Breaking down assets and liabilities further
Mitchell Franklin; Patty Graybeal; Dixon Cooper; and Amanda White
In addition to what you’ve already learned about assets and liabilities, and their potential categories, there are a couple of other points to understand about both of these balance sheet items.
Assets and classifications as current or non-current
In thinking back to assets, some items like inventory and office supplies are likely to be used to generate revenue quite quickly (either by being sold as inventory is, or used as office supplies are). And others like manufacturing equipment will hold value for the business over a longer period of time. In accounting, we classify assets based on whether or not the asset will be used or consumed within a certain period of time, generally one year. If the asset will be used or consumed in one year or less, we classify the asset as a current asset. If the asset will be used or consumed over more than one year, we classify the asset as a noncurrent asset.
Assets and classifications as tangible or intangible
Most assets that we’ve discussed so far are tangible – items that we can touch or move – office printers, inventory, machinery. However, not all assets are tangible. An asset could be an intangible asset, meaning the item lacks physical substance—it cannot be touched or moved. Think about pharmaceutical companies and a patent that they hold to manufacture a particular drug. That patent is an intangible asset – it provides value to the firm, but we cannot touch it. Other examples can include trademarks or something called goodwill – when you purchase another business and pay more than the value of its net assets because you think there is other value (such as the value of a brand name or reputation).
What about liabilities?
Similar to the accounting for assets, liabilities are classified based on the time frame in which the liabilities are expected to be settled or paid. A liability that will be settled in one year or less (generally) is classified as a current liability, while a liability that is expected to be settled in more than one year is classified as a noncurrent liability.
Some examples of current vs non-current assets and liabilities
Examples of current assets include accounts receivable, which is the outstanding customer debt on a credit sale; inventory, which is the value of products to be sold or items to be converted into sellable products; and sometimes a notes receivable, which is the value of amounts loaned that will be received in the future with interest, assuming that it will be paid within a year.
Examples of current liabilities include accounts payable, which is the value of goods or services purchased that will be paid for at a later date, and notes payable, which is the value of amounts borrowed (usually not inventory purchases) that will be paid in the future with interest.
Examples of noncurrent assets include notes receivable (where a customer agrees to pay over a year or longer in instalments), land, buildings, equipment, and vehicles. An example of a noncurrent liability is a bank loan (which are usually repaid over a number of years).
Why does current versus non-current matter?
At this point, let’s take a break and explore why the distinction between current and non-current assets and liabilities matters. It is a good question because, on the surface, it does not seem to be important to make such a distinction. After all, assets are things owned or controlled by the business, and liabilities are amounts owed by the business; listing those amounts in the financial statements provides valuable information to shareholders. But we have to dig a little deeper and remind ourselves that shareholders are using this information to make decisions.
Providing the amounts of the assets and liabilities answers the “what” question for shareholders (that is, it tells shareholders the value of assets), but it does not answer the “when” question for shareholders. For example, knowing that an organization has $1,000,000 worth of assets is valuable information, but knowing that $250,000 of those assets are current and will be used or consumed within one year is more valuable to shareholders. Likewise, it is helpful to know the company owes $750,000 worth of liabilities, but knowing that $125,000 of those liabilities will be paid within one year is even more valuable. In short, the timing of events is of particular interest to shareholders. Why? Because they may be using this information to predict future performance and make decisions about whether to continue investing, or sell their shares and get out.
Not all transactions affect equity
As we continue to develop our understanding of accounting, we will encounter many types of transactions involving different elements of the financial statements. The previous examples highlighted elements that change the equity of a business. Not all transactions, however, ultimately impact equity. For example, the following do not impact the equity or net worth of the business:1
- Exchanges of assets for assets
- Exchanges of liabilities for liabilities
- Acquisitions of assets by incurring liabilities
- Settlements of liabilities by transferring assets
However, they do still need to be recorded as accounting transactions to ensure that records are complete. In addition, you may exchange non-current assets for current assets – this alters the balance of assets, but not assets overall. This shift in balance within accounts can be useful information for shareholders and decision makers.
It is important to understand the inseparable connection between the elements of the financial statements and the possible impact on business value (equity). We explore this connection in greater detail in later chapters when we explore the financial statements in more detail and begin learning how to analyse the financial statements for decision making.
- accounting equation
- assets = liabilities + owner’s equity
- accounts payable
- value of goods or services purchased that will be paid for at a later date
- accounts receivable
- outstanding customer debt on a credit sale, typically receivable within a short time period
- current asset
- asset that will be used or consumed in one year or less
- current liability
- debt or obligation due within one year or, in rare cases, a company’s standard operating cycle, whichever is greater
- value of products to be sold or items to be converted into sellable products
- non-current asset
- asset that will be used or consumed over more than one year
- non-current liability
- liability that is expected to be settled in more than one year
- notes payable
- value of amounts borrowed that will be paid in the future with interest
- notes receivable
- value of amounts loaned that will be received in the future with interest
- retained earnings
- cumulative, undistributed net income or net loss for the business since its inception