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 statement statement of cash flows the baby only 25 years old there are three categories of cash flows operating cash flows the things that you do every day investing cash flows investing in the productive capacity of the business buying more buildings and trucks and what-have-you and financing activities getting the money to buy the stuff that I need repaying loans paying dividends to shareholders all those three operating investing and financing which one is the most important yeah you remember operating activities because that summarizes the cash results of things that we do on a daily routine basis those three reports that you see right in front of you summarize everything about a company's performance that's given to people outside the company that is financial accounting you managerial accounting is all about communicating to people inside the company it's the information that's used on a detailed basis every single day inside the company managerial accounting its secret its detailed its daily let me illustrate the difference between managerial accounting and financial accounting with this simple example we'll talk about Walmart again we saw before that Walmart's sales four hundred and sixty six billion dollars now at four hundred sixty six billion is that a financial accounting number or a managerial accounting number yeah it's a financial accounting number we saw it in their income statement that's report made available to people outside the company so that's four hundred and sixty six billion dollars is that sales number is a financial accounting number now let's imagine for a second that you run Walmart you're the CEO of Walmart let's go crazy in our imaginations here and you're running the business that means you're making daily decisions about what needs to happen in a Walmart and the financial accounts come and say hey our sales last year four hundred sixty six billion and you say okay that's nice thanks but I'm trying to run a business here I need to know more details about that number four hundred sixty six billion I need that sliced and diced and I need to cut down I need to know more specifics I need detail I need daily detail so let's think what additional things would you like to know about that one number four hundred sixty six billion we're only talking about the sales that financial accounting number if you were to try to run Walmart what additional things would you like to know about that one number the four hundred sixty six billion I say list ten additional things we could list hundreds of additional things but here's a few that I thought of in addition to knowing that the total sales are four hundred sixty six billion I don't want to know okay how many of those sales were in North America and how many of them were in Mexico and South America and how many in Europe and how many in Asia I want to know it by region by country in fact I want to know what my store and I don't want to just know it by store I want to know how much did we have last year in that same store and what was our target for this year in that store so that we have more than last year and do we have more than we we were gonna have I want it at the store level now let's go down even further I want to know by department are we selling mostly groceries are we selling mostly children's clothing men's clothing outdoor lawn care kind of stuff what are our sales specifically in fact let's go to specific items how many of this kind of shoe did we sell how much milk did we sell how many bananas did we sell how many LA Moors did we sell I wanted over my specific items I want to drill down to as much detail as possible because I'm running a business here I wanted to identify my best sellers my worst sellers I want to make a plan 466 billion total sales doesn't give me enough information to make a specific plan of running my business on a daily basis how about physical location in the store top shelf bottom shelf in shelf back of the store front of the store you tell me how we can influence ourselves by where we play stuff in the stores I know there are some things that are safer to put in the back people won't forget about them and there are some things that unless we put him in the front nobody's gonna buy him I want to know that stuff I want to know how much is sold by seasons what's sold in January what's sold in February what's sold during the holiday selling season in fact I want to go a little bit deeper how about day of the week what happened on Mondays Tuesdays Wednesdays by time of day should we be open 24 hours should we even open before noon you tell me the sales by hour by region by item tell me all this stuff when it's raining outside what sales when it's hot outside what sells hey we ran a bunch of ad campaigns I want you to show me the impact of those ad campaigns on the sales numbers what were they in the week before what are they the week after by payment method how many people pay cash how many use this credit card I'm going to use that credit card so we have our own credit card so we even accept cash the demographics of the buyer this is where it gets quite interesting because if people pay with a credit card I've got their name attached to their list of purchases so I know what they buy and if they buy on a regular basis from Walmart Walmart I can develop a pattern of purchases and maybe it's been more than six months since they bought those certain shoes that they like or since they bought that certain grocery items they seem to want to buy if I've somehow managed to get their email address from them maybe through some buyer loyalty program then I can email them a coupon and say why don't you you haven't bought bananas in six months well here's a coupon for 50% off bananas if you're behind today I could use this specific information to target two specific buyers so the Financial