Assets Definition and Meaning

Assets Definition and Meaning | Accounting Smarts
Charles Hall

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Charles Hall

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June 10, 2022

All business needs assets to operate, but what exactly are assets and how do the different types of assets affect my business?

All business needs assets to operate, but what exactly are assets and how do the different types of assets affect my business?

Assets are resources with economic value owned by a business that can be used to produce future value. Assets can be categorized into 5 groups:

  • Current assets
  • Fixed assets
  • Long term investment
  • Intangible assets
  • Other assets

Within each category, there are many different types of assets as well as different ways to utilize them to maximize growth.  Keep reading for an in-depth guide to all things assets.

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Different Asset Categories

As we mentioned above, assets are broken up into five main classifications. This helps to easily identify assets by similar type and purpose.  They are intentially arranged on the balance sheet in order of liquidity, with the most liquid assets (such as cash) list at the top. 

The Importance of Current Assets

Current assets are listed first because they are the most liquid, meaning they can be quickly converted to cash in less than a year. 

Assets that fall into this category in order of liquidity are:

  • Cash/cash equivalents
  • Marketable securities
  • Accounts receivable
  • Inventory
  • Prepaid expenses

What Are Cash Equivalents?

Cash is obviously what is in your checking or saving account by what are cash equivalents?  Cash equivalents are short-term investments or marketable securities which can be easily converted into cash amounts. 

Examples of cash equivalents are:

  • Cash management pools
  • Certificates of deposit
  • Commercial paper
  • Money market funds
  • Treasury bills
  • Treasury notes

What are Accounts Receivable?

Accounts receivable is any money owed to your business for product or services delivered. Whenever someone purchases something from your business but does not pay for it right away, the money they owe you goes under accounts receivable. 

Invoices are typically used to document what someone owes. An invoice documents a specific transaction and details the terms of the deal and payment requirements. 

What is Inventory?

Inventory is saleable product whether purchased or produced.  We typically associate inventory with finished goods your business has already produced or purchased but has not sold yet. However, other items fall into this category as well, such as:

  • Raw materials
  • Units in production (work in process)

What Are Prepaid Expenses?

When you make an advanced payment for a good or service that you will receive in the future, this is considered a prepaid expense.

Examples of prepaid expenses are:

  • Insurance
  • Rent

Current Assets Are Important

As a small business, you must be able to pay your debts when they come due. Otherwise, you will end up having to borrow money. Current assets are an indicator of your ability to pay current liabilities.  Hence having more current assets than current liabilities positions your company for growth. 

Small businesses should have at least a 1:1 ratio of current assets to current liabilities. Many people use the current ratio formula to keep track of this. 

The current ratio measures your business's ability to pay off its debts. It is calculated by dividing your business's current assets by current liabilities. Typically, a ratio between 1.5 to 3 is considered healthy for most industries. 

Fixed Assets Are Productive

Fixed assets, also known as Property, Plant, and Equipment, are physical items with useful lives of more than one year. These items are not intended to be immediately sold, rather they are intended to improve the productivity of the business. 

Examples of assets that fall under this category are:

  • Buildings
  • Computer equipment
  • Computer software
  • Furniture and fixtures
  • Land
  • Leasehold improvements
  • Machinery
  • Vehicles

Most fixed assets wear out as they are used and have to be expensed over time.  This expensing process is call depreciation.

Depreciation of Fixed Assets

Depreciation is the associated cost of a fixed asset wearing out.  Depreciation tries to match the revenue generated by the fixed asset with the associated “wearing out” cost of the fixed asset.  Just like cash is removed from your books when it is spent, the value of fixed assets are removed as they are used through depreciation.

Depreciation calculates the decrease in the value of the asset over its useful life. There are four popular ways to do it:

  • Declining balance depreciation
  • Straight-line depreciation
  • Sum-of-the-years' depreciation
  • Units of production depreciation

Land Is Not Depreciated

All fixed assets need to be depreciated throughout their useful life, except land. This is because land is not depleted over time like other fixed assets, land typically appreciates in value over time. 

Understanding Long Term Investments

When a company invests in another institution and does not plan to sell the acquired assets within a year, these assets are considered long term investments. 

