Any business planning to stay on top of its bookkeeping, accounting, and financial modeling, needs to account for its assets vs. its liabilities. Regardless of the type of business account you’re dealing with, these will be presented on your balance sheet.
In this article, we take a deep dive to understand these core business components: What they mean, how they can impact a business, and what to consider before acquiring either.
From an accounting perspective, assets are defined as resources or goods a business, individual, or government owns that help generate revenue, add long-term benefits and value to the business, reduce expenditure, or increase its value. Anything with economic value for a company or the ability to increase an individual’s net worth, is an asset.
Defining assets in accounting terms takes the element of control into consideration: Assets are also items or resources owners can sell or use to obtain something else of value. The three requirements something must satisfy to be classified as an asset are:
Some examples of assets are cash and cash equivalents, unpaid invoices, investments, equipment, patents and trademarks, property, etc.
From an accounting perspective, liabilities are obligations or payments a business or individual has yet to make good on. These may be monetary, or in the form of services yet to be rendered. A liability must have the following three elements:
All businesses have liabilities, except in peculiar cases where the company only receives and makes cash payments. Liabilities can include loans, salaries, accounts payable, sales taxes, unearned revenue, credit card bills, customer credit, etc.
Assets are grouped based on their convertibility, physical existence, usage, and ownership. These classes are current and fixed/non-current assets, tangible and intangible assets, operating and non-operating assets, personal and business assets, fictitious assets, and investment assets.
Current assets consist of funds and items or resources that can be quickly converted to cash (i.e., liquidity), typically within one year. They are also referred to as liquid or short-term assets, and include, but are not limited to, cash, cash equivalents, office supplies, short-term deposits, inventory, marketable securities, and unpaid invoices or accounts-receivable assets.
Fixed/non-current assets provide long-term value but cannot be converted to cash as quickly and efficiently as current assets. They are also referred to as long-term assets and include, but are not limited to, patents, trademarks, land property, and heavy machinery and equipment. The value of fixed assets tends to depreciate over time and with use (e.g., cars).
Tangible assets are physical in the sense that they can be seen, touched, or felt. These assets are also easy to convert to cash where it becomes necessary for a business or individual to do so. Some examples are vehicles, inventory, and office equipment.
Not to be confused with fictitious assets, intangible assets are those assets that exist without the physical element, i.e., they cannot be seen or felt, but have economic value. They are also harder to convert to cash and include logos, copyright, patents, trademarks, etc.
Operating assets are those through which revenue is generated for daily business operations, for example, paying liabilities like wages owed. Such assets include cash, accounts receivable, inventory, and fixed assets.
Non-operating assets generate value, but not for the daily operations of a business. In this category, you’ll find things like investment securities, unused equipment, land, or property, etc.
As the name suggests, personal assets are those belonging to private individuals. They are controlled by their owner and do not fall under the company’s purview.
On the other hand, business assets are owned by a company and cannot be used for private purposes. Decisions concerning the management of business assets need to be made by the company’s leadership, as these are meant to maintain the economic growth of the business.
Fictitious assets, like intangible assets, lack a physical element; as their name suggests, they’re not real assets - instead, they’re cash expenditures than haven’t yet been accounted for, but are expected to generate revenue in the future. By definition, fictitious assets have an expiration date: Examples include discounts on shares, promotional and marketing costs, and preliminary costs.
These are assets that have the primary purpose of generating a profit and boosting the investment portfolio of an individual or business. Examples of assets in this class are stocks, bonds, and currencies.
Investment assets can either be growth assets or defensive assets. Growth assets are those with high potential to bring bigger short-term gains (e.g., property and volatile stocks), while defensive assets provide smaller, but stable, revenue (e.g., debt securities and savings accounts).
Classifying assets based on their convertibility, physical existence, usage, and ownership is not merely a matter of convenience or unnecessary accounting terms. Understanding the nature of an asset helps business owners and private individuals determine what assets to invest in.
For example, knowing the difference between operating and non-operating assets paints a clearer picture of how they contribute to a business’s revenue. The solvency of current and fixed assets must be considered before acquisition in case of inevitable situations that rely on liquidity. When assets are acquired without proper consideration, they can become current or long-term liabilities without warning.