Accounting number is 466580 no details that I can use on a daily basis to run this business that's managerial accounting inside secret daily detail I want to run through some specific illustrations of managerial accounting applications product costing how much does it cost to make my product if I'm making wood furniture how much does it cost me to make that wood furniture if I'm making industrial equipment how much does it cost me to make that industrial equipment if I'm Boeing how much does it cost me to make a Boeing 777 aircraft if I'm delivering the service if I'm Southwest Airlines how much does it cost me to get a passenger from New York to San Francisco what does it cost product costing then we'll do breakeven I'm going to open up a store location I want to know if there's going to be enough sales for me to break even to avoid having a loss so we'll do some examples of break-even budgeting numerical planning running your business plan out on paper first to identify any problems before they happen in the real world hopefully when we talk about budgeting you're going to think about your own personal budgeting practices and finally the last managerial accounting illustration that I want to give us performance evaluation we'll see the key concept that is this you get what you measure if you measure certain aspects of performance of your employees they're gonna focus they're going to hone in on those aspects performance evaluation product costing breakeven budgeting performance evaluation let's do illustrations of each one of those one important function of managerial accounting is computing the internal costs of providing our products or our services let's do an illustration what does it take to make wood furniture what do you need well you need some wood but what else do you need so we're gonna want to compute the cost of all the things required to make wood furniture we're gonna follow the flow of cost through this company it's August 17th the customer comes in and orders one custom-made dining table a beautiful piece of work made out of oak it's about 20 feet long they want to be able to fit a lot of people and they want it finely honed and maybe they want their own coat of arms carved into the top they want a very nice table it's August 17th they say okay I'm going around to various furniture makers describing to them the table that I want I need a bid how much will you charge me to make this table for me so okay if I want to make an intelligent bid I'm at her first figure out how much it's going to cost me to make that table so what's it gonna take to make a custom-made dining table well first it's going to take the wood and a managerial accounting setting we call this indirect materials the actual stuff that the item is made out of so in this case it's wood for making the automobiles and to being metal and rubber and the other things that go into making automobiles so direct materials that's pretty easy to estimate you describe the size of the table and the design it's gonna use wood that cost me about a thousand dollars by the way I'm not telling any of this to the customer I'm doing this privately the back room on a piece of paper so direct material is about a thousand dollars but the wood doesn't form itself into a table how many hours is it can take my workers my skilled craftspeople to make this thing happen well again I can estimate that pretty well it's about 30 hours we call these people the direct labor people they're the skilled craftspeople who actually do the work and it's gonna take them 30 hours and I pay them a wage rate of $30 per hours that's gonna end up being $900 okay am I done if I go out into the desert somewhere with a pile of wood and some workers do I have myself a nice oak custom-made dining table although I need some machines and I can estimate all right it's gonna take me about 200 machine hours to finally plane and polish and make the wood so it looks just so-so the direct materials thousand dollars direct labor $900 and I want to stop and make sure that you understand these two numbers are easy anybody who makes furniture can easily estimate the amount of direct materials they might have oak in this case it's going to take to make this dining table and the number of hours is going to take their direct labor-hour people the skilled craftspeople to do this thing and they know how much they pay these people so this 1,000 plus 900 that's pretty easy but is this it no it can't be it you need infrastructure overhead we call it you've got to have a roof over your head you got to have Supervisors you got to have maintenance people you got to have quality control inspectors you got to pay property taxes you got to have insurance you got to have all of this okay so how much of my overhead costs I've got my factory building here I'm working on this oak table right here I'm working on a children's desk over there other people I've got some bookcases going on over here I've got a china cabinet over there and I've got one supervisor kind of supervising all those jobs how much of that supervisor salary should be assigned to this oak table how much the property taxes on this building should be assigned to this oak table how much of the wages that I paid on my maintenance people how much of that should be assigned to this oak table right here how can we do that see that's the hard part the overhead is the hard part direct materials direct labor they come together that's pretty easy to estimate but the overhead cost that's hard and here's the thing to remember somebody's got to pay for these overhead cost who while there are two choices either I build it into the cost and Bill the customer for it so the customer pays or I got to pay it myself well I guess I could pay it for myself for a while but then I'm going to go out of business so I got a factor in how much overhead cost should be assigned to this particular