The Accounting Equation – Breaking Out Asset Categories
The accounting way to separate assets into categories uses liquidity as the measure. Anything that is expected to be converted to cash within one year of your balance sheet date is considered a current asset; all others are plunked down into one of the long-term categories. Long-term assets ﬁt one of three types: long-term investments, ﬁxed assets, and intangible assets.
Liquidity refers to how easy it would be to turn an asset into cash. Your checking account counts as cash, making it 100 percent liquid. As for your other assets, think about how long it would take to turn them into cash if you absolutely had to. For instance, inventory should move pretty fast, but your customized delivery van might take a lot longer to sell.
Even within these broad categories, the assets have a particular pecking order. For example, your current assets (which you already know are liquid) have a liquidity pecking order. Cash is already cash, so that always come ﬁrst; prepaid expenses, on the other hand, have a ﬁxed use-up date, which usually makes them the last current asset listed. Fixed assets have their own ranking system as well, but this is based on how long you expect them to last (a.k.a. their useful lives).
Current assets include anything that could be or that you expect to be changed into cash within a year of the date on your balance sheet. These assets are listed in their order of liquidity, from cash down to the current asset that you expect would take the longest to convert to cash (usually prepaid expenses). Here are the most common current assets, in order of liquidity:
- Cash, which includes every cash account plus any cash you have on hand
- Accounts receivable, which is money your customers owe to you for sales to them
- Inventory, which includes anything you will resell regardless of the form it’s in now
- Short-term investments, such as stocks or bonds that you plan to cash out within a year
- Prepaid expenses, which are expenses paid in advance of use, such as insurance or rent
When your company is doing well and you have extra cash lying around, you may choose to invest that money so it can earn even more. Any investments that you make and plan to hold on to for more than a year ﬁt into the long-term investments category. These investments could include stocks, bonds, and high-yield CDs; they also can include things such as buildings that you are holding for investment purposes only.
Long-term investments often provide current earnings, such as interest or dividends. Those earnings have to be included when you figure out your profit or loss for the period. Since they aren’t regular revenues, they are reported separately, usually as “other income” at the very bot- tom of the statement of profit and loss.
Long-term investments are often used to ﬁnance expansions, minimizing the amount you would have to obtain from outside sources (such as bank loans). Instead of withdrawing the cash, and hoping to be able to put it back in when it’s needed, many small-business owners instead invest that surplus cash, then sit back and watch it grow.
As your expansion plans get closer, and you think the time is coming to liquidate those investments, you should shift them over into the short-term investments. When you expect to sell them within the upcoming year, they transform into current assets for the balance sheet.
Any physical asset that your company owns and does not intend to sell falls into the ﬁxed-asset category. Fixed assets range in size, useful life, and purpose. A $40 ofﬁce chair counts as a ﬁxed asset just as much as a 15,000- square-foot storage facility. The point is that they are both part of what the company needs to have in order to produce revenues, and you plan to keep them around for a long time.
Fixed assets can include things such as:
- Building improvements
- Ofﬁce furniture
- Computer systems
Fixed assets also come with a unique contra account, called accumulated depreciation. This account ﬁts in the asset category but has a normal credit balance (which is what makes it a contra account). It holds all of the depreciation expense ever taken on the connected assets. Depreciation expense tracks the declining value of assets and lets you take that decline as a tax-deductible expense, but spread out over the entire life of the asset.
Some companies own assets without physical form that they plan to hold on to for the long haul. These are called intangible assets, and some companies couldn’t succeed without them. In order to count an intangible as an asset, your company must own it or the rights to it, and it has to have a measurable dollar value.
Some of the more common intangible assets include patents, copy- rights, licensing agreements, trademarks, franchise rights, leaseholds, and goodwill (the most intangible of them all). Goodwill can be the most con- fusing asset, because it really exists only in perception and can be measured only when a business is purchased. The goodwill asset represents the reputation of a company—its good name. It comes into accounting play only when someone buys a company for more than it would be worth by the numbers alone.
Like ﬁxed assets, intangible assets have useful lives over which they decline in value, at least for accounting purposes. This decline is called amortization, and it counts as a tax-deductible expense. Since intangible assets can be hard to pin down, their useful lives are considered to be their legal lives or forty years, whichever is shorter. Amortization can be held in a separate contra account, called accumulated amortization, or simply be deducted directly from the intangible asset balance; the choice is yours (or your accountant’s).
It can be very hard to value intangible assets that haven’t been purchased. For example, when you write a screenplay, you hold the copy- right. That copyright is your intangible asset, and it’s worth something, but that something can be hard to put a number on. Ask an experienced business accountant to help you assign a value.