Assets vs. Liabilities
There are several core criteria, all of which must be met, used to define what constitutes an asset:
- The asset is controlled by the entity. So you must control the actual asset and have the right to use it.
- The asset arises from a past transaction. So you must have actually paid for the asset already, an agreement to purchase an asset (while important) is not sufficient until you’ve actually paid up.
- The asset has future economic benefits that will flow to the enterprise. So the asset must actually be worth something and will generate value for the organization. Paying $10K for an asset that is only worth $2000 will result in an asset on the books worth only $2000, not what you actually paid for it.
These criteria can be applied to many different things that people don’t always consider when they think of the assets of a company. Here are a few examples to get you thinking:
- Prepaid Expenses: Say your company pays rent in advance for the month, the payment has occurred, there is future benefit to the company, and you have control of the ‘asset’ in that you’re contractually able to access the property.
- Accounts Receivable: Amounts that are due to your company are also considered assets even if you haven’t received the cash yet. The transaction occurs when you sold the product or delivered the services, you are entitled to the economic benefit, and you control it in that the other party is legally obligated to pay you.
Similar to assets there are several criteria that must be met in order for something to be considered a liability.
- The liability is an obligation of the organization. In this case if the organization has a legal obligation to provide a service or transfer assets the a liability should be recorded.
- The liability arises from a past transaction. The transaction that generated the liability should have already occurred, you wouldn’t consider something to generate a liability if the underlying service or product hasn’t been provided.
- The liability will result in the transfer of assets, provision of services, or other economic benefit. Essentially this means that if your organization is required to provide something of economic value then it should be recorded as a liability. The definition is fairly broad by considering both assets and services.
- Deferred Revenue. This is a liability booked to reflect amounts you have been paid already for services you haven’t actually provided. Consider a hotel where you charge a deposit when customers book a room. You’ve received cash from the customer and are obligated to provide a future service (letting them stay at your hotel). As such a liability should be booked.
- Accrued Liabilities. These are a bit of a catch all for many types of services or obligations that company has incurred but not paid for yet. Consider employee vacation time. As the employee works they become entitled to this based on their employment contract, taking care of the first two criteria. When the employee goes on holiday you’re obligated to pay them, satisfying the last criteria. Other accrued liabilities can relate to external services, environmental clean-up costs, and retirement obligations.
By Jeffrey Glen