dining table remember the customer came in on August 17th that wants to buy this table well the overhead cost I'm really not sure but let's go back and town let's go to the month before in July here's what I do know month in July I had total overhead costs total for the whole factory five hundred thousand dollars in addition my skilled craftspeople work ten thousand hours and I use my machines a total of twenty five thousand hours okay well who cares about my direct labor people because they're not part of my overhead who cares about my machines well it's this cuz I got to figure out how to assign that five hundred thousand total overhead and so let's think about this a little bit let's say I've got two projects going I got this big fancy dining room table made out of oak going on and I got fifteen workers gathered around doing various things and I get a little child's desk project on the other side of the factory over there there are two workers they're working on that one which one of those two projects the big dining room table project here or the little child's desk project over there which one of those two is going to consume more overhead cost well where there's more workers so one way to think of assigning the overhead cost is just to say okay as a rough estimate if you got more worker hours you ought to be assigned more overhead or if we say well it's not worker hours not direct labor hours it's machine hours the more you use the machines the more overhead costs should be assigned well that kind of makes a little bit of sense because the bigger a job is and the more involved it is it creates more overhead cost so that might be one way we could do this overhead and we have to use old information we're going back to July but it's better than nothing it's better than paying for the overhead cost ourselves so let's think about this perhaps we could say this listen last month the way it worked was we had five hundred thousand dollars in total overhead cost ten thousand and direct labor-hours our skilled craftspeople so it was about fifty dollars per direct labor-hour now let's be careful about this number fifty because how much are we paying those direct labor to our workers we're actually paying them a wage of thirty dollars a piece this is something different roughly speaking for every hour one of my skill craftspeople works on a project a dining room table or a child's desk or a bookcase for every one of those hours they are consuming or requiring about $50 worth of overhead cost the supervisors got to come over there using electricity the maintenance people have to come over that's their share their property taxes about $50 per hour it's not exact but it's better than nothing so that's one way that we can assign overhead to each individual project you tell me how many direct labor hours the workers are gonna work on a certain project and I'll tell you how much overhead should be assigned to that particular project or maybe we'll say now machine hours is the right way to do it last month we had $500,000 of overhead and we used our machines a total of 25,000 hours the more you use the machines the more they're going to break down the more maintenance work is gonna have to happen the more the supervisors can have to come over the more electricity you're using so maybe we say machine hours is a better way to do this and in that case it would be 20 dollars per machine hour if I make a plan for making this oak table and it's going to require 200 hours of machine work well then that's gonna create 20 dollars of overhead for every machine out roughly speaking based on this month's data or maybe there's some combination a little bit of the overhead maybe is more directly related to direct labor hours maybe that's the part about the supervisors the more workers I've got then the more the supervisor cost should be assigned to a project or maybe some the machine hours the more I use the machines than the more electricity that I use the more maintenance cost there's going to be so some combination this could get quite complex but you see the basic idea we've got to do something the overhead cost has to be assigned to individual projects that child's desk that bookcase this oak table on some rational basis can we do it in proportion to the amount of skilled craftspeople hours but some proportion of the amount of machine hours we've got to do something well let's do it on the basis of direct labor hours of direct materials thousand dollars direct labor nine hundred dollars an overhead well we've got 30 hours of direct labor work and we said roughly speaking based on what happened last month that it's about $50 of overhead costs are created for every hour that my workers work on a job remember it's not what I paid them but it's the amount of overhead cost that they create through doing their and worth 30 hours tons $50 per hour that's another 15 so I could say that the total cost of this table is three thousand four hundred just add up to three thousand plus nine hundred plus fifteen hundred now look at those three numbers one of them we're not really sure about two of them we know for sure how about the direct materials yeah you can estimate that pretty closely how much wood are you gonna use about the direct labor you had some experience with your workers you know how long it's gonna take them to make a project like this and you know how much you're paying them $30 higher it's the overhead that we're not so sure about so let's try a different way to do it let's assign the overhead based on machine hours based on how much we use the machines that's how overhead gets created well the director shows us the same thousand dollars direct labor is the same nine hundred dollars if we base the overhead on machine hours this particular oak table job is going to require two hundred hours of using our machines and we decided based on data that happened last