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Sunday, 7 March 2010

Accounting Terms - Assets, Capital and Liabilities

Assets, liabilities and capital are so essential to accounting, that they form the basis of the accounting equation (Assets = Capital + Liabilities). An asset refers to anything that an entity owns or has control over. Capital is the entity's obligation to its owner or owners, while a liability is anything that the business owes to others besides the owner. Therefore, capital is also a liability or obligation of the business, but it is a special kind as it is owed to the owner.

If you look at the accounting equation, you would recognize that there are other relationships arising from the equation. First, the equation suggests that what the business owns (assets) should be equivalent to what it owes (capital and liabilities). In addition, Capital = Net Assets (Assets - Liabilities).

Assets, which include goods, machinery, buildings and receivables, can be either current assets or non-current assets. Current assets are those that the business expects to realize, in an accounting sense, during the following trading period or in the short term. A non-current asset has a long-term purpose and is one that the business intends to keep. What you must realize is that, while businesses sell non-current assets, when they are purchased, the entity wishes to keep them for longer than one trading period. The asset type is critical in determining the financial position and income of the business. Current and non-current assets have a different effect on the income statement and balance sheet.

Just like assets, liabilities can be either current or non-current. A current liability can be settled within the trading period or short-term, while a non-current liability is one with a longer repayment period. Examples of liabilities include mortgages, credit from suppliers and other payables). A mortgage is an example of a non-current liability; an example of a current liability is "payables."

Capital refers to what the owner or owners invest or put into the business. Anything withdrawn by the owner, for any reason, is called withdrawals or drawings. When a business makes a profit, the business cannot do what it pleases with the profit. The profit is the return on investment for the owner after all. Therefore, if a business makes a profit or loss, it affects the asset position and the capital owed to the owner. Capital can include shares, venture capital or personal funds.

It is interesting to note the relationship between assets and liabilities. A transaction can increase the assets of a business but increase the liability of the business as well. To the uninitiated, this may seem counterintuitive. However, recall that assets refer to what the business owns and controls. If a bank lends the business (not the owner) $20,000.00 to buy a vehicle, the business does not yet own the vehicle (until it is fully paid off).

However, they control the use of the vehicle, although the bank could repossess it for repayment failure. As such, the liability is also an asset; note that a liability does not form part of Net Assets. The connection between assets, capital and liabilities forms the basis of the double-entry system or duality concept, where all debits equal corresponding credits.

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