Maria Peloponisiou~ 5 min Reading time | 08. Aug 2019
As one of the three factors in the basic accounting equation, Assets = Liabilities + Equity, assets are a fundamental part of the double-entry bookkeeping system. In order to make sense of your balance sheet, it’s important to know what assets are and the diﬀerences between the types of assets that appear on it. Additionally, being clear on how the value of ﬁxed assets is calculated over time – depreciation and amortisation – will help you gain more accurate insight into how your business is doing at any given time.
What are Assets?
Assets are, in the simplest terms, everything a company owns. On a balance sheet, assets are usually listed in the order of liquidity, or how long it would take to convert them into cash. The most liquid asset is cash itself, and is usually at the top of the balance sheet, followed by things like accounts receivable, then inventory. Assets expected to last a year or more are known as ﬁxed assets, and are found near the bottom of the balance sheet – these are assets such as equipment, vehicles, and properties. Assets can also be grouped into tangible assets and intangible assets – so things such as inventory, property, cash and vehicles are tangible assets whereas copyrights, patents, and licenses are intangible assets.
When you’re looking at a balance sheet, the total of all of your assets will give you an idea of the value of your business, and the liabilities and equity will give you some idea of how they were paid for and how much money would be avaiblable to you if everything was sold. Negative equity, for example, is a red ﬂag that your company is in debt or ﬁnancial distress.
Depreciation vs. Amortisation
Enter depreciation and amortisation, similar calculations applied to two diﬀerent types of ﬁxed assets. When you buy something for your business that you expect to last a year or more, it loses its value over time. Depreciation and amortisation both capture this decline in value so it’s accurately reﬂected on the balance sheet.
Depreciation is a calculation that expenses the value of a tangible asset over time, whereas amortisation does the same for intangible assets. So purchases that will be ﬁxed assets get recorded on the balance sheet as assets. Then, each year, the value of the asset is reduced by a set amount, and the amount is recorded as an expense on the balance sheet. This decreases both the assets and the equity of a business as the asset moves through its meaningful life.
Depreciation and amortisation ledger accounts are what is known as contra accounts, or accounts that reduce the value of a related account – so there is usually an accumulated depreciation and an accumulated amortisation expense account on the ledger that oﬀsets the value of ﬁxed assets over time. Keep in mind that these calculations apply only to assets with a meaningful life of a year or more – so renewing an annual license would be recorded as a simple expense, whereas a permit that lasts ﬁve years would be recorded as an asset amortised over that time period.
Depreciation, the recorded decline in value of a tangible asset, is sometimes calculated slightly diﬀerently from amortisation. Often equipment like vehicles will depreciate faster soon after they are purchased and more slowly later, and as such, the depreciation is often recorded on an accelerated basis – so more is reduced in earlier reporting periods. This is a more common method of recording depreciation than reducing the value of the asset on a straight-line basis, or the same amount each reporting period, since it more accurately reﬂects the ﬁnancial realities associated with buying tangible equipment. When the useful life of the asset has expired, a tangible asset will usually have some remaining salvage value, which is included in the calculation.
Amortisation, the recorded decline in value of an intangible asset, is conversely usually calculated on a straight-line basis. This is because immaterial assets such as permits, licenses, and patents don’t usually have any value once they expire. Amortisation also doesn’t usually incorporate any salvage value into the calculations for the same reason. So if a business owner buys a patent for $10,000 with a lifespan of 10 years, it would probably be amortised at a rate of $1,000 per year to reﬂect its decline in value as it approaches its expiry date.
Why are Depreciation and Amortisation important for your Business?
You might be thinking that this seems like a complicated series of calculations for a single purchase – but depreciation and amortisation are important! They enable your balance sheet to more accurately reﬂect the value of your business at the time it’s calculated. If a large item was simply recorded as an expense, for example, then the balance sheet for that month might show a drastic reduction in equity, which wouldn’t reﬂect the value that the item is adding to the business. If the item was simply recorded as an asset but its decline in value wasn’t accounted for, the assets on the balance sheet (and therefore also the equity) would be higher than it really is.
Having a handle on these two concepts can also help you if something seems oﬀ with your balance sheet – if there’s a sudden dip in equity that doesn’t seem right, for example, you can take a closer look at your assets to make sure they’re categorized correctly, rather than worrying about being on a sinking ship! Even when you have accounting software to help you prepare balance sheets, it’s still up to you to make sense of them.