According to Daniels (2005), “……assets and liabilities are two of the primary elements that make up the ‘accounting equation’” (p. 23). The two items have a variety of classificatory forms and descriptions. The scholar continues to say that “…..over the years- and under the various classificatory forms and descriptions- assets and liabilities have been associated with a variety of different definitions, recognition criteria and measurement bases” (Daniels 2005, p. 24).
The author of this paper is going to address some of these issues. The main objective of this paper is to describe and analyse the statement presented above. The writer will also express their opinion on the matter. They will use several peer reviewed articles published in accounting and business journals which will serve as guidelines for writing the paper. The articles will also be used to support the statements and assertions made in the paper.
The paper is well structured. It opens with a brief introductory statement. A critical review of three articles published in accounting and business journals follows the introduction. In the critical literature review, the writer attempts to use the knowledge obtained from these articles to describe and analyse the issue at hand. The articles will be used in addressing assets and liabilities as the two major elements of the ‘accounting equation’. This means that the articles selected revolve around this issue. The writer then embarks on a critical analysis of the same, drawing information from various sources. This will help the writer to come up with a sound conclusion that is consistent with the analysis conducted earlier on.
Three articles form the basis of the analysis in this paper. They all touch on assets and liabilities that present the two primary elements of the ‘accounting equation’. As it has been stated earlier, the three articles are published in accounting and business journals. In this section, a critical review of these articles will be carried out. The author will try to analyse how these articles address the issue of assets and liabilities as two main components of accounting equation.
Recognition of Contingent Liabilities Arising From Litigation: An Amendment of SFFAS No. 5- Accounting for Liabilities of the Federal Government
This is an article that has been cited in several studies conducted in the field of accounting principles. The authors of the article are members of The Federal Accounting Standards Advisory Board. The article is a composition of the entire advisory board and no person can take credit for the document. The board was made up of 9 individuals. It was tasked with the responsibility to recommend appropriate standards of accounting to the authorities. The article in question was published on December 1998, that makes it a recent article. As such, it is relevant to the discussion provided in this paper. The board was asked to devise standards to address contingencies in the case of pending and imminent litigations (Norwood et al. 1998). The report by the board provided five classifications of liabilities. Contingencies are a liability addressed in the report, in addition to other liabilities.
The authors of the article begin with defining contingencies. According to them, contingencies can be conceptualised as “….a set of circumstances or conditions involving uncertainties as to a possible gain or loss” (Norwood et al. 1998: p. 98). A contingency is considered to be a liability provided a similar act caused a measurable outflow of resources in the past. In the article, the board members feel that contingencies brought about by pending or imminent litigations are prone to failure. This prediction of failure jeopardises the government’s power and ability to effectively defend the interests of the public (Epstein & Evas 2007).
It is noted that it is difficult to predict the likelihood of a liability occurring when it comes to legal matters. However, contingencies are likely to bring about a considerable outflow of resources in the organisation. According to the authors, board members felt that lawyers, auditors, and accountants should assess and evaluate the potential effects of pending litigations and estimate the losses of the same to the company. In accounting equations, these amounts should be classified as liabilities (Norwood et al. 1998).
Measuring and Identifying Intangible Assets
The above article was extracted from the Journal of Public Affairs. The authors of this article are Phillip Siegel and Carl Borgia. The two are from Florida Atlantic University. The article was published in 2007 and was based on the assumption that current global economy is affected by the use of intellectual capital to a large extent. The two scholars provide a brief overview of intellectual capital in the context of accounting principles. It is noted that intellectual capital has been described by many analysts as an intangible form of capital (Siegel & Borgia 2007). As such, one of the major purposes of the article was to provide evidence of the existence of intangible capital. Another objective was to come up with an alternative basis for measuring and recognising intangible capital.
The authors of the article insist that the exclusion of accumulation of capital affects the evaluation of the organisation’s productivity and gains negatively. The article cites the use of computer technology. It uses this to demonstrate the existence of intangible capital. In addition to the capital used by organisations when investing in computers, the issue of computerisation is much broader. As such, more capital will be required to cater for extra expenses incurred during the installation, as well as in maintaining the system. This, together with the expenses incurred in other computerisation incentives which include activities, such as restructuring of the entire organisation, purchase and installation of software, software development, as well as training costs, is incurred by the organisation (Siegel & Borgia 2007).
