matter what the vendor did next. 40 00:07:08.079 --> 00:07:15.048 That is an obligation with no condition left on it, which is exactly what the tightened rule asks about. 41 00:07:15.048 --> 00:07:23.492 Whether it belongs in Monday's statements, and what would sit opposite it, is a question later units take up with prepayments. 42 00:07:23.492 --> 00:07:31.332 What matters now is smaller and firmer: we read the terms before we pick the date, because the terms are what decide. 43 00:07:31.332 --> 00:07:42.255 Recognizing one side of an executory contract while ignoring the matching right or duty would report half of an arrangement as though the other half did not exist. 44 00:07:42.255 --> 00:07:51.368 Recognizing both sides would put 3,000 dollars of supplies on Beacon's balance sheet while those supplies sit in the vendor's warehouse. 45 00:07:51.368 --> 00:08:05.180 Neither report describes where Beacon stood on Monday, so nothing goes into the records that day. None of that says Beacon has no legal duty on Monday. A signed order is a contract, and the duty is real. 46 00:08:05.180 --> 00:08:20.149 What Beacon does not have yet is an obligation to transfer an economic benefit now, instead of a promise that becomes payable once the vendor delivers. Enforceability and a present obligation are two different questions. 47 00:08:20.149 --> 00:08:24.504 The notes are a third place, between the records and the totals. 48 00:08:24.504 --> 00:08:40.561 Some purchase commitments have to be disclosed, and a commitment whose price has turned against the buyer can require a loss before anything is delivered, which for inventory is an inventory purchase commitment question under Topic 330. 49 00:08:40.561 --> 00:08:47.977 Both tests have conditions this lesson does not establish, and neither changes what Beacon records on Monday. 50 00:08:47.977 --> 00:09:01.041 The Codification classifies the Conceptual Framework as nonauthoritative: it explains why the elements read the way they do, and cannot settle a question a Codification Topic answers directly. 51 00:09:01.041 --> 00:09:13.833 The tightened rule describes the ordinary case, and a few arrangements land in the records before either side has performed. Where the rule stops, arrangements recorded before performance. 52 00:09:13.833 --> 00:09:31.863 A derivative goes on the balance sheet from inception, a written guarantee creates an obligation while the guarantor has done nothing, and a purchase contract can create a liability before delivery once the agreed price has moved far enough above the asset's value. 53 00:09:31.863 --> 00:09:39.824 Each gets its own unit later. They are named here because a signature does sometimes put an amount in the statements. 54 00:09:39.824 --> 00:09:54.596 What changes when the supplies arrive. The vendor delivers on Wednesday, and Beacon now controls the supplies and holds a present right to the benefit its drafting staff will get from consuming them. 55 00:09:54.596 --> 00:10:06.474 Beacon also owes 3,000 dollars with no condition left, because the only condition attached to its promise was that the vendor perform, and the vendor performed. 56 00:10:06.474 --> 00:10:22.211 Beacon itself did nothing on Wednesday, so the other party's act is what moved the date. An executory promise ordinarily becomes a present obligation for the contract amount at the moment the other side performs. 57 00:10:22.211 --> 00:10:32.307 Delivery is what makes the obligation present, so the accounting transaction is the delivery itself and not the invoice that reports it. 58 00:10:32.307 --> 00:10:48.490 Satisfying a definition is necessary for recognition and not enough on its own, because the amount also has to be measurable and faithfully representable, and the agreed 3,000 dollars on the signed order supplies both. 59 00:10:48.490 --> 00:10:58.437 Friday changes two amounts and nothing else. Beacon's cash falls by 1,000 dollars, and what it owes the vendor falls to 2,000 dollars. 60 00:10:58.437 --> 00:11:14.768 Settling a payable reduces one asset and one liability, and it creates no expense, earns nothing, and brings in no new resource. That is why the date Beacon pays is a poor guide to the date Beacon took on the obligation. 61 00:11:14.768 --> 00:11:25.368 A few elements, many accounts. We have the when for this purchase. The rest of the entry answers what, and that turns out to be two questions, not one. 62 00:11:25.368 --> 00:11:32.598 The financial statements report a short list of categories, and there is no tenth one hiding somewhere. 63 00:11:32.598 --> 00:11:43.267 Assets, liabilities, and equity, plus the revenues, expenses, gains, losses, owner investments, and owner distributions that explain how equity changed. 64 00:11:43.267 --> 00:11:54.007 These are the financial statement elements, and every effect Beacon records lands inside one of them. Supplies and Accounts Payable are not on that list. 65 00:11:54.007 --> 00:12:07.134 They are accounts, which are the individual records Beacon keeps so it can answer questions later: how much do we hold in drafting supplies, and how much do we owe Northline specifically. 66 00:12:07.134 --> 00:12:21.664 A company has a handful of elements and can have hundreds of accounts, and every account it opens belongs to exactly one element. Accounts Payable is an account, and the element it belongs to is liabilities. 67 00:12:21.664 --> 00:12:26.929 So how much does the choice of account decide? Less than most of us expect. 