By: Andrea Terzi
Assets and liabilities
In a double entry ledger book, debits reflect acquisitions of value and credits reflect releases of value. This information offers a source for preparing some key documents that show how the activities of giving and receiving shape monetary values.
One such document is the balance sheet. This is a means to measure, at a specified point in time and in one single unit of account, all the values that a given economic unit owns (called assets) and all the values that it owes (called liabilities). The connection with the ledger is that both an increase of assets and a decrease of liabilities result from an acquisition of value (i.e., a debit entry), while both an increase of liabilities and a decrease of assets result from a release of value (i.e., a credit entry).
For a given economic unit, however, not all entries in the ledger (where debits match credits) will show on the balance sheet. One reason is that because it refers to a given point in time, a balance sheet reflects the net results of past ledger entries. For example, a loan that has been fully repaid will not show. Neither will the value of a property that has been purchased and resold.
In addition, there are three reasons for which the value of all assets and of all liabilities need not match:
a) The value of assets and/or liabilities may change, independently of transactions. For example, a U.S.-based company’s liability in euros will fall if the dollar price of euros falls; the value of a property will fall if the expected selling price decreases.
b) Assets and/or liabilities may evaporate. For example, fire may destroy an uninsured property, a liability may be canceled, and any values that the economic unit has received, but meanwhile consumed, will not appear—such as when a business acquires labor services or a household acquires consumer services, neither of which can be stored.
c) New liabilities and new assets may materialize without being linked to specific ledger book entries. For example, a new liability appears when a new tax is imposed by the state or the judicial system. And a new asset appears when the economic unit creates a value internally (i.e., not obtained from others), such as semi-finished and finished products stored as inventories by business.
The difference between the value of assets and the value of liabilities is called net worth and is a measure of the accumulated stock of wealth of the economic unit. If this is a business, it is called the owner’s (or shareholders’) equity.
Figure 2 shows the key broad entries of a typical balance sheet. While liabilities are obligations that entail future payments to other parties, assets are things that have value and are normally expected to generate cash inflows, as well as cash outflows. For business, real assets include investment goods like plants and equipment, unfinished products, and other inventories. For households, they include property that retains a reselling price.
Figure 2. Structure of a balance sheet
|ASSETS (net increase in debits)||LIABILITIES (net increase in credits)|
|Real assets||Financial liabilities|
|Net worth (= Assets – Liabilities)|
Financial accounting techniques, principles, standards, and rules
An economic entity’s balance sheet is of significance to all users interested in monitoring that economic entity’s performance, and the study of financial accounting techniques and principles helps enhance the accuracy of accounting records. Audits ascertain the validity and reliability of information. Because those who have direct knowledge and ownership of the ledger may not have an interest in sharing it with others or may have an interest in showing inaccurate or deceitful statements, accounting standards and regulations set principles and rules on how businesses should compile their balance sheets and how they must disclose them to third parties.