The article however clearly states that for intangible assets to be considered as capital, they must have the ability to increase the productivity of an organisation. They should also have a ‘definable’ value to the said organisation. It is now easier for scholars and accountants around the world to explain intangible assets. They describe them as an increasing proportion of acquired assets (Daniels 2005). It also promotes sound decision making processes.
Definition and Recognition of Liabilities, Contingent Liabilities and Commitments
This was an article published in the Financial Management Framework, a journal published by the Queensland Government in March 2012. The purpose of the article was to provide guidance for definition and recognition of liabilities. It also addresses the requirements for liabilities, contingent liabilities, as well as the disclosure of commitments (Atkinson 2012). For instance, the article defines liabilities as an obligation of a particular entity that arises from past events. The settlement of these obligations is likely to cause an outflow of capital from the entity.
The article further defines a contingent liability as a possible obligation in an entity (Atkinson 2012). Such an obligation arises from the past activities which occurrence or existence will be confirmed “…….only through the occurrence (or) non occurrence of a single or many uncertain events likely to occur in the future (and which) are not under the entity’s full control” (Atkinson 2012: p. 39). The so- called past events are transactions carried out in the past, and which have brought about obligations that will result in an outflow of agency’s resources (Atkinson 2012).
According to the authors of this article, liabilities are obligations that business must fulfil. The business should therefore strive to pay back the accrued debts to the creditors lest legal action is taken against the business.
As it has already been indicated, assets and liabilities are the two primary elements making up the ‘accounting equation’. Such financial statements include the balance sheet. Many writers and scholars have come up with a variety of definitions, classificatory forms, as well as different descriptions of assets and liabilities. Many recognition criteria and measurement bases have also been devised for assets and liabilities (Epstein & Evas 2007).
Definition of Assets and Liabilities
Various definitions for the two terms- ‘assets’ and ‘liabilities’- have been proposed in the past. Given that they are the two primary elements of the ‘accounting equation’, the two are major components of financial statements. This is especially evident in the balance sheet where the evaluation of assets and liabilities form the basis for evaluating an organisation’s financial position (Potter 2005).
In financial accounting, assets are the economic resources of an entity. This comprises the tangible and intangible resources that can be owned and which can be ‘controlled to produce value’. Thus, assets have a positive economic value to the entity in which they reside (Tollington 2001). As such, they can be described as anything that is of monetary value to an entity.
A formal definition of assets describes them as resources controlled by a particular entity or entities. Those entities present the outcomes of previous transactions and events. They are also resources from which future economic benefits are expected (Williams & Haka 2008). They are profitable to the entity only, or in combination with others.
Liability, on the other hand, can be considered as the debt or obligations of an entity. It can also be defined as creditors’ claim on the business assets. Financial accounting defines liabilities as obligations of an entity that arise from past transactions and events. The need to settle these obligations calls for the use of assets (Daniels 2005). This translates into an outflow of an entity’s resources leading to economic benefits in the future.
Classificatory Forms of Assets and Liabilities
According to Potter (2005), there are two major classificatory bases for assets. These are tangible and intangible assets. Tangible assets can be classified further into current and fixed assets. Intangible assets, on the other hand, comprise of nonphysical resources and rights that are of value to a particular firm or business entity (Daniels 2005).
Fixed assets- also referred to as noncurrent assets- are the plants and equipments owned by a particular entity. These are the assets that cannot be easily converted into cash. Fixed assets are properties bought by a business and which it intends to use for a long period of time. There are various items classified as fixed assets. These include land, buildings, machinery, vehicles and even furniture. These items are used to generate income for the business entity over long periods of time. It is noted that during this time, the items are not expected to outlive their worth. The worth of the fixed assets can be used to define the financial strength of a particular entity (Siegel & Borgia 2007). Some fixed assets are however prone to depreciation. As a result, they may lose their worth over time as a result of activities such as wear and tear. However, some fixed assets may appreciate and improve their value over time. This is, for example, such assets as land.