month that would create about twenty dollars of overhead for every hour we'll use our machines so 200 machine hours times twenty dollars of overhead created for every hour we use our machines that's four thousand dollars thousand plus nine hundred plus four thousand that's five thousand nine hundred now stop because you might say well wait a second why don't you just wait until the end of August so you can figure out more current data based on the August data well you could do that it would still be an estimate plus you can't say to your customer listen I really can't tell ya how much it's gonna cost to make your table and therefore I can't set a reasonable price because it's not the end of the month you're gonna have to come back at the end of the month and then I can tell you what your customers gonna say your customer says listen if you can't quote me a price now look go to one of your competitors there's another example of good managerial accounting being a competitive tool if I can understand my cost well enough so I could get an estimate the cost of the direct materials direct labor and overhead BAM right now on August 17th when the customer comes in if I can do that right now then I can quote him a price and that gives me a chance to get this job here's the problem though I got two different costs here depend on how I sign the overhead I got three thousand four hundred and I got five thousand nine hundred which is the right cost what does it cost to produce this table it's a three thousand four hundred where we assign the overhead based on the proportion of direct labor-hours skilled craftspeople usage is it $5,900 where we assign the overhead based on that how intensively we use the machines or is it something else some combination of the two or something else entirely okay well what difference does it make Wow makes a huge difference first of all let's say that the number is five thousand nine hundred and a customer comes in and says I'll give you five thousand for the table well you do your calculations and you say no I won't accept a price of five thousand because if I do that I'm going to lose money I compute my cost to be five thousand nine hundred in fact if my cost really is five thousand nine hundred what I will suggest to the customers why don't you go to my competitor down the street because if I can get my competitor to do this job for five thousand dollars what I'm pretty sure that it's going to cost them five thousand nine hundred dollars to do it I can help drive my competitor into bankruptcy now I would not be a nice thing to do but hey it's business but what if and you'd listen to me closely what if the real cost what if the right way to assign overhead is by direct labor-hours suggesting that the real cost of three thousand four hundred but I don't know that I mistakenly think that I should be assigning overhead based on machine hours so I mistakenly think that my cost is five thousand nine hundred customer says I'll pay you five thousand you mistakenly think based on your incorrect assignment of overhead cost it cost me five thousand ein hundred to do it you're offering to pay me five thousand forget about it but in reality if the overhead should be assigned based on direct labor-hours the real cost is only three thousand four hundred if you tell your customer to go away you're sending away profit they're willing to pay you five thousand to give them something that only cost you three thousand four hundred to make so should we make this table or not yeah it makes a big difference how we assign the overhead and at what price should we sell the table if we don't understand our cost we don't know how to intelligent make our prices and if we don't know how to set our prices intelligently and our competitor down the street does know how to estimate their costs appropriately and so can set their prices appropriately our competitor is going to beat us cost flows and product costing there are three kinds of cost in a production setting direct materials that's easy direct labor the skilled craftspeople that's easy it's this overhead thing how much overhead should be assigned to each project that's where it gets hard that's where the art is involved we can't have an entire course a series of courses a year-long seminar on just this one thing but you can see why it's a crucial issue another illustration of the you managerial accounting is breakeven analysis one huge benefit of financial analysis in general and break-even analysis in particular is that it can counteract the natural over optimism of entrepreneurs now don't get me wrong I'm not saying that accounting numbers can make all your decisions for you you and the end still have to make the judgment call should we do the charity banquet or not should we open the scuba shop and the mall or not should we build a new restaurant in this location or not you've got to make that business decision but the accounting numbers in this case the break-even analysis that can at least help you identify ideas that are really bad that have no hope of working and also help you identify ideas that are almost certain to work and most decisions you're going to find Wow we got to use our judgment here but at least the accounting analysis has helped you structure it a little bit and has forced you to gather data so that you're not making a decision based on just your optimistic view of life as an entrepreneur you're using a little bit of data bringing you down to earth just a little bit break-even analysis a very simple intuitive way to understand business decisions budgeting is another important topic in managerial accounting remember managerial accounting detailed stuff that we use every day inside a business not the kind of thing that we're going to reveal the people outside it's the kind of stuff that we're going to be using inside budgeting making a systematic plan on paper so we