While assets are what you own, liabilities are what you owe.  Common examples are bank loans, credit card balances, accounts payable (money you owe your vendors), and pretty much any other type of loan or note that you owe to someone else.

Liability accounts are presented on the Balance Sheet and normally have a credit (negative) balance.  A debit to a liability account decreases it while a credit will increase it.

Liabilities are further broken down into current and long-term.  A current liability is one that is expected to be paid off within one year.   Conversely, a long-term liability is expected to not be fully paid off within one year (like a 5 year bank loan, for example).  It is common practice to take the portion of a long-term liability that will be paid off within the next 12 months and include that in the current liabilities section of the Balance Sheet and leave the remainder in the long-term liabilities section.

Now, it’s example time!

Let’s say that your company took out a bank loan on January 1 of $60,000.00 with repayment terms of 60 months (5 years).  To keep our example simple, we’ll assume that the interest rate is 0% (a pretty sweet deal!).

On January 1 you will book the following entry (assuming you deposited the money into your bank account):

Checking Account            $60,000.00
Note Payable                               $60,000.00

Remember, debits go on the left! 

This entry increases the balance of your checking account and also increases the balance of the liability account.  The net result is that you have more money (yay!), but you also owe the bank that same amount of money (boo!)

Each month that you make your required payment of $1,000.00 you will make the following entry:

Note Payable                        $1,000.00
Checking Account                     $1,000.00

This entry decreases the balance of you checking account (remember, you’re making a payment here) and it also decreases the balance of the Note Payable account, since you have now paid some money back and the balance that you still owe is less than it was before.

After 12 monthly payments of $1,000.00 the Note Payable will have a balance of $48,000.00 at the end of the year.  It’s important to realize that nothing we’ve done here has any effect on the net income of the company.  All of our entries have been on the Balance Sheet.  In the real world, some of the monthly payment would be allocated to interest expense, like this:

Interest Expense                 $100.00
Note Payable                       $900.00
Checking Account                     $1,000.00

And remember, you borrowed that $60,000.00 for a reason.  So some of that money was probably spent on items that will be recorded as expenses.  Remember from our discussion on assets, that if you used $50,000.00 to purchase a new piece of equipment that will last for 10 years, that amount will be capitalized on the Balance Sheet as a Fixed Asset.  Then it will be depreciated over a number of years, so the effect on the Net Income will vary, depending on how the money was spent.

One last thing that I want to make everyone aware of is the following equation:

Assets – Liabilities = Equity

Let’s restate the equation:

what you own – what you owe = what you are worth

So you can measure the worth of a company by taking the total Assets and subtracting the total Liabilities to arrive at the Equity (commonly referred to as Shareholder’s Equity or Owner’s Equity).  That is the true value of a business, at least on paper.  There are other “real world” factors to consider such as cash flow, shareholder distributions, payroll, etc.  We’ll cover these topics later, but my next Accounting Basics post will be all about the Equity section of the Balance Sheet.

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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.

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I found a long discussion about an old accounting joke that I heard while attending my very first accounting class at Clinton Community College.  The members of this forum were trying to figure out how old this joke was and what the original version of it was since there were several variations of it.

Here is the joke as I heard it back in 1991: (I say that as if it was a really long time ago!)

This story is set in the days before computers, when accountants had to do everything manually on paper.  A man who worked in the accounting department of a large company was famous for never, ever making a mistake.  His ledgers always balanced to the penny and he never had to make any adjusting entries to correct anything.  All of his co-workers noticed that he had a peculiar routine to start his day.  Every day he would come into work, sit down and open the drawer to his desk.  He would look inside for a few seconds, nod his head and then get to work.  He was the perfect accountant for over 40 years until the day finally came when he retired from the company.  They gave him a gold watch, patted him on the back and walked him out the door.  As soon as the door slammed shut behind him the other accountants raced over to his desk to see what was inside.  They found a note taped to the bottom of the drawer that read “Remember, debits go on the left”.

It’s amazing what passes for humor in the accounting world, huh?  But I did find something interesting in the discussion about this joke.  They were discussing a variation on the story.  It involves something about people needing to walk past the window to get their debits approved so “debits go by the window, and the window is on the left.”

According to one person, there is some basis to this joke.  In the old days the windows in an accounting room (or any writing room) were always on the left so as to not cast a shadow from the writing hand.  So remembering “The debits go by the window” put the debits properly on the left.  Of course the joke then goes on to say that the accountant changed jobs and all of his entries were backwards because the window was on the other side of the room.

What’s the point of this whole thing, you might be asking yourself?  It is simply that “debits go on the left”.  It really does help to think about the very basics of accounting when you are doing any type of bookkeeping.  If you think in terms of the “T account”, debits go on the left of the T and credits are on the right.  Entries on the left will increase assets and expenses and decrease everything else.

Sometimes my colleagues will start talking about how a particular transaction will affect certain accounts, but they talk in broad, general terms which I find confusing.  I always bring it back down to the basics of debits and credits.  Sure, it’s great to know that if the business owner sells that piece of equipment they will have a big gain to pay taxes on, but that doesn’t help me get his books in order.  That particular transaction will require a credit to the fixed asset account, a debit to accumulated depreciation, a debit to the checking account and a credit to the gain on disposal account.  And some people love to generalize with round numbers and they often screw up the math and come up with a bottom line that is way off.  I always like to take two minutes and jot down the debits and credits on paper with the actual numbers.  That way I know what I’m talking about and there won’t be any surprises later on.

I’ve wanted to write about this topic for a few days now, but I couldn’t figure out how to word everything so that it would flow nicely.  Now that I’ve finally written it I can see that I still haven’t figured out how to make it flow but I’m not going to re-work it too much.  I really just wanted to get the info about this old joke out there and I’ve accomplished that, so I’m happy.

If you have any accounting-related humor, please leave a comment.  I would love to learn some more ways to ridicule other accountants!

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