Assets that fall into this category are:

  • Bonds
  • Real-estate
  • Stocks

Businesses may wish to make long term investments when their cash is not immediately needed for short term projects.  Long-term investments allow an asset to grow while it is not being used in the operations of the business.

Small businesses may consider this option to prove to possible investors that they have enough capital available to invest for a long period of time. This shows that they are performing well and not just trying to survive year to year. 

However, small businesses need to be sure that they still have the necessary current assets available to continue paying off their debts when they make these sorts of investments.

What Is an Intangible Asset?

An intangible asset is an asset that is not a physical item but helps the company produce value on an ongoing basis. Examples of intangible assets are:

  • Brand equity (recognition)
  • Client relationships
  • Company reputation
  • Copyrights
  • Domain name
  • Franchises
  • Goodwill
  • Intellectual property (know-how)
  • Lease agreements
  • Licensing agreements
  • Patents
  • Trademarks
  • Trade secrets

Two Types of Intangible Assets

There are two different types of intangible assets. They are:

  • Limited-life intangible assets. Intangible assets that fall into the limited-life category have a limited lifespan that is known. Assets such as copyright and patents fall under this category.
  • Unlimited-life intangible assets. Unlimited-life intangible assets do not have a known life span. It is impossible to figure out how long they will have value. A trademark is a good example of an unlimited-life intangible asset. 

Why Intangible Assets Are Important

Small businesses acquire intangible assets to increase the value of their business in the long-term. They have value due to the business's sole legal or intellectual rights over them. 

Intangible assets also help to improve the value of your business's tangible assets. For example, brand recognition (an intangible asset) can help sell the business's inventory (a tangible asset).  

Can Intangible Assets Be Destroyed?

Intangible assets can be destroyed and/or diminished in value. The main example of how this occurs is through business failures, such as bankruptcy. When a business goes bankrupt, assets such as its trade secrets will be diminished in value or destroyed. 

Brand reputation is another asset that can be destroyed rather quickly in a few different ways. For example, if your business responds negatively to a bad review, this can harm your reputation.

Amortization of Intangible Assets

As mentioned before, correctly recording your assets on your balance sheet is important. To record intangible assets correctly, you need to allocate their use over their useful life. To do this, we use the process of amortization. 

Amortization is like depreciation, but for intangible assets. The main way to calculate it is with the Straight-line method

If an intangible asset has an unlimited life, it is subject to an impairment test periodically. An impairment is a decline in the asset's value permanently, unlike amortization, which has a defined set of years.

What Are Considered "Other" Assets?

When an asset does not fit into the other main categories, it falls under the "other" asset classification. This category is the last line in the asset section of the balance sheet. 

Examples of assets that fall under this category are:

  • Advances to officers
  • Bond issue costs
  • Deferred tax assets
  • Long-term prepayments 
  • Prepaid pension costs

Why Are Assets Important?

Assets are everything your business owns. They are what help you operate from day-to-day. From the vehicles you drive to the patents you hold, they are everything you use to make money for your business. 

Assets are important because they help:

  • Generate revenue for your business
  • Increase business value
  • Keep your business running

How Do Assets Increase Revenue?

Correctly utilizing your assets can help increase sales and decrease expenses. 

The more efficiently you use your assets, the more sales you will be able to generate. To use your assets efficiently, you need to look at how you can cut down on expenses associated with them. For example, you can lease equipment instead of buying it. 

A good way to keep track of how well your assets are generating revenue is with the asset turnover ratio. You get this ratio by dividing net sales by average total assets. The higher the ratio, the more efficiently your company is using its assets. 

Assets Help Determine Business Value

There are multiple ways to determine the value of your business. The asset-based business valuation is one of them. This valuation can be done in one of two ways.

  • Going concern asset-based approach (book value)
  • Total assets - Total liabilities
  • Liquidation asset-based approach (liquidation value)
  • Determining the net cash received if all assets are sold, and liabilities paid off

By accurately recording your assets, you can benefit the value of your company by:

  • Assuring shareholders and potential investors
  • Creating an accurate reporting of profit and loss 
  • Increasing goodwill towards your business
  • Showing the profitability of your business

Importance of Caring for Your Assets

Properly caring for your assets can reduce your business's risks. For example, if you do not maintain your production machinery, it could break, resulting in:

  • Lost working time
  • Potential health risks
  • Potential worker safety risks
  • The need to spend money on fixing or buying a new production machine

Why Are Assets Valued?

