Business ventures require their owners to handle specific tasks–such as purchasing goods and services, taking on debt, or putting their own money into the business–for smooth running and up-gradation of the business. The business transactions have to be documented in a book or balance sheet in order to have a solid understanding and give shape to the financial health of the business. This is where assets and liabilities come into play, as both are fundamental elements of a balance sheet, the financial statement of a company.
What is Asset?
Any tangible or intangible economic resource that is owned or controlled by an individual, a company, a government or an economic entity for accounting purposes with an expectation to produce positive economic value and benefit in the future, is called an asset.
The definition of an asset as provided by the IFRS (International Financial Reporting Standards) is:
“An asset is a present economic resource controlled by the entity as a result of past events. An economic resource is a right that has the potential to produce economic benefits.”
US GAAP (Generally Accepted Accounting Principles used in the United States of America) defines an asset as follows:
“An asset is a present right of an entity to an economic benefit.”
Example of Assets
Examples of assets at the individual level include:
- checking savings accounts
- cash or cash equivalents
- retirement accounts
- equity in a home or other property
- vehicles, jewelry, and other personal property
- treasury bills
- investments such as bonds, annuities, life insurance policies, and mutual funds.
Examples of assets at the business level include:
- cash and cash equivalents
- accounts receivable
- properties such as plants, equipment, and motor vehicles
An asset is a key component of financial stability at both personal and business levels, as it generates cash inflows and limits cash outflows. It is generally reported on a company’s balance sheet, which holds the elements of the accounting equation: Assets = Liabilities + Equity.
Types of Assets
We can Categories assets as the following:
1. Tangible Assets
The assets that have a physical form and are tactile in nature are called tangible assets. They include cash, inventory, real estate, equipment, vehicles, buildings, and so on. Tangible assets can be subdivided into the following types :
- Current Assets: The assets that can be converted into cash or cash equivalents quickly on the requirement or within one year are known as current assets. They are often used in day-to-day operations and are widely known as “short-term assets”. These assets are generally non-depreciable in nature. Current assets include :
- Cash and cash equivalents
- Account receivables
- Short-term deposits
- Marketable securities
- Office supplies
- Fixed Assets: Also known as “long-term assets,” these assets can not be readily converted into cash or cash equivalents. Fixed assets include :
- Real estate
- Machinery and other equipment
2. Intangible Assets
Those assets which do not exist in any physical form and can not be touched are known as intangible assets. These assets often have greater long-term value compared to some tangible assets, as tangible assets are used up within the shorter term. Sometimes, it becomes difficult to quantify the value of intangible assets. The following constitute intangible assets :
- accounts receivable
- pre-paid expenses
- computer programs
3. Operating Assets
The assets that are necessarily required to generate revenue via the primary operations of a business are known as operating assets. Some examples are–
- Real estate
- Machinery, tools, and equipment
4. Non-Operating Assets
The assets that are not compulsorily required to perform core business operations in order to generate revenue, but may still be helpful in generating income through other ways. Some examples of non-operating assets are:
- Unused land
- Marketable securities
- Unallocated cash
- Interest from deposits
- Short-term investments
- Administrative computers
- Spare equipment
5. Financial Assets
Financial assets are non-physical liquid assets that obtain their value from contractual agreements on future cash flows and ownership claims of an underlying asset. They are financial instruments that represent investments in the assets and securities of other companies. The valuation of these assets depends on the categorization of and motive behind the investment. Financial assets include:
- Sovereign and corporate bonds
- Preferred equity
- Mutual funds
- Bank deposits
What is Liability?
Liability is a business’s financial or service-based debt or obligation payable to another individual or business entity at the end of an accounting period to settle past transactions or events. It is one of the financial responsibilities of a business entity that requires the entity to sacrifice future economic benefits in the form of money, goods, and services.
Liability is a vital component of financial accounting and is recorded on a balance sheet. The examples of liabilities include:
- accounts payable
- deferred revenues
- accrued expenses
- salaries payable
- bank overdrafts
Types of Liabilities
We can divide liabilities into two broad categories–Current liabilities and Non-current liabilities.
1. Current Liabilities
These are the short-term obligations of a company that is payable, usually in cash, within 12 months or a normal operating cycle. However, current liabilities may be settled using other current assets also instead of cash. Examples of current liabilities include:
- Accounts Payable: It is the money owed to the manufacturers and vendors.
- Accrued Expenses: They are the expenses that have been incurred but not yet paid or documented.