can see problems before they arise in the real world because budgets help you see problems in advance and probably solve them in advance before they ever actually happen so it's a how much excitement do you want in your life if you want to have your excitement in other ways do budgets that'll allow your business your personal affairs to run more smoothly so then you can save your excitement for other things so what are the benefits of a cash budget in particular in this case and a budget in general well would you budget things but really means you're running a simulation of how your company is going to operate for the next few months and you say well okay we need to make advance arrangements for this we need to arrange that loan a well in advance of when we actually have to make it the budget allows you to have realistic targets a budget gives you hope this is especially important for startup companies because startup companies have some lean times they burn through a lot of cash for example it's nice to have a cash budget the budget creates the light at the end of the tunnel and the budget helps us identify and solve problems on paper before they ever happen in the real world there are huge benefits to budget for all organizations for businesses and for you and me personally there are four flavors of accounting standard bookkeeping to gather all the information financial accounting reporting to outsiders managerial accounting recording inside the company that detailed information that we need to make daily decisions and finally income taxes let's talk more about income taxes income tax accounting is its own specialized field there are elements of income tax compliance let's make sure that we're obeying the law there are elements of income tax planning let's make sure that we structure our affairs so that we don't have to pay any more tax than we need to and for you and me there's just the element of filling out our tax form well here in this discussion we'll talk about some general principles with respect to income taxes we won't drill down to the level of actually filling out your tax form that would be a discussion for another day but let's make sure that we understand the general concepts the basic terms with respect to income tax accounting to facilitate our discussion of income tax systems I've designed a very simple income tax system here that contains the important elements of all income tax systems around the world so in this simple system for income from 0 to $50 you don't pay any income tax at all you're allowed to make that money tax-free in this governmental tax system that I've designed for all income over $50 you got to pay a tax rate of 50% so this is going to make our calculations simple so again this has all the elements of the tax system in the United States and in the European Union and Hong Kong and China everywhere else so we'll use this to represent tax systems around the world so we'll answer these questions under this tax system how much tax would you pay if you made $50 what have you made fifty one dollars what have you made $100 let's do the computations in each one of those three cases if you make $50 you don't pay any income tax under this system first $50 are tax free so that's a pretty easy to computation to do alright but what if you make fifty one dollars okay the first $50 still you pay no tax that 50 first dollar you're going to pay the rate of 50% so your total tax that you're going to pay is fifty cents this illustrates the important notion of the tax bracket you'll sometimes hear people but Mon the fact that oh I got a raise so now I'm in the next tax bracket well that's kind of a naive comment and I'll show you why the tax bracket is this the first tax bracket in this case is from 0 to $50 and the rate on that first $50 is always zero no matter how much you ever make so when you make the 51st dollar when you go into the next tax bracket where income is taxed at the rate of 50% that is not applied retroactively Li you don't have to go back and pay the 50% rate on the first 50 that first $50 is never taxed the rate is always zero that's the first tax bracket the second tax bracket in this simple example is everything over $50 in that second tax bracket yes the tax rate is 50% but let's think should we be sad that we got a raise in this case we went from making $50 to $51 does that cost us any money well no it does not because when I make $50 I have the $50 I don't pay any tax if I make $51 yes it's true that I now have to pay half of that 50 first dollar in tax so I have to pay 50 cents in tax but I get to keep the other half so if I make $51 I have the first 50 tax free and I get to keep half of the 51st dollar so I have 50 dollars and 50 cents going to the next tax bracket doesn't cost you any money it just means you have to pay a different rate on the extra income that you're going to make so don't be afraid of making more money and going into the next tax bracket that's a cause for celebration under this simple tax system how much tax do you pay if you make $100 well again the first 50 is never taxed at all so the tax that you pay is 0 the second 50 is taxed at the rate of 50% so you're going to pay a total of $25 tax if your taxable income is $100 this allows us to discuss two important concepts the average tax rate and the marginal tax rate the average tax rate is simply the tax that you owe 25 dollars in this case divided by how much you made $100 in this case 25 dollars divided by $100 that's 25 percent that's the average tax rate and it's a very intuitive notion what's the average tax rate for all taxpayers in the United States oh it's somewhere between 17 and 20 percent the average tax rate the tax that they have to pay divided by the amount that they make so 25% average tax rate in this case if you make $100 economists say that a more important rate than the average tax rate is the marginal