Assets are valued for a number of different reasons. The reason for valuing the asset will help determine which way the asset should be valued. Reasons for valuing your assets include:

  • For disaster loss purposes
  • To sell the asset
  • To substantiate depreciation deductions
  • To use the asset for collateral for a loan
  • Your asset has become obsolete 
  • Your business has gone bankrupt, and you need to liquidate

Different Ways to Value Assets

Assets can be valued in a few different ways, including: 

  • Cost method
  • Fair market value method
  • Standard cost method

Understanding the Cost Method

The cost method is the easiest method. The price at which the asset was bought is the current value of the asset. You do not need to use any formulas or do any math for this method. 

However, this method is not very accurate because many factors affect an asset's value. Many assets lose value over their lifetime, while some may gain it. Therefore, it is better to use a method that takes these different aspects into account.

Using the Fair Market Value

The fair market value is used to determine the price the asset would sell for on the open market. It is the most common way that assets are valued. 

This process is difficult, though, because there is not just one formula that can be used. You need to take into consideration all the circumstances connected to the property, such as:

  • Desirability
  • Use
  • Scarcity

Some common valuation types to determine the fair market value are:

  • Net asset value. This is the book value of tangible assets minus intangible assets and liabilities.
  • Absolute value models. These are based on the characteristics of that asset (i.e., discounted dividend, discounted free cash flow)
  • Relative valuation ratios. Compare similar assets (i.e., P/E ratio)

The IRS gives a more in-depth explanation about how to find the fair market value for each type of asset. 

Standard Cost Method of Valuation

This method uses expected cost instead of actual costs. You find the difference between expected costs and actual costs from past experiences and use them to determine the asset's expected cost. 

Valuing an Asset with An Appraiser 

Using an appraisal to value your asset involves having a specialist come in and use unbiased methods to determine the asset's value. This specialist is known as an appraiser. 

An appraiser will use a valuation method to find the asset's worth, such as the fair market value or the liquidation value. However, since they are not from within the company, they are often trusted more by others to have determined a fair value of your assets. 

Appraisals are often done for assets such as:

  • Artwork
  • Buildings
  • Jewelry
  • Stock 

Understanding Liquidation Value

Liquidation value is only used when a business is being forced to liquidize, normally resulting from bankruptcy. Due to this, assets are normally valued much lower than the fair market value since the business is being forced to sell them. 

To better understand how to find the liquidation value of a single asset, check out WallStreetMojo

Why Is Asset Valuation Important?

Valuing your assets is important for a number of reasons, including:

  • Determines how much of a loan amount can be covered by assets that are used as collateral 
  • It helps size up your business in the event of a merger
  • It is a mandatory part of an audit
  • It ensures you are paying the right amount of taxes
  • It will help you get the right price if you plan on buying or selling the asset

Knowing the correct value of your assets can help you know the value of your business. Knowing the value of your business can help you to make important decisions about how to grow. 

Does It Matter How You Buy an Asset?

Many small business owners will often ask if assets acquired with cash need to be recorded in their accounts differently from assets acquired with a loan. The answer is no.

Assets are depreciated and valued the same no matter how they are purchased. 

Do You Need to Use Your Assets?

You need to use your assets if you plan to deduct or depreciate the cost. You can buy an asset and not use it within the first year, but you cannot deduct or depreciate it in that year. Instead, you have to start the deduction process in the year it becomes usable.

However, if the asset is "placed in service," the trick around this is that you can deduct it, even if you are not using it. This means that the asset needs to be readily available to use but not necessarily used. 

For example, if you buy a printer in year one but store it away until year two, it cannot be deducted or depreciated for year one. However, if you install it in year one and make it readily available to use but do not use it until year two, it can still be deducted and depreciated for year one. 

How Are Assets Treated for Tax Purposes?

We have focused mostly on how assets fit onto a balance sheet for accounting purposes. However, assets are treated differently for tax purposes than they are for accounting ones. 

Unlike for accounting purposes, the IRS distinguishes assets by if they can be depreciated or expensed. 

