Accounting Basics: What are assets?

A big part of my job in public accounting is working with my clients’ bookkeepers to review their work and make any necessary corrections or adjustments.  Many of them don’t have any formal training in accounting and really don’t have a deep understanding of what they are doing or why they are doing it.  The small business owner usually doesn’t place a lot of emphasis on the bookkeeping function, so they don’t want to pay top dollar for a more experienced bookkeeper.  This drives me crazy!!!

I really wish these small business owners would realize the value of proper bookkeeping and reporting.  Most of them are so busy working in the business that they can’t put in any time to work on the business.  It’s a common problem, especially among small companies where the owner is also the main employee.  If the owner would step out of the “employee” role and spend some time in the “manager” role, they could make good business decisions that would benefit everyone in the company.  Of course, they would then need a set of accurate, up to date financial reports which their current bookkeepers probably aren’t capable of giving them.

In an effort to help educate bookkeepers and anyone else who is interested (and who isn’t interested in this stuff?), I am starting a series of posts under the title “Accounting Basics”.  Each post will tackle one specific topic or accounting concept.  I will be approaching each topic from a small business bookkeeping point of view, with some necessary accounting theory thrown in.

The first topic is “What are assets?”:

Assets are commonly defined as “what the company owns”.  Some examples of assets are cash, checking and savings accounts, accounts receivable, inventory, prepaid expenses and fixed assets.  Asset accounts are presented on the Balance Sheet, not on the Income Statement.  On the Balance Sheet, assets are typically presented first (at the top of the Balance Sheet).

Assets are broken down into several categories:

Current Assets:  Assets that are expected to be sold or used up within one year such as cash and cash equivalents, accounts receivable and inventory

Fixed Assets:  Assets that are expected to be used for more than one year such as equipment, furniture, fixtures, motor vehicles and buildings

Intangible Assets:  Assets that are non-physical such as patents, copyrights, goodwill and covenants not to compete

Other Assets:  Any assets that don’t fit into any of the other categories.  These will be long-term (last more than one year).  Examples are prepaid insurance or deposits with utility companies.

Assets normally have a debit (positive) balance.  For instance, your checking account usually has a balance above zero.  This positive balance is presented as a debit balance on the books.  Asset accounts are increased by debits and decreased by credits.

Let’s run through some examples which will demonstrate the proper treatments of asset accounts:

Fixed Assets

A company has written a check for $2,500 to purchase a new piece of equipment.  We know that this equipment will last a few years and it is a pretty large purchase for the company.

A lot of untrained bookkeepers will record this check as a debit to an expense account such as “Equipment Expense”.  This would not be the proper treatment for this transaction since we know that the piece of equipment is expected to be in use for more than one year.  It should be capitalized (meaning it should be added to a fixed asset account), not expensed.

So the proper accounting entry in it’s most basic form would look like this:

Equipment                   2,500.00
Checking Account                    2,500.00

This shows a debit (an increase) to the Equipment account, which is on the Balance Sheet and a credit (decrease) to the Checking Account, which is also on the Balance Sheet.  That’s right, this transaction has no effect on the Profit & Loss report at all!  This makes sense if you consider that the company is simply trading one asset (money) for another (equipment).

Many Profit & Loss reports are grossly inaccurate because of this type of improper recording of fixed asset purchases.  It’s one of the most common mistakes that I see and it’s easily avoidable once you understand the concept of fixed assets.

You can pretty much treat intangible assets the same as fixed assets.  The only real difference is that fixed assets are depreciated over time and intangibles are amortized.  These topics will be covered at some point in the future.

Prepaid Expenses

Now let’s consider a check written on September 30, 2007 for $1,200 to pay for a full 12 months of insurance coverage, from October 1, 2007 through September 30, 2008.  If we are looking at December 31 financial statements, we should see a balance in Prepaid Insurance of $900.  Since the $1,200 applies to 12 months of coverage, we should only expense $100 per month, leaving the remainder in an asset account on the Balance Sheet.

So when the check is written we would debit the entire $1,200 to an asset account such as “Prepaid Insurance”.  Then at the end of each month we would make a journal entry to credit (decrease) that prepaid account and debit (increase) Insurance Expense.  This allows us to properly match the expense with the time period that it is incurred.  Each month 1/12 of the total is expensed, instead of expensing the entire amount on the day the check is written.

In a lot of companies the books aren’t maintained at this level of detail, which is fine, but I think it helps to understand the concept anyway.

Summary

That’s pretty much all there is to it!  Assets really aren’t all that complicated, if you can just keep these 3 basic rules in mind, you’ll do OK:

Assets are things that the company owns

Assets are increased by debits and decreased by credits

Assets are presented on the Balance Sheet and are not part of the Profit & Loss report

I have over-simplified some things here, but this post has already gone on far too long!  Future posts will expand on these accounting basics and we’ll go more in-depth.