Accounting for Liabilities
Liabilities are the measure of anything that decreases economic value and assets are anything that increases the economic value of an organization (Kimmel, Kieso, & Weygandt, 2011). The measure of assets is vital to an organization because this measure can determine a variety of decision making situations such as financing, investor interest, and budgeting concerns. The most basic and essential idea of assets is that they represent the value of the company.
There are two forms of assets called current and noncurrent assets. Current assets are those assets which can be converted into cash within one year (Kimmel, Kieso, & Weygandt, 2011). Current assets include items such as certificates of deposit, stocks, bonds and other marketable securities. These current assets also include accounts receivable, inventory, prepaid expenses, and any other items which can be sold or converted within a year. Current assets are very important to companies, especially companies seeking lending because creditors like to see current assets in order to know that they can get their investment returned in the event of bankruptcy. Current assets are also a measure of short term cash flow. Because current assets can be converted into cash quickly, they represent the company’s ability to sustain operations from day to day. This is also important because it shows the strength of the company.
Similar to current assets, noncurrent assets are any item that can be converted into cash after one year or longer (Kimmel, Kieso, & Weygandt, 2011). Noncurrent assets are not easily converted into cash and these items might include: prepaid expenses, certain types of inventory, intangible assets such as the value of property, etc… One important aspect of noncurrent assets that should be mentioned is that many noncurrent assets are assets which are industry specific. For example, an industrial sewing machine might have tremendous value but because the asset is so specific to an industry it may take a very long time to sell. This long conversion time for an asset is due to the fact that buyers for this item might be scarce. So while a particular asset might have a large dollar value its sales conversion rate could be rather long making it a noncurrent asset.
Noncurrent assets are important and need to be measured in the total value of the company. Noncurrent assets help to determine the overall value of the company such as when the company is being sold. Anyone buying a company would need to take these assets into account.
The value of assets is important to the company and when measuring these assets they are often placed in order on the balance sheet from easiest asset conversion to longest. This arrangement from quickest to longest liquidity is called the order of liquidity (Kimmel, Kieso, & Weygandt, 2011). This order of liquidity allows investors to view assets according to their value and ease of conversion. This arrangement or chronology of assets on the balance sheet also provides the company a means of viewing assets which can show how liquid the organization is and where there might be problems. In a very basic sense, the order of liquidity makes the determination of asset and company value easy to understand.
Both current and noncurrent assets play a vital role in the determination of company value. Having both types of assets represents an organization which has both short and long-term value. While both types of assets are important, current assets are more important from a lending and operational standpoint. The current assets will play the larger part in investor lending and in cash flow management. This is not to say that noncurrent assets are not vital to the organization. The noncurrent assets play a major role in determining the intrinsic value of an organization. This is to say how much is the company worth to a purchaser? For these reasons both current and noncurrent assets are important and necessary measures for any company.
Kimmel, P. D., Kieso, D. E., & Weygandt, J. J. (2011). Financial accounting: Tools for business decision making. Hoboken, NJ: John Wiley & Sons.