Current assets, on the other hand, are those that can easily be converted into cash. This is, for example, to pay for current liabilities within a short period, usually twelve months. Typically, current assets comprise of liquid cash, as well as cash equivalents (Epstein & Evas 2007). They enable a business entity to achieve short term obligations with much ease.
Liabilities, on the other hand, can also be classified into two major categories. These are current liabilities and long term liabilities. Current liabilities are those obligations that can be settled using cash within a period not exceeding one year. A business may also resolve to settle the liabilities through the creation of new current liabilities (Epstein & Evas 2007). This means that a business may borrow to settle these liabilities.
Long- term liabilities, on the other hand, take more than one year to mature. They are the long- term sources of the business’ funding. They benefit the business for long periods of time and thus take longer periods to pay. A case in point is when the business takes a huge loan to purchase equipment, land and other assets. The company may commit itself to paying the debt over a long period of time. Within this period, the assets purchased by the loan will generate revenue for the entity.
Recognition Criteria for Assets and Liabilities
For a liability to be recognised in a financial statement, it has to meet certain ‘definitions’. A liability must be a current or rather present obligation in an enterprise. It is an obligation that requires the enterprise to undergo an outflow of resources in order to settle it. These obligations transfer economic benefits to an organisation. As a result, organisations are legally bound to honour these obligations. Failure to honour the creditors may lead to a legal suit against the business. The cost of the obligation or liability can also be reliably measured. For example, the entrepreneur is very much aware of the amount of money they owe the bank and other lending institutions.
For assets to be recognised in a financial statement, they must have an identifiable monetary value (Tollington 2001). Assets should be independent of the entity which owns them. This means that the asset can be sold, transferred or rented out while at the same time the business continues to operate (Atkinson 2012). Their cost can also be measured reliably. Assets also hold future economic benefits given that the company can sell or dispose them in the future through liquidation process to get funds to operate the business. On the other hand, the assets can also be used as collateral when borrowing money from banks and other lending institutions. As such, the future economic benefits of assets cannot be downplayed.
Measurement Bases for Assets and Liabilities
There are various standards used as measurement bases for assets and liabilities. To come up with accurate figures of an organisation’s liabilities and assets, it is important to carefully analyse the financial statements. This is to help one come up with key figures that can explain the actual financial position of the said business (Epstein & Evas 2007). Some of the values that should be analysed through the use of a balance sheet include:
- Returns on the invested capital
- The indebtedness of the entity and
- Cash flow in the entity
Current value can be used to measure highly liquid assets, as well as many liabilities. Working capital is also an effective tool used to measure assets and liabilities, especially when used in retail and small scale businesses (Daniels 2005). It is, however, worth noting that the usefulness of working capital as a measure of assets and liabilities depends on the nature of the industry. Working capital is considered to be an important measurement tool since it provides information on the flow of capital in a business. The flow of capital is considered to be a significant indicator of what is happening in the firm.
Debt is also an important tool in the measurement of liabilities and assets. Through debt assessment, the business’ worth can be determined when comparing the business’ assets and liabilities. Taxation can also be used in the measurement of a business’ assets and liabilities. This is because an enterprise is taxed depending on the value of assets it owns, as well as the capital generated as a result of its activities (Atkinson 2012). It is however important to note that the management can be dishonest in disclosing the actual value of the business, as well as in disclosing the revenues. Deferred tax also greatly affects the measurement of assets and liabilities.
In the past, assets and liabilities were used for assessing the worth of an enterprise. They formed the primary elements of the ‘accounting equation’ as indicated severally in this paper. However, over the years, the two components have elicited a variety of definitions from analysts, writers and philosophers from all over the world. A variety of classificatory forms and descriptions have also been defined to further improve the general public’s knowledge on assets and liabilities. Many criteria can also be used to recognise assets and liabilities. Measurement bases for assets and liabilities have also been devised (Epstein & Evas 2007). I feel that assets and liabilities are the two most important elements in accounting. The value of the business can be judged by evaluating what the business owes its creditors. This can be compared to the revenue generated by the business and the assets owned.
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