Understanding The Difference of An Asset Vs. A Liability -- Determining Your Net Worth
The Pure Empathy Education Group
Understanding The Difference Between an Asset vs. a Liability
Understanding the Relationship between Assets, Liabilities, Income and Expenses
Perhaps one of the most difficult concepts to understand in beginning accounting is the relationship between assets, liabilities, income and expenses. We discovered the most lucid explanation of this relationship in Robert T. Kiyosaki's book Cash Flow Quadrant. We recommend that you read this book to get great insight on understanding how to create assets and avoid liabilities. Let's define these terms in a way that is easier to grasp. Kiyosaki defines an asset as something that puts money into your pocket. That is, assets generate income. Conversely, liabilities take money out of your pocket. Expenses not paid with cash generate liabilities. For example, the mortgage on your home is a liability; so is the outstanding balance on your credit cards.
In the double-entry accounting system customarily used by business and taught in accounting classes, the assets and income must counter-balance each other. In a solvent business, assets acquired are recorded as a debit amount; income is entered as a credit amount. To counterbalance the asset and liability entries, we enter income as a credit amount and expenses as debit amounts. What do we mean by debit and credit. The terms go back to the old manual accounting forms used by business in the days before personal computers. Your personal checkbook register is an example of such a form. Debits are always recorded in the left column; credits are recorded in the right column. Some forms, such as the checkbook register have a running balance column to the right of the debit and credit columns. Some accounting textbooks try to teach debits and credits as positive and negative which, in my opinion, causes more confusion than clarification for the accounting student.
Kiyosaki's definition also allows the accounting student to better see the relationship's in the Basic Accounting Equation:
Assets = Liability + Equity
Other names you may see for equity are net worth and retained earnings. Assets as we said earlier, have debit balances; liabilities and equity have credit balances. Thus, we could rewrite the above equation as
Debits = Credits
In a double-entry accounting system the total amount of all debit postings must be equal to the total amount credit postings or there is an error in the books. This what we refer to as the books being out of balance.
* assets put money in your pocket and are recorded as debit amounts,
* the corresponding income is recorded as credit amounts,
* liabilities take money out of your pocket and are recorded as credit amounts, and
* the corresponding expenses are recorded as debit amounts.
* Finally, equity or net worth is recorded as a credit amount.
Below is a you tube video by Robert K Robert Kiyosaki - Assets vs Liabilities
How to Determine Your Net Worth
Listing all your assets is the first step to figuring out your net worth.
Assets and Liabilities
Your net worth is a snapshot of your finances. The picture will change slightly the next time you pay a bill and again, the next time you receive a paycheck. To determine your current magic number, the first step is to take a look at all of your assets, which are anything of value that you own. Make a list of all these items and next to each, list the amount it's worth. These typically include:
- Cash -- any physical currency and coins you have
- Funds in the bank -- all the money you have in a savings, checking, or money market accounts, and any certificates of deposit (CDs)
- Stocks, bonds and mutual funds: also list savings bonds
- Retirement accounts -- includes 401(k) funds, IRAs and any other retirement accounts
- Life insurance -- counting any cash value you have in the policy
- Motor Vehicles: the current blue book value of any cars, motorcycles, boats, RVs, etc.
- Real Estate -- the current market value of property (house, condo, land, etc.) you own, even if you have a mortgage
- Personal Valuables -- including the market value of jewelry, collectibles (from baseball cards to art) and furniture
- Money you're owed -- as long as you have a reasonable expectation of being paid back [source: Sahadi]
In reality, just because you own these assets doesn't mean you'll be able to access their monetary value today. Only cash and other highly liquid assets -- things that you can exchange for a good market value quickly -- are easily accessible. Although it might take months to turn real estate into its true cash value, use the full market value when calculating your net worth today. If you're unsure of what something you own is worth -- like an antique -- is worth, find a professional appraiser.
When you're done listing assets, make a separate list of liabilities and amounts. Liabilities are any debts or payments you owe to someone else. Here are the most common:
- Mortgage -- the principal or amount you have left to pay on your mortgage(s)
- Home equity loan -- how much you owe if you have a home equity loan
- Automobile loan -- the amount you have yet to pay on your car(s) and other motor vehicles
- Student loans -- the amount left on student loans
- Credit card debt -- any balance owed to a credit card company
- Understanding Assets vs Liabilities
- It might seem basic the definition of assets and liabilities...
- Assets versus Liabilities
- The basics of assets and liabilities are straightforward, and the definitions are very basic. Yet understanding assets and liabilities and how they impact your financial circumstances can be the difference between financial success or failure.
- Definitions of Assets and Liabilities
- In accounting terms an asset is something you own, that provides a future economic benefit. It is an item that can be sold and has intrinsic value. A liability is money you owe or debt you hold.
Assets include cash, investments, bank accounts, real estate, vehicles, collectibles, antiques and other items you own.
Liabilities include mortgages, home equity loans, automobile loans, student loans and credit card debt.
As an individual or a business the goal is to have a positive net worth, and to have that net worth grow over time. Net worth is established by adding your assets and subtracting your liabilities. If the number is positive there is a positive net worth. This number establishes your financial value.
- Beyond the Accounting
- There is more to assets and liabilities than a definition and numerical calculation determining financial value. The better assets and liabilities are understood the better financial decisions can be made. This is what builds wealth.
- Appreciating and Depreciating Assets
- Not all assets are equal because assets are either gaining or losing value. Assets that gain value are appreciating assets and assets that lose value are depreciating assets.
Appreciating Assets increase in value over time. These are investments. When we put money in a savings account, certificate of deposit, bond, or mutual fund we are anticipating that the asset (account) value will increase. Purchasing a home creates the expectation that the asset will grow in value during the period of ownership.
Depreciating assets include purchases that lose value over time. Let’s say you buy a new outfit. Whether it is a simple outfit or a fancy suit or dress does not matter. Whether you paid $100 for it or $1000 for it, the results are the same, you will never be able to sell the outfit for what you paid for it. This is a depreciating asset. Unfortunately much of the money spent falls into this category. The cars you drive, the food you buy, and trips you take are all depreciating assets. Once the money is spent on the item, you may be able to use it, but you will not get the value from the item, that went into the purchase.
- Debt and Liabilities
- Debt creates a liability. This is true even for assets like real estate. The challenge with debt is that the interest that is paid, reduces the equity in the asset. If you buy a home and pay $200,000, but then over the course of the mortgage pay another $200,000 in interest, the actual costs of the home is $400,000 plus repairs and improvements that were put into the home. If you do not make purchases wisely all of the equity (assets minus the liability) can be lost in interest payments.
- When looking at assets and liabilities as to tool to increase wealth, it becomes possible to make better financial decisions that will build your portfolio. Then, financial goals can be reached and your net worth increased.