Discover the definition for the term asset.
- So, let's start drilling down into the balance sheet. Let's start with assets. What exactly is an asset? Assets are the firm's economic resources, formally defined as probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. This carefully worded definition includes several important phrases that merits some discussion. First, the word probable. Contrary to popular belief, accounting is not an exact science.
Business is full of uncertainty, as acknowledged by inclusion of the word probable in the definition of an asset. For example, will all people who owe a business money pay? Probably not. As a result, accounts receivable, the asset representing the amounts owed by customers, is reported at an amount lower than the gross or face amount of all receivables. It's reported at the amount that will probably be paid. Second term. Future economic benefits.
Although the balance sheet summarizes the results of past transactions and events, its primary purpose is to help forecast the future. Hence the only items included as assets are those with implications for the future. Let's suppose your business owns a now-obsolete patent. That patent was purchased 10 years ago at a cost of $50,000. It may have been an asset 10 years ago, but because it now has no future economic benefit, it's not an asset now.
Finally, the term obtained or controlled. Accountants have a phrase, substance over form, meaning that financial statements should reflect the underlying economic substance and not the superficial legal form. If a company controls the future economic benefits associated with an item, that item qualifies as an asset, whether it's legally owned or not. For example, a company will sometimes report a building as an asset on the balance sheet, when in fact the company has not actually purchased the asset, but only leased it under a long-term non-cancelable lease.
If the lease gives the company control of the building for most of the building's economic life, then the leased building is reported as an asset. Remember, the underlying concept here is that the balance sheet should report economic substance, not legal form. Now, assets generally are listed on the balance sheet in the order of their liquidity, which is the ease with which the item can be turned into cash. As a result, cash and items that can be turned into cash are listed first.
These items are most commonly cash, short-term investments, accounts receivable, inventory, and pre-paid expenses. Assets such as buildings and equipment used in the operation of the business are listed next. Intangible assets are usually listed last. Now, at what amounts are assets reported? That is a great question, and the answer may surprise you. It depends. Some assets are reported at the current market value, like cash, what it's worth today. Some assets are reported at their net realizable value, the amount that the asset is expected to yield.
The accounts receivable example mentioned previously is an example of an asset that is listed at the amount that is expected to be realized or received. Some assets are reported at their historical cost, like buildings and equipment and land. It is tough in most cases to get at these assets' current market value, so we go with a measure that everyone can agree on. What was the original cost? Hey, hold it. You mean that the amounts listed on a balance sheet are not all comparable? Some are historical, some are current market value, and some are an estimate of future value? That's exactly what I mean.
Amounts on the balance sheet are like fruit in a fruit basket. There are apples and there are oranges. But knowing that fact, there are different valuation measures, puts you ahead of many users of financial information. Many think the balance sheet is just a basket of apples. Now, you know something many people don't. When it comes to amounts on the financial statements, there are a variety of valuation measures.
Stay tuned for Part 2 of the training series, which covers ratio analysis, forecasting, and business valuation.
- Types of financial assets and liabilities
- Balance sheets
- Income statements
- Statements of cash flow
- How business transactions impact accounting
- Debits and credits
- Accrual accounting
- Adjusting journal entries
- Preparing financial statements