Accounting is fundamentally about Assets, Liabilities and Equity. Once you understand what these are, you will be well on your way to understanding Accounting.
Beginners will be happy to know that the general day to day meaning of the word 'asset' relates perfectly to the accounting meaning. So when you listen to phrases such as "Mr. X or Miss Y is an asset to the organization" you know that the speaker is implying that these individuals are of value to the company.
In the accounting sense, an asset is an item of value owned by a company. Assets may be tangible physical items or intangible items with no physical form. Assets add value to a company, and are important to a company’s continued success.
As with assets, you may look at the wider world to gain an understanding of what's a liability. No one is particularly pleased when he or she is described as a “liability”. This is so because the liability description is a negative one.
In accounting, liabilities are obligations of the company to transfer something of value (an asset – see above) to another party. On a company’s balance sheet, a liability may be a legal debt or an accrual, which is an estimate of an obligation.
You’re now two thirds of the way to understanding the basics of accounting, and what you’ll see on the typical balance sheet. The final third is equity. In day-to-day parlance, you may be familiar with the word “equity” if you’re a homeowner. Homeowners who make regular mortgage payments will accumulate equity value in their property, and will be able to borrow against that equity.
Equity is the owner’s value in an asset or group of assets.
In accounting, equity is usually defined as the value of the assets contributed by the owners. This is added to the total income earned and retained by the company to give the company's total equity value. This description of equity is correct but very simplistic. A more profound description is really that used by the homeowner, that is, equity is the owner’s value in an asset or group of assets.
As an example, a company with total assets valued at $1,000, may have debt (liabilities) valued at $900, in which case the owner’s value in the assets is $100, representing the company’s equity.
The following is the Equity equation:
Total Assets minus Total Liabilities (T - A = E). T - A (or Equity) is also referred to as Net Worth, Capital & Shareholders Equity.
GROUPING ASSETS
Assets are grouped in order of liquidity, not only because it makes sense but also because liquidity is the lifeblood of a company. Liquidity refers to the ease in which an asset can be converted to cash. Cash is therefore the most liquid of all assets.
Assets that are very liquid are shown on the balance sheet as current assets. Current assets are assets that are expected to be converted to cash in 12 months or less. Those assets with convertibility exceeding twelve months are considered to be illiquid and are categorized as fixed or long-term assets.
CURRENT ASSETS
1. Cash
2. Short-term investments
3. Accounts Receivable
4. Inventory
5. Prepayments (Prepaid expenses)
The assets above represent the current assets that are usually found on the typical balance sheet. As shown, the assets are arranged in descending order in order of liquidity, from cash, which is the most liquid asset, to prepayment, which is the least liquid of the five items above.
The management of current assets is fundamental to the operating success of a business. This is where the vital operating assets are found, driving the day-to-day activity of the company. Companies are forced to spend significant sum of money to ensure proper management of current assets.
For instance, cash is usually monitored by the company’s Treasury department, which focuses on the management of bank accounts, investments, lockboxes etc. Accounts receivable is managed with collections and credit staff, while inventory is managed with an array of staff for purchasing, disbursement and valuation.
