Kevin has edited encyclopedias, taught history, and has an MA in Islamic law/finance. He has since founded his own financial advice firm, Newton Analytical.
While it's pretty easy to figure out what is an asset and what is a liability, it is quite a bit harder to determine just how much each is worth. In this lesson, we look at the challenges of measurement in accounting.
How We Count Matters
One of the fundamental assumptions of the business world is that everything can be assigned value. For example, chances are that a greater value is placed on the computer or smartphone that you're reading this on than the bottle of water that you're drinking. However, figuring out just how to measure certain kinds of value can be quite a challenge for accountants. In this lesson, we're going to look at the difficulties that come with measuring assets, liabilities, and equity. Along the way, we'll look at what happens when companies fail to measure their assets properly.
Problems with Assets
Assets are those things owned by a company that can be used to meet debts. This doesn't always have to be physical materials. Promises from other companies are also assets, as are contracts that allow a company to pursue a particular line of business. For example, a contract letting a company be the sole entity that can operate a gold mine is an asset, even if the company doesn't own the mine itself.
However, there are a number of issues that emerge when we try to measure assets. First of all, different assets can have different values to different people. Take art, for example. Determining the value of a piece of art is a very subjective process. We need only look at the auctions where art is often sold to see this. Chances are that the people bidding can afford practically any price, but they only place so much value on a given piece. A painting may be purchased for 18 million dollars and be represented as an 18-million-dollar asset. However, if no one else is willing to spend that for the painting, its value is inflated.
Meanwhile, the prices of assets can change over time. Very famously, this happened with the price of tulips in 1637. In an event known now as tulip mania, the price of the flower skyrocketed to 10 times the average annual wage. Obviously, a tulip is only worth a few dollars today, so someone who put their family savings in tulips wanting to be forever rich would be sorely disappointed.
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Liabilities, on the other hand, are those things that a company owes as debts. Again, there are complicated issues at play here. Companies may seek to minimize their liabilities in order to make it look like they've got more sound management practices. Now, to some degree, this is perfectly legal. Take large debts, for example. If you were a company that just purchased a million-dollar store, it would look horrible for the short term if you posted a million-dollar liability. However, you are allowed to spread out that liability over a period of time. If the asset purchased is tangible, this is called depreciation. If it is intangible, it's called amortization.
Problems with Equity
Of course, issues with measuring liabilities and assets are compounded when it comes time to measure equity. Remember that equity is what's left when liabilities are subtracted from assets. If assets are too low or liabilities too high, the equity will be too low. Likewise, if assets are too high or liabilities are too low, the equity will be too high. If you've ever read about the downfall of certain firms that used shoddy accounting practices, many of these can be linked back to problems with equity. Investors constantly thought they had more value than they had, and as a result, lost their money. This resulted in a sell-off of the company in question, as well as criminal charges for the managers.
In this lesson, we looked at the challenges that face accountants when trying to determine the value of assets, liabilities, and equity. We saw that differing opinions on the value of a set of goods can change how assets are measured, while opinions on how a good's cost should be spread out can change the outlook on liabilities. Meanwhile, any change to these two has an impact on the final equity of the firm.
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