68 00:12:26.929 --> 00:12:38.020 Suppose a second studio records Wednesday's delivery to an account called Drafting Materials and organizes its payables by vendor name instead of by category. 69 00:12:38.020 --> 00:12:53.392 Its total assets and its total liabilities come out identical to Beacon's, because the accounts a company opens do not change how much lands in the element each account belongs to. Do not push that further than it goes. 70 00:12:53.392 --> 00:13:03.992 Choosing between two accounts inside one element leaves total assets and total liabilities alone, and it can still move two numbers somebody relies on. 71 00:13:03.992 --> 00:13:12.320 Current and noncurrent obligations are reported separately, so a lender computing working capital reads that split. 72 00:13:12.320 --> 00:13:27.818 Supplies also get consumed within the period while equipment gets depreciated over several years, so an account that misdescribes what Beacon bought sends the cost out through the wrong route and in the wrong year. 73 00:13:27.818 --> 00:13:41.867 What the asset is decides both the account and the treatment, and the title on the account does not decide the treatment on its own. So read the event, name the elements, then pick the accounts. 74 00:13:41.867 --> 00:13:53.816 Work in the other order and we are deciding what happened from whatever account title came to hand, which is how a reported total ends up resting on a typing choice. 75 00:13:53.816 --> 00:14:08.024 Why an account has two columns. Beacon's obligation to the vendor stood at 3,000 dollars on Wednesday and 2,000 dollars after Friday's payment, and an account has to preserve more than that closing figure. 76 00:14:08.024 --> 00:14:18.212 A single running total answers how much Beacon owes today and nothing further, which is the difference between a bank balance and a bank statement. 77 00:14:18.212 --> 00:14:23.826 Anyone tracing Friday's payment needs the increases and the decreases kept apart. 78 00:14:23.826 --> 00:14:40.043 A T-account keeps them apart with a title, one column for each direction, and a balance read from the difference, so the 3,000 dollars delivery and the 1,000 dollars payment stay visible after they have been netted against each other. 79 00:14:40.043 --> 00:14:46.905 Which direction goes in which column follows a convention, and debits and credits works through it. 80 00:14:46.905 --> 00:14:58.964 Nothing here depends on that convention, because the analysis that the obligation rose on Wednesday and fell on Friday is complete before either amount is placed in a column. 81 00:14:58.964 --> 00:15:09.776 The worked example credit purchase and partial settlement runs these three dates through the accounts if you want to see the entries before the next lesson. 82 00:15:09.776 --> 00:15:26.257 Exit check. Beacon signs a 9,000 dollars equipment order on March 3, takes delivery on March 20, and pays 4,000 dollars on April 5. State the dates on which Beacon's recorded amounts change and what changes on each. 83 00:15:26.257 --> 00:15:42.891 March 20 affects two elements, so name both, and name an account Beacon might reasonably use for each. Then separate the two decisions you just made: naming the elements is one, and choosing the accounts is the other. 84 00:15:42.891 --> 00:15:57.609 A lender reading total liabilities sees the effect of the element decision and not the account decision, so say why, and then say how the account decision still changes numbers Beacon reports. 85 00:15:57.609 --> 00:16:08.264 Finally, draw the payable as a T-account across both dates, and say what the two columns preserve that a single running balance would lose. 86 00:16:10.264 --> 00:16:16.048 Two things to try before you go, in the words the practice bank uses. 87 00:16:16.048 --> 00:16:30.629 Question. A company places a purchase order for office supplies. Two days later the vendor delivers the supplies on credit, and the company accepts them. 88 00:16:30.629 --> 00:16:45.496 Under the stated terms, the order alone created no recognized asset or liability. Which statement correctly distinguishes the event, elements, and accounts? 89 00:16:45.496 --> 00:16:54.292 A. The purchase order is the asset, and Supplies is the financial statement element. B. 90 00:16:54.292 --> 00:17:10.065 Delivery creates the stated asset and obligation; Supplies and Accounts Payable are accounts that preserve detail about the asset and liability elements. C. 91 00:17:10.065 --> 00:17:28.264 No accounting event occurs until cash is paid because only cash movements can be recorded. D. Accounts Payable is the economic event, and delivery is the account used to record it. 92 00:17:33.264 --> 00:17:48.168 The answer is B. Delivery creates the stated asset and obligation; Supplies and Accounts Payable are accounts that preserve detail about the asset and liability elements. 93 00:17:49.368 --> 00:18:13.792 Question. In a different fact pattern, a company begins with 5,000 dollars cash and 5,000 dollars equity. It receives 4,000 dollars of unused supplies on credit and later pays the vendor 1,500 dollars. 94 00:18:13.792 --> 00:18:22.176 No other events occur. Which set of ending element totals is correct? 95 00:18:22.176 --> 00:19:01.849 A. Assets 3,500 dollars; liabilities 0 dollars; equity 3,500 dollars. B. Assets 7,500 dollars; liabilities 2,500 dollars; equity 5,000 dollars. C. Assets 9,000 dollars; liabilities 4,000 dollars; equity 5,000 dollars. D. 96 00:19:01.849 --> 00:19:14.472 Assets 7,500 dollars; liabilities 4,000 dollars; equity 3,500 dollars. 97 00:19:19.472 --> 00:19:30.920 The answer is B. Assets 7,500 dollars; liabilities 2,500 dollars; equity 5,000 dollars.