Accounting Terms You Should Know: Part 3

As we continue on the third part of our series on accounting terms, today we’re going to take a look at the accounting line items on your balance sheet that relate to assets.  As we’ve previously written about the balance sheet, the balance sheet is just a snapshot in time of all of your business’s assets and all of the obligations and liabilities that it owes to third parties.  But today, we’re just focusing on the asset side of the balance sheet.

While our posts about accounting terms are necessarily a little heavy on accounting-speak–in fact, that’s kind of the point–as we walk through the assets on the balance sheet, try to keep in mind the overarching point here:  All of these accounts relate to both tangible and intangible resources that your business owns.  Or, if you’re thinking in Business Model Canvas terms, as we highly encourage you to try–these are the key resources that your business uses to generate revenue by providing value to your customers.  So let’s dive in!

Short-Term Assets

The asset side of the balance sheet typically gets divided into two groups:  short-term assets and long-term assets.  Short-term assets are current assets that are expected to be converted to cash or consumed within one year or the company's operating cycle, whichever is longer. They are frequently used to finance the day-to-day operations of a business. Common examples of short-term assets include cash, accounts receivable, inventory, and marketable securities.

Cash and Equivalents

Cash and equivalents are the amount of money that you hold in your various bank accounts and short-term investments that are easily convertible to cash. The short-term investments that we’re talking about here are considered to be very low-risk and include items such as money market funds, short-term government bonds, and commercial paper.

Cash and equivalents are the very first line on your balance sheet under assets because we organize the balance sheet in descending order of the liquidity.  As we go down the list of assets accounts, those assets become less liquid.

Accounts Receivable

Accounts receivable are funds that a company is entitled to receive from its customers. For example, whenever you sell a good or service and invoice for it later, you’re creating an account receivable because the customer still owes you payment for whatever they purchased. 

As we mentioned above, we order the assets on the balance sheet in descending order of liquidity, so cash and equivalents come first because they’re the easiest assets to convert into cash.  Accounts receivable usually come right after cash and equivalents because they’re still pretty liquid but not quite as liquid as cash and equivalents because you’d need to take an extra step–collecting on those accounts receivable–in order to term them into cash.

Inventory

A company's inventory may include raw materials, finished products, spare parts, and other items necessary to run the business. Inventory management is the process of keeping track of inventory levels, orders, and stock.

As you’d expect given how we order the balance sheet in descending order of liquidity, inventory is a little harder to turn into cash than accounts receivable.  With accounts receivable, you’ve already sold something, and now you just need to collect the cash from your customer.  But with inventory, you still have to make a sale first, and only then can you collect the cash from your customer (unless you have one of those nifty businesses that get paid before they deliver a product, which is nice work if you can get it…).  So there’s an extra step standing between you and your money.

Prepaid Expenses

Prepaid expenses are assets that represent payment in advance for goods or services to be received in future. It’s common to have to pay insurance policies, rent, and utility bills in advance, and that will result in a prepaid expenses asset on the balance sheet.

Prepaid expenses can be a little tricky because you need to remember to expense them over time.  If, for example, you prepaid your rent for the whole year, then you have an asset on your balance sheet in that amount on January 1st.  And that makes sense because you’re entitled to the possession and use of the underlying real estate for the next year, and there’s value in that.  You’re worth more than an otherwise identical business that doesn’t have that asset.  But on December 31st, the asset is gone because you’ve used it up, so it shouldn’t be on your balance sheet anymore.  Getting that asset off your balance sheet over the course of that year is called expensing that asset.

Don’t want to mess with that?  Well, that’s why Haven allows you to give your accountant or your bookkeeper access to your Haven account so that they can easily go into your general ledger and crete entries to expense that asset down to zero over the course of its useful life, leaving you blissfully free of the accounting to focus on generating revenue for your business!

Long-Term Assets

Long-term assets are defined as assets that are not expected to be turned into cash within one year. This time frame can vary depending on the company and the industry, but is typically one year or more. Long-term assets are important because they help a company to grow and expand its operations. Examples of long-term assets include buildings, machinery, land, and patents, although it’s important to note that some asset accounts might have a short-term component and a long-term component because some portion of the asset account might be expected to be converted into cash within the next year.

Property, Plant, and Equipment

Property, plant, and equipment (PP&E) is a category of long-term assets. PP&E includes land, buildings, machinery, vehicles, and furniture, and many specific PP&E assets require large expenditures to acquire. Regardless of when you acquire and pay for PP&E, you’ll generally depreciate PP&E over the useful life of the asset, which means that a recurring expense will show up on the income statement every accounting period over the useful life of the asset.

Intellectual Property

Intellectual property is a type of intangible asset.  It typically takes the form of ideas, know-how, inventions, designs, and branding, and you’ll frequently find it associated with legal protections like trademarks, patents, and copyrights.

Goodwill

Goodwill is an intangible asset that shows up on the balance sheet when one company acquires another for a price that exceeds the fair market value of the acquired company's net assets.  So if your business acquired another business for $1 million but the business’s assets were only worth $750,000, then your balance sheet would show $250,000 in goodwill.

If your business has never acquired another business, then goodwill isn’t something that you’re likely to have to worry about.  But if your business has acquired another business, then whatever goodwill shows up on your balance sheet is something that you’re going to have to test for impairment annually.  (In other words, you’re going to have to determine whether the value has declined and then take a charge if it has.)

Bottom Line

All of the assets in your business are the stuff that make up your business.  But remember, just having assets doesn’t mean that you have a business.  It’s the activities that make the business, and those activities require resources; i.e., your assets.  Remember that you want to acquire the assets that will most easily help you create the most value in your business activities.  If an asset doesn’t help you create much value, then sell it and put the proceeds toward something that will help you create more value.