tax rate what's the rate you're gonna pay on the next dollar that you make and the reason that's an important concept from an economic standpoint is that's the rate that I have in mind when I'm considering how should I put in some extra time and make more money because on the extra money that I make I'm gonna have to pay the marginal tax rate the tax rate on the next dollars that I'm going to make I'm an entrepreneur with good business ideas should I work hard and devote my time and energy to starting that business and making money because if I start that business and make extra money I'm gonna have to pay the marginal tax rate 50 percent in this case so the marginal rate that's the number that people have in mind as they consider it whether they should work harder the average tax rate just takes all the elements of the tax system and what's the average amount of your income that you pay marginal tax rate what rate am I going to pay on the next dollar that I make average tax rate just how much to attack so I pay given all the complexities and tax brackets in the system divided by how much I made in this case if you make $100 your average rates 25% marginal rate is 50% and that marginal rate is the rate that you look at as you consider should I work hard start my own business put in some extra hours to make a little extra money you might be asking yourself so why exclude some income from taxation in this simple system why let people make that $50.00 without paying any tax at all well the concept here is that there is a fixed cost to living I have to have a certain amount of money to put a roof over my head and put food on the table and clothes on my back so let's not tax any of that money because those are the essentials of life once I've got those things taken care of okay now the government could start to take some tax from me so that's the very simple and appropriate in my opinion a concept behind this notion of allowing some income not to be taxed and this is true in all income tax systems around the world there's a fixed cost to living if I take money away from a person who's not making very much they're gonna have to give up some important things their food won't be so good the quality or quantity won't be as good as otherwise would be so let's let them keep that money let's instead collect tax money from those who are making a surplus because they're not giving up the necessities of life so that's why some income is always excluded from taxation in all income tax systems around the world another phrase that you might have heard is progressive tax system what's a progressive tax system well it's simple tax system that we've been talking about is a progressive tax system let me show you why if you make $50 as we saw you pay no tax so your average tax rate is 0% if you make $100 we did the calculations and saw that you pay tax of $25 so your average tax rate is 25% in this system if you were to make a thousand dollars the first 50 is not taxed at all the second 950 is taxed at a 50% rate so you'd pay four hundred and seventy five dollars in tax your average tax rate would be forty seven point five percent so what you see is the average tax rate goes up the more money you make that is a progressive tax system and all income tax systems around the world are progressive systems the more you make the higher your average tax rate and again that makes sense because people who are making more money can afford to pay more tax because there won't be denied the necessities of life so the more money you make the higher your average tax rate I've been careful here to say that income tax systems around the world are progressive not all tax systems are progressive for example the sales tax is an example of a regressive tax the less money you make the more percent of your income you're gonna pay as sales tax and why is that if you don't make very much money most of the money that you do make is used on buying goods and services on which you will frequently have to pay sales tax whereas if you make lots of money a lot of the money that you make is going to be put in investments and other things or you're not buying goods and services and are not paying sales tax so the sales tax is an example of a regressive tax the lower your income the higher your percentage of income that is paid in the form of sales tax but income tax systems around the world are progressive just as we've seen here you what is the impact of a tax deduction in our simple tax system so let's say you make $100 remember the first 50 is never taxed the second 50 would be taxed at the 50% rate so you're gonna pay 25 dollars in tax total now let's say that of that hundred dollars you make you decide to spend ten dollars in a way that the government favors perhaps you spend that ten dollars as a charitable contribution or you spend that ten dollars paying mortgage interest on your home so the government says yeah we want to encourage that behavior that's a good way to spend ten dollars then you're going to get a tax deduction for that ten dollars so how does that enter into the payment of your taxes well now you have to compute your taxable income you made $100 but ten of that you spent in a special way which is tax deductible so your taxable income is only $90 so first 15 is still tax-free now the second 40 is taxed at the 50 percent rate so you're gonna pay tax of $20 so you see here that the tax deduction of $10 reduces your income taxes from $25 initially to $20 after you subtract the tax deduction again what are tax deductions they are expenditures by individuals that the government favors for charitable contributions for investing in your IRA or your 401k plan for paying interest on your home mortgage there are also business tax deductions five a business and I make $100 but then I use ten dollars of that to pay wages to my employees or pay electricity on my building or pay