Difference Between Expensed and Depreciated 

Items are expensed when they are current or low-fixed cost assets. To expense an item is to receive the tax deduction in the current tax year. You can then use the money that the expense reduction has freed up from the taxes right away. 

Items are depreciated when their useful life is greater than one year. Depreciation for tax purposes is an annual deduction of your business's taxes, similar to depreciation for accounting purposes. 

If an item is depreciated, it will take several years before you can receive the full benefit of the tax benefit. 

Taxes and Listed Properties 

Listed properties are a type of business asset that is used for both business and personal purposes. These assets are closely monitored by the IRS and have specific requirements when it comes to tax deductions. 

The IRS requires that you keep a journal that can prove the dates of when and how the asset was used for business purposes. You also need to be able to prove:

  • The amount of "each separate expenditure with respect to an item of listed property."
  • The amount of how much of the use was for business and how much for personal

Examples of listed properties include:

  • Boat
  • Digital cameras
  • Motorcycle
  • Passenger automobiles weighing 6,000 pounds or less
  • Video recording equipment

Paying Capital Gains Tax

When you sell certain assets for profit, you have to pay a capital gains tax. Most assets are considered capital assets and are subject to the capital gains tax. Assets that are not considered capital assets include:

  • Accounts or notes receivable
  • Copyrights 
  • Depreciable property
  • Items in inventory for sale to customers
  • Patents
  • Real estate
  • Trade secrets

A capital gain is when the asset's selling price is higher than the original cost of the asset. If you lose money by selling the asset, you are not taxed because this is considered a capital loss. 

The business' income determines the capital gain tax rates. There is a short-term capital gains rate and a long-term rate. If you sold your asset within 12 months, it is subject to a short-term rate. 

How to Use Your Assets to Grow

Understanding how to diversify your assets can help you grow as a business. Also, understanding how to manage your assets as your business grows is important as well. 

In other words, assets can help your business grow, but they need to be effectively managed to keep up with the growth; otherwise, they will hinder it. 

Properly Managing Your Assets

Managing your assets will help keep your business afloat. To do this, you need to properly forecast your sales. If your actual sales differ greatly from your expected ones, your business will be in trouble.

For example, if you do not sell as much inventory as you forecasted, your revenue will be much lower, and your inventory costs much higher. 

If you sell more than you expected, you will not be able to keep up with production demand. This will limit your growth. That is why you need to be constantly evaluating your assets and forecasting your sales properly so that you will not limit your growth. 

Focus on Self-Liquidating Current Assets to Start

When you first start your company, you should have mostly current assets that are self-liquidating. Self-liquidating assets are assets that are liquidated by the end of the period. They rise and fall with demand. 

You want to focus on the current assets because you want to ensure you can pay off all your debts at the end of the year. You do not want your money tied up in long-term investments or lots of fixed assets that you will not be able to liquidate in time to pay your bills.

Moving to A Permanent Level of Current Assets

As you become successful, you can start to have current assets that are less liquid. For example, you could consider producing more inventory to have on hand for your clients to make their selections. 

Essentially, you have a certain level of current assets maintained to support your business's growth that does not fluctuate with demand. As your business grows, so does the more permanent level of current assets. 

Investing Long-Term

Once your business has proved its success and started to grow, you can start to think about long-term investments and assets that have a useful life of more than one year.

You must make sure you always maintain a current assets level that allows you to pay off your debts. This is why you should wait until your business has proven its growth before investing in the long-term. You do not want to end up in debt if your capital is tied up in long-term investments and you do not have enough current assets to pay it off. 

You will have a certain number of fixed assets at the beginning stages of your business to ensure your business can function properly, such as machinery and buildings. However, as you grow, you will be able to think about your company's long-term growth and success by tying your money up in long-term investments. 

Assets Are Important to Your Business

Assets are an extremely important aspect of any business. Properly recording and managing them can increase your business's value as it continues to grow.

Knowing how to utilize your assets and grow them with your business properly is a major key to running any successful business. They are so much more than just property the business owns. They are the fuel that drives it.

Charles Hall

Charles Hall

Charles has spent 25 plus years in the world of accounting and business. His experience includes working as a CPA/Auditor international accounting firms. He has worked as a controller and as a COO for small to medium sized companies.

Learn more about Charles Hall