Assets and Liabilities – Definition and Recognition Criteria

Business discussions with your company accountant will almost certainly end up involving comments about either assets or liabilities and if you’re lucky both! Assets are what the company owns and liabilities are what the company owes, easy. If we count everything in the office and then add up all our unpaid bills we know all of our assets and liabilities. Unfortunately, it’s not quite that straightforward, though with a little bit of guidance and a few ground rules it’s pretty easy to fully understand these concepts.

Here are a few ways for the recognition criteria between Asset and Liability.

Definition of Assets

An asset is any resource held or controlled by a business or economic entity in financial accounting. It is anything that has the potential to provide positive economic value. Assets are ownership values that can be transformed into currency.

There are several core criteria, all of which must be met, used to define what constitutes an asset.

Criteria to recognize assets

The criteria to recognize assets are as follows.

  • The asset is controlled by the entity. So you must control the actual asset and have the right to use it. If you have the asset on your property but it belongs to someone else, say a business partner, the asset is technically theirs.
  • The asset arises from a past transaction. So you must have actually paid for the asset already, an agreement to purchase an asset (while important) is not sufficient until you’ve actually paid up.
  • The asset has future economic benefits that will flow to the enterprise. So the asset must actually be worth something and will generate value for the organization. Paying $10K for an asset that is only worth $2000 will result in an asset on the books worth only $2000, not what you actually paid for it.

So in essence you need to consider control, economic benefit, and past transaction. As long as you consider those three and can reasonably argue that all criteria are met you can consider the item an asset.

These criteria can be applied to many different things that people don’t always consider when they think of the assets of a company.  Here are a few examples to get you thinking:

  • Prepaid Expenses: Say your company pays rent in advance for the month, the payment has occurred, there is a future benefit to the company, and you have control of the ‘asset’ in that you’re contractually able to access the property.
  • Accounts Receivable: Amounts that are due to your company are also considered assets even if you haven’t received the cash yet. The transaction occurs when you sold the product or delivered the services, you are entitled to the economic benefit, and you control it in that the other party is legally obligated to pay you.

Definition of Liabilities

A liability is defined in financial accounting as the future sacrifices of economic benefits that an entity is obligated to make to other entities as a result of past transactions or other past events, the resolution of which may result in the transfer or use of assets, provision of services, or another future yielding of economic benefits.

Similar to assets there are several criteria that must be met in order for something to be considered a liability.

Criteria to recognize liabilities

The criteria to recognize liabilities are as follows.

  • The liability is an obligation of the organization. In this case, if the organization has a legal obligation to provide a service or transfer assets the liability should be recorded.
  • The liability arises from a past transaction. The transaction that generated the liability should have already occurred, you wouldn’t consider something to generate a liability if the underlying service or product hasn’t been provided.
  • The liability will result in the transfer of assets, provision of services, or other economic benefits. Essentially this means that if your organization is required to provide something of economic value then it should be recorded as a liability. The definition is fairly broad considering both assets and services.

Some common liabilities to consider, that often aren’t recorded by companies, include:

  • Deferred Revenue: This is a liability booked to reflect amounts you have been paid already for services you haven’t actually provided. Consider a hotel where you charge a deposit when customers book a room.  You’ve received cash from the customer and are obligated to provide a future service (letting them stay at your hotel). As such liability should be booked.
  • Accrued Liabilities: These are a bit of a catch-all for many types of services or obligations that the company has incurred but not paid for yet. Consider employee vacation time.  As the employee works they become entitled to this based on their employment contract, taking care of the first two criteria.  When the employee goes on holiday you’re obligated to pay them, satisfying the last criteria.  Other accrued liabilities can relate to external services, environmental clean-up costs, and retirement obligations.

So now when your accountant starts talking about the need to book a liability or an asset related to something this framework should help you understand a bit more clearly why.

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