property taxes on my building any legitimate business expense that's also a tax deduction so there are really two kinds of tax deductions tax deductions legitimate business expenses and tax deductions spending by individuals that the government wants to encourage charitable contributions 401k investments payment of interest on the mortgage of your home and we see that what a tax deduction does is reduces your taxes now you say well that's great I should get the largest mortgage and pay the most interest that I possibly can because I'll get all these tax deductions no no no let's be careful here in order to get this $10 tax deduction I had to spend $10 on my home mortgage interest so I had to spend $10 don't to a charity so $10 is gone yes the pain is eased a little bit by the fact that I now get to reduce the taxes that I pay to the government by five dollars but there's still a cost I spent ten dollars for charity or whatever else in order to save five dollars in taxes so you got to make sure still that you want to spend the ten dollars but the government is easing the pain by giving you a deduction for that ten dollars so that's a tax deduction how about a tax credit it's a difference between the tax deduction and the tax credit let's go back to the our same example you make a hundred dollars and our system you know the first fifty you pay no tax the second fifty you pay the rate of fifty percent so you're gonna pay twenty five dollars tax great now let's say that you spend ten of those dollars in a very favored way according to the government maybe you spent the ten dollars increasing the energy efficiency of your home you put solar panels on your roof you did something that the government really wants to encourage in this case they're going to give you a tax credit again this is determined by the government through a governmental process we're gonna give you a ten dollar tax credit so how's that difference from a tax deduction well you compute your tax you pay no tax on the first fifty dollars you pay a rate of fifty percent on that second $50 so you pay twenty five dollars in tax but the government says if it's a tax credit you spent that money so well you spent it just the same way we would have so what we're gonna say is you can reduce that directly from your taxes you owe us twenty five dollars in taxes just reduce that ten dollars that tax credit so you only have to pay us fifteen dollars this is evidence that the government really approves of the way that you spent that ten dollars I've reduced my tax directly by the whole ten dollar tax credit so which is better a tax deduction or a tax credit well we see that the ten dollar tax credit in this case reduces my income taxes from twenty five dollars down to fifteen dollars that same ten dollars if it's a tax deduction reduces my taxes only from twenty five dollars down to twenty dollars tax deduction reduces my taxes by five dollars tax credit reduces my taxes by ten dollars so if somebody gives you your choice do you want a ten dollar tax deduction or a ten dollar tax credit you show them how wise you are you the tax credit let's talk about the two different kinds of income out there there's ordinary income and there's capital gains income ordinary income is just like it sounds it's ordinary income the wages that you get from the job that you have your salary let's say you've got savings account in the bank you're an interest that's ordinary income dividends you've got some investments you get some dividends that's all ordinary income capital gains income is when you make an investment let's say you buy a stock portfolio and hopefully you're going to buy low and sell high let's say I buy it $1,000 and sell at $1300 that $300 that went up that's called capital gains income so there's ordinary income wages salary interest dividends and there's capital gains income income from investments worldwide in particularly the United States capital gains income is typically taxed at a lower rate now we could get in a long philosophical discussion about whether this is right or wrong let me just give you other rationale on both sides the reason that capital gains income is typically taxed at a lower rate is one governments want to encourage people to invest invest in businesses and invest in portfolios for savings purposes so to encourage that will tax any capital gains income as a lower rate in addition people say listen if I'm going to invest money in a stock portfolio I already paid tax on that money when I originally made it he can attacks me again when I invest it so that's the rationale in favor of taxing capital gains at a lower rate on the other side hey income is income if I work through the sweat of my brow and make money I should pay tax on that if I invest my money and my investments go up in value I should have to pay tax on that there's no difference it's just a different way to make income capital gains income should be taxed the same rate as anything else those are the arguments on both sides the fact is that in most jurisdictions around the world capital gains income is taxed at a lower rate in fact in some places capital gains income is not taxed at all in the United States ordinary income is taxed at one rate capital gains income is taxed at a lower rate let's go back to our simple tax system for income from zero to $50 you know pay any tax at all that's the first tax bracket for income above $50 the tax rate is this if it's ordinary income you pay a rate of 50 percent if it's capital gains income you pay a rate of 20 percent so we're introducing the notion of ordinary income and capital gains income to different rates it's how much income tax would you pay if you made a hundred dollars let's think about this if the hundred dollars that you make is ordinary income meaning you just went to your job and that's your wage or that's your salary or you had some interest that you