Accounting Principles – Classification of Assets and Liabilities

Fixed or capital assets are those which represent that portion of the capital of the organization invested in assets which are more stable in their nature; those which tend toward permanency in their character. Among this group will be found, property and plant, composed of real estate (technically representing land but more commonly found to include both land and buildings), and equipment (including machinery, tools, power plant and other operating or auxiliary equipment). Other items in the group are furniture and fixtures, outside investments, comprised of stocks and bonds of other companies, and bonds and mortgages of other companies or individuals.

Working and trading assets are those which represent that portion of the capital which is invested in assets, (a) available for use in creating the product, or service, which the organization offers for sale, (b) involved in the process of creating the product, or (c) in product completed and ready for sale. This group is usually represented by inventories, and includes materials and supplies, goods in process of manufacture and finished goods; also items incidental to the operation or conduct of the business, such as the inventories of coal, oil, and waste, stationery, postage, etc.

Current assets are those which represent that portion of the capital which is invested in assets maturing within a short time; those which may be realized upon readily or converted into cash; those which are available for the liquidation of current liabilities. They include, cash in hand, deposits, working funds, accounts receivable, notes receivable, and interest which has accrued. They are sometimes called “liquid” assets.

Special or miscellaneous assets, as a group, are difficult to define on account of their varied natures. Certain of them may represent investment of capital. Some of them may represent reserves or surplus. In some instances the accounts may be balanced by offsetting accounts reflecting direct liabilities or contingent liabilities; in others, the account may be maintained as a memorandum, in order that certain things may not be lost sight of, and be balanced by an offsetting account for the purpose of maintaining equilibrium. This group comprises, patents, copyrights, trademarks, good-will, sinking funds, leaseholds, contract rights, franchises, treasury stock, notes receivable discounted, and consignments received. Such items as patents, copyrights, trademarks, good-will, leaseholds and franchises might represent investments of capital. On the other hand some of them might be acquired by gift or by accumulation, in which cases they would probably be offset by reserves or surplus. Sinking funds are usually set aside to provide for the liquidation of some liability and would constitute a setting aside of capital unless the funds were offset by a reserve accumulated out of profits. Notes receivable discounted would be offset by an account merely for the purpose of maintaining an equilibrium.

Deferred charges to expense, constituting the last group, may be defined as investments of capital in items of expense not applicable to the accounting, or fiscal, period in which they originate, the charge to expense for which is deferred to a subsequent period. They are sometimes called ” assets by courtesy.” They embrace all prepaid expenses, prominent among which are, insurance, taxes, rent, advertising, organization expense, moving expense, etc.

Liabilities may be divided into four general groups: capital liabilities, current liabilities, special liabilities, and deferred credits to income. Reserves are sometimes classified as liabilities, but it would appear to be more nearly correct to consider them as a portion of the capital or proprietorship, which has been set aside for specific purposes, and they will be so considered and treated in this discussion.
Capital liabilities are those which arise in connection with capital obtained for investment in the business. If specific at all with regard to their maturity, they are usually obligations, the term of which extends over a period of years. They are usually of such a nature, that they do not become due until the date specified for their maturity, except by special provision in the instrument whereby they are represented. When such provision exists, it is usually in the form of a right accruing to the holder of the obligation, by virtue of which he may enforce collection if interest on the obligation is not paid when due. Among capital liabilities are found, bonds, debentures, long-term notes, etc.

Current liabilities are those which mature within a short time. They are those for which funds must be obtained to provide for their liquidation. They are the obligations incurred in connection with operating expenses, the securing of materials and supplies, the purchase of trading goods, or obtaining of current funds. They are the constantly maturing obligations which must be met out of the realization of current assets. They include such items as taxes accrued, wages accrued, accounts payable, notes payable, interest accrued, dividends payable.