- Accrued Interest: It incorporates the total amount of unpaid interest on a loan or bond that has built up since the previous payment made.
- Dividends payable: They represent the amount owed to the shareholders after the dividend is declared by the enterprise’s BOD (Board of Directors).
- Income Taxes payable: It is the tax owed to the government to be paid
- Wages payable: It is the total amount of accrued income earned by and due to the employees to be paid by the company.
- Unearned Revenues: Sometimes we make advance payments for our products. The companies are liable to deliver the goods and/or services at an assigned future date after being paid in advance.
- Liabilities of Discontinued Operations: Although people tend to glance over yet, this liability requires close scrutiny. The operations, divisions, product lines, or entities that have recently been terminated or are currently non-functional impact financially on a company. The companies should keep a separate account of all the losses and gains from these discontinued operations so that they get a clear picture of how to make money in the future.
2. Non-Current Liabilities
As understood from the name itself, these liabilities are long-term dues or obligations which take more than 12 months for payment. While current liabilities determine liquidity, non-current liabilities assess the solvency of a company. Long-term liabilities incurred by the companies include deferred taxes, payroll, rent, and pension obligations. Other examples of non-current liabilities are :
- Warranty Liability: It is the estimated amount of time and cost of repair and replacement that the company expects to incur for the goods already shipped and delivered, or for the services already provided, based on an agreement of warranty.
- Contingent Liability Evaluation: It refers to a potential liability that may arise due to an uncertain future event out of the business entity’s control.
- Post-Employment Benefits: Post-employment benefits, also known as post-retirement benefits, are long-term liabilities that an employee or his family members receive upon his retirement as a reward for his service in the company. These benefits have a very significant impact on the valuation of a business as the pensions are to be paid in the future and the investment risk is borne by the sponsoring employer.
Dissimilarities between Asset and Liability
In accounting, assets and liabilities often appear together, but they differ in their meaning, function, nature, and other aspects. Let us have a look at those differences:
- The most important and key difference between assets and liabilities is that assets generate cash inflows or future economic benefits. Whereas liabilities present future obligations and cause cash outflows.
- Assets refer to the economic resources that add value to the enterprise as well as aid in performing future operations. Liabilities refer to the promises and commitments between two parties regarding money, goods, and services.
- All the properties and estates owned by a business entity fall under assets. But all the debt owed by a company to another entity falls under liabilities.
- Every asset has a debit balance, while every liability has a credit balance.
- With accounting, an increase in the asset is debited but a decrease in the asset is credited. An increase in liability is credited, whereas a decrease in liability is debited.
- Assets are depreciable in nature, i.e. their value decreases over time. However, liabilities are just the opposite, i.e., their value does not depreciate.
Similarities between Asset and Liability
Although assets and liabilities are opposite in meaning, yet, they have some similarities too. The similarities are as follows:
- Assets and liabilities are two fundamental components of a balance sheet, an important financial statement, that help in gauging and shaping the financial health of businesses. Both of them have balances that are reported to the business owners through the financial reports at the end of the accounting period.
- Both the assets to liabilities ratio (current ratio) and the liabilities to assets ratio (debt ratio) is crucial in determining a company’s liquidity as well as debt repaying ability. Investors, looking to gather information about companies, get interested in these ratios in order to invest in the companies.
Comparison Between Assets and Liabilities
Assets and liabilities are two vital aspects that make up a company’s balance sheet and help in gauging its financial standing. In order to manage a business, the owners must have a clear picture of the relationship and comparison between the two.
Maintaining the balance between the proportions of assets and liabilities is the key to ensuring profit in business. According to the U.S. Small Business Administration, a company’s assets should be more than its liabilities so that it has enough cash or cash equivalents to clear its debts. In other words, a higher proportion of assets to liabilities indicates higher liquidity and good financial health. Whereas, a higher proportion of liabilities to assets signals financial trouble.
However, liabilities should not be considered bad as they help in the financial growth of a business. Moreover, it should be viewed as a way of acquiring assets to improve the efficiency of an enterprise without reducing the owner’s share of the business. Assuming that a company needs to replace its existing equipment with better and advanced equipment, it can do so by using credit to purchase that new equipment. By this, they can operate better and grow more, facilitating more income.
Liabilities are also a very important aspect of the demand-supply chain in the economy. Owing to supply and demand, consumers enter into a liability agreement with the producers to pay the price of the products. However, it is important to ensure that liabilities never get bigger than assets in order to maintain good financial health.