Liabilities can be current or short-term, non-current or long-term, and contingent liabilities.
These are debts or obligations due to be paid within a year. Current liabilities come in the form of accounts, bills, and interest payable, bank account overdrafts, short-term loans, accrued expenses, customer credit, customer prepayments, wages and taxes owed, etc. and can be monitored using accounting software.
Long-term liabilities are due to be paid in over a year. Just like current liabilities, they should be closely monitored because they factor into long-term solvency. These liabilities include, but are not limited to, long-term loans, employee benefits, bonds payable, deferred tax liabilities, capital leases, mortgage payable, leases, long-term accounts payable, deferred revenue income, etc.
Contingent liabilities depend on the outcome of an ongoing or anticipated event. These liabilities are generally not recorded until the expected event's probability surpasses 50%. When registered, the liability amount is estimated, not fixed. The primary examples here are lawsuit costs and product warranties.
Knowing which category liabilities belong to helps entities keep track of their implications: The repayment terms on current and non-current liabilities are essential for creating payment plans in line with their expiry dates.
Knowing which category they belong to deters accruing too many liabilities in any one of them. For example, having multiple concurrent long-term loans could easily become overwhelming.
Assets and liabilities coexist and complement each other. Here’s how:
As much as they have been established in the previous paragraphs, the benefits of different assets cannot be overemphasized:
In a discourse addressing assets and liabilities, it might seem a bit strange to attribute benefits to liabilities, but the word does not connote only negativity. Some of the merits of liabilities are:
Equity represents the amount a business is worth once it’s liquidated and all its debts are paid. The equity needs to be positive - if the figure is negative, the liabilities have outweighed the assets, and the business is at risk.
The basic accounting equation for the calculation of the equity or net worth of a business is:
Total assets - Total liabilities = Equity
When a business can pay out its liabilities, the remainder of its assets is referred to as stockholders' equity. The state of equity provides some insight into how the finances of a business have progressed or failed, and the anticipated growth rate and pattern. An increase in equity can result from increased revenue, stock sales, and the addition of capital by shareholders, while a decrease can be due to depreciation in the value of assets and an increase in liabilities.
This section addresses terms related to both assets and liabilities
Valuation is the process of determining what a business would be worth if sold. Valuation may be done on the business as a whole or assets alone. The three major approaches to valuation are the cost, market, and discounted cash flow approach.
Asset valuation is a process a business undertakes to determine the value of all the assets it owns. The valuation of its assets can be used for restructuring purposes, audits, or loan applications. Assets can be categorized into tangible and intangible assets for convenience. For tangible assets, valuation methods include the cost, standard cost, market value, and base stock method.
The term used to describe asset or liability value is “fair market value,” and it can be both current or projected.
Accruals represent the income and expenditures that have not yet been executed. Basically, it’s what the business owes or is owed that has not been inputted in any financial statements. What falls under accruals will largely depend on the accounting period. For example, machinery repairs can be accounted for at the end of the financial year.
Liabilities include loans, salaries, accounts payable, sales taxes, unearned revenue, credit cards, customer credit, etc.
Some examples of assets are cash and cash equivalents, unpaid invoices, investments, equipment, patents and trademarks, real estate, etc.
The answer to this question depends on whether the owner has more assets than liabilities. If a car can be liquidated or used to generate revenue, it will be considered an asset. If there are more liabilities than assets on the balance sheet, and the car is not integral to the running of the business or everyday life of the individual, it becomes a liability.
On the assets vs. liabilities balance sheet, houses are usually assets. However, they can become liabilities if their upkeep costs more than they can be sold for. Also, mortgages taken out on houses are always liabilities.
Danica’s greatest passion is writing. From small businesses, tech, and digital marketing, to academic folklore analysis, movie reviews, and anthropology — she’s done it all. A literature major with a passion for business, software, and fun new gadgets, she has turned her writing craft into a profitable blogging business. When she’s not writing for SmallBizGenius, Danica enjoys hiking, trying to perfect her burger-making skills, and dreaming about vacations in Greece.
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