In a previous post we had a look at the concept of a financial statement called a balance sheet. In this post we’ll examine the types of accounts that we’ll use on the balance sheets.
First let’s recall our accounting equation.
Assets = Liabilities + Owner’s Equity or put another way.
Owner’s Equity = Assets – Liabilities.
What the balance sheet shows is how much the business owes owners or said another way how much equity the owners have in the business. Depending on the size of the business that is a single person or many people or other companies/entities.
The equations shows that if liabilities grow then our value goes down as we owe money to other people. So in the course of doing business we want to accumulate or grow our assets and reduce our liabilities which would mean we have more value in the business.
Assets can be classified in a few different ways. In general they are resources which are owned by the entity. Assets maybe physical things. Like machines, buildings, inventory to sell. Or they could be non-physical like expected payments from customers (accounts receivable), deposits/investments in bank accounts, patents or goodwill.
It’s important to consider the life of the asset. Cash for example is already cash, we can take it out of the bank when we want. Accounts receivable can be easily converted to cash as we expect our customers to pay what they owe. A building on the other hand like a warehouse or production plant is not something we are going to sell quickly and usually hold for many years and usually it would take a little while to be able to convert to cash if we wanted to sell.
So assets can be classified as either current or non-correct. Current meaning they can be converted into cash within a business operating cycle or at least one year. Non-current assets are then generally something that will benefit the business for longer than an operating period or one year.
Next we need to consider value. I might buy a product that I intend to sell. The product has a cost amount. This is going to include things like my purchase price, freight and other things to take possession of the asset. The cost is (hopefully) not the same as what I’m going to sell the product for or what I expect to get for it. The value at the point of selling it is what the buyer will be willing to pay. What I do know is the cost at what I acquired it for. Hence this is an important concept in working with assets is that we need to record their cost when we register them in the ledger.
Determining cost is a whole different topic that we’ll explore later. In some companies there are people that dedicate their life to tracking and determining cost. As well, there are accounting standards that determine how we should value assets that are to show on the balance sheet.
Next we’ll look at liabilities.