made on a savings account or dividends and you got from investments that hundred dollars an ordinary income is going to be taxed zero on the first $50 and at the rate of 50 percent on the second 10 T five dollars tax the same thing that we saw before the ordinary income if on the other hand this hundred dollars income that you made is capital gains income you invested $100 in a mutual fund and it went up to $200 so it doubled in value awesome I'd like to see that invest $100 it doubles and volume goes up to $200 that hundred dollars are you making capital gains the increase in the value is tax the capital gains rate so the first 50 not taxed at all it's a zero percent tax bracket the second 50 would be taxed at the capital gains rate of 20 percent in our simple system here so you'd only pay 10 dollars tax so if somebody gives you your choice do you want to classify this income as ordinary income and pay $25 tax or capital gains income and pay ten dollars tax which would you prefer to do well if it's legal you'd prefer to pay the ten dollars and here is where a lot of the complex tax shelter arrangements arise you've heard of tax shelters tax shelters take on many forms one form is doing this structuring your affairs so that income can be classified as capital gains income rather than ordinary income for obvious reasons capital gains income is taxed at lower rates and lots of things both legitimate and shady have been done to create tax shelters to change the nature of income from ordinary income to capital gains income so when you hear discussions of tax shelters and this and that this is one thing that people are talking about changing the nature of income from ordinary income to capital gains income because capital gains income is typically taxed at lower rates people prefer to have any income they make classified as capital gains income if at all possible let me summarize our discussion of income taxes first there's the notion of the tax bracket income is taxed in chunks the first part of income in almost every tax system around the world is not taxed at all so that's a zero percent tax bracket and your income after that is chopped up into pieces this piece is taxed at one rate the more money you make the higher different pieces are taxed the higher rate so that's the notion of the tax bracket and the important thing to remember is this income in the low tax brackets is never taxed at a higher rate ever in our simple system for that first $50.00 is never taxed at anything other than a zero percent tax rate same thing in the United States the income that's excluded from taxation under your personal exemptions and the standard deduction is never taxed it's in a zero percent tax bracket so don't be afraid of making more money and going up into the next tax bracket because that first amount of income is never taxed at higher rates we also discussed the notions of the average tax rate in the marginal tax rate the average tax rate how much tax you pay divided by how much do you make average tax rate in the United States for individuals somewhere between 17 and 20 percent depending on who you are that's the average for everybody across the United States marginal tax rates on the other hand that's the rate that you're going to pay on the next dollar that you make and economists say that that marginal rate is a very important rate because that's the rate that people have in mind as they consider should I work harder and make more money because it's that marginal rate that I'm going to have to pay we saw the difference between a tax deduction and a tax credit a tax deduction if you spend money on a tax-deductible item you don't have to pay tax on that particular item so we saw it in our example if you have a ten dollar tax deduction that's how you're gonna save you five dollars in income taxes so the government says thank you for spending your money in that way you don't have to pay tax on that money a tax credit on the other hand is so favored by the government that the government will say if you spend ten dollars in a certain way that's the same as our spending that ten dollars you just keep that money you don't have to pay any tax at all if you have a ten dollar tax credit your taxes go down by the whole ten dollars a tax it is more valuable to you in a tax sense than the tax deduction we discussed the difference between ordinary income and capital gains income the most important thing from a tax standpoint is capital gains income is taxed at a lower rate ordinary income is most of the income with which you and I are familiar wages salaries interest on savings accounts and so forth capital gains income if you invest in a stock portfolio and it goes up the increased amount is called capital gains income and you typically pay a lower income tax rate on capital gains therefore many tax shelters are designed to classify income not as ordinary income but as capital gains income overriding everything with respect to income taxes is this they're precise rules set down by the government where you live and your objective in income tax accounting is following those rules so that you comply with a law you want to pay all the tax that you owe it's certainly a legitimate thing to plan your affairs to pay the minimum tax allowable under the law but you want to make sure that you obey the rules and pay the tax that you owe you

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Keywords: accounting, accounting 101, accounting basics, accounting course, accounting overview, financial accounting, managerial accounting, learn accounting, understanding accounting, income tax accounting, tax, bookkeeping, finance, finance courses, accounting courses, business courses, online education, online learning, online classes, online courses, e learning, elearning, free online courses

Id: YjkRSlTxsZM

Length: 106min 3sec (6363 seconds)

Published: Mon Sep 17 2018