Special liabilities are perhaps not liabilities in a strict sense of the word. Accounts for them are, however, frequently found in the books and they should not be passed over without explanation. They frequently represent a condition of accountability, rather than liability, and in some cases where a liability might be expected to exist it is contingent upon the realization of some existing asset. Prominent in this group are consigned sales and notes receivable discounted. In some instances it is also made to include an account with consignors for goods received on consignment.

Deferred credits to income, represent income which has been received in a period prior to that to which it is applicable. In cases of this kind payment has usually been received in advance on account of right, services, or goods which will not be delivered until some subsequent period. They are sometimes referred to as deferred liabilities and include such items as rents and royalties, etc., received in advance.
Reserves are to be considered as capital, set aside for specific purposes, rather than direct liabilities. If it is true, that capital or proprietorship is an accountability, rather than a liability, it is probably also true that reserves are accountabilities, rather than liabilities.

Proprietorship is that financial investment which is represented by the excess of assets over liabilities. It may be expressed in several ways, depending upon the type of organization. It may be restricted or unrestricted. It may be restricted, in that it is set aside as a reserve for the purpose of providing for the depreciation of some of the physical assets, or a possible loss through failure to collect outstanding accounts. As unrestricted, it may appear as capital of the proprietor, or in the case of a corporation, as capital stock, undistributed profits, or surplus. As capital stock it may be either common or preferred. It may also be represented by temporary evidence of its existence in the form of scrip.

It would appear to be appropriate at this time to discuss a question with regard to proprietorship upon which there is some difference of opinion among accountants. The subject for discussion may be presented in the form of the question “Is proprietorship a liability?” The arguments for and against, considering proprietorship as a liability, will also bring out the reason why English accountants place liabilities on the left hand side of the balance sheet, rather than upon the right hand side, as is the custom in this country. Whether or not, proprietorship is a liability depends entirely upon the viewpoint of the accountant. It depends upon whether or not there is a distinction made between the financial status of an individual, as an individual and a business entity. In other words, when John Jones engages in business, the question to be decided is, shall he be regarded as an individual who has invested money in a business organization and which organization is indebted to him for the funds so invested, or as the organization itself? In order to make the situation conform to the first suggestion it is necessary to raise a theoretical entity in the form of John Jones, Proprietor, which is indebted to John Jones, Individual, for funds invested. Under such circumstances and with the creation of such theoretical entity, it would be quite proper to consider the account of John Jones, Proprietor, as a liability, were it not for the fact that the law does not recognize such a distinction. If perchance the assets of John Jones, Proprietor, are insufficient to liquidate the liabilities of John Jones, Proprietor, the law permits any assets of John Jones, Individual, to be appropriated by due process of law and applied to the liquidation of outstanding liabilities of the business.

Looking at it from the other point of view, there is no distinction made between John Jones, Individual, and John Jones, Proprietor. John Jones is the business; whatever assets the business may have are his. Whatever liabilities exist he must liquidate. The excess of assets over liabilities constitutes his equity in the organization, or the extent of his proprietary interest; it is his capital. What he possesses he cannot very well be liable to himself for. He cannot sue himself for the capital which he has invested in the business. Upon such grounds it would appear to be more reasonable and logical to consider proprietorship as an accountability rather than a liability. The positive and negative forces of his business organization account for his financial condition. While he is able to determine his financial condition through having his account stated, there is no liability. He cannot enforce collection. If he desires to obtain the funds, or the capital, invested in the business he is forced to wind up his affairs as a proprietor either through realization and liquidation of the concern, or a sale to other interests.
It was probably from the first interpretation of organization above stated that the English placed liabilities on the left hand side and assets on the right hand side of the balance sheet. It has been said that while this is required by law that it was due to ignorance of accounting on the part of the framers of the law that such provision was made. This may, or may not have been the case, but at all events such has become an established practice with the English accountants. The business is considered as a distinct entity, liable to the proprietor, for the excess of assets over liabilities in favor of other creditors.