Assets: Definition, Characteristics and Objectives

In this article we will discuss about Assets:- 1. Definition of Assets 2. Characteristics of Assets 3. Objectives of Valuation 4. Types.

Definition of Assets:

Financial accounting has basic elements like assets, liabilities, owners’ equity, revenue, expenses and net income (or net loss) which are related to the economic resources, economic obligations, residual interest and changes in them. Similarly, balance sheet which displays financial position of a business enterprise, has basic elements like assets, liabilities, and owners’ equity.

Assets denote economic resources of an enterprise that are recognised and measured in conformity with generally accepted accounting principles. Assets also include certain deferred charges that are not resources but that are recognised and measured in conformity with generally accepted accounting principles.

Deferred charges are carried forward on a trial balance. Financial Accounting Standards Board of U.S.A. defines assets as “probable future and economic benefits obtained or controlled by a particular entity as a result of past transactions or events.” The Institute of Chartered Accountants of India defines assets as “tangible objects or intangible rights owned by an enterprise and carrying probable future benefits”.

Characteristics of Assets:

Assets have the following main characteristics:

(1) Future Economic Benefits:

‘Future economic benefit’ or ‘service potential’ is the essence of an asset. This means that the asset has capacity to provide services or benefits to the enterprises that use them. In a business enterprise, that service potential or future economic benefit eventually results in net cash inflows to the enterprise.

Money (cash, including deposits in banks) is valuable because of what it can buy. It can be exchanged for virtually any goods or services that are available or it can be saved and exchanged for them in the future. Money’s command over resources—its purchasing power—is the basis of its value and future economic benefits.

Assets other than cash provide benefits to a business enterprise by being exchanged for cash or other goods or services, by being used to produce or otherwise increase the value of other assets, or by being used to settle liabilities. Services provided by other entities including personal services, cannot be stored and are received and used simultaneously.

They can be assets of a business enterprise only momentarily—as the enterprise receives and uses them—although their use may create or add value to other assets of the enterprise. Rights to receive services of other entities for specified or determinable future periods can be assets of particular business enterprises.

(2) Control by a Particular Enterprise:

To have an asset, a business enterprise must control future economic benefit to the extent that it can benefit from the asset and generally can deny or regulate access to that benefit by others, for example, by permitting access only at a price.

Thus, an asset of a business enterprise is future economic benefit that the enterprise can control and thus, within limits set by the nature of the benefit or the enterprise’s right to it, use as it desires.

The enterprise having an asset is the one that can exchange it, use it to produce goods or services, use it to settle liabilities, or perhaps distribute it to owners. Ijiri placed considerable emphasis on control criteria in his definition of assets. That is, assets are resources under the control of the entity.

Although the ability of an enterprise to obtain the future economic benefit of an asset and to deny or control access to it by others rests generally on foundation of legal rights, legal enforceability of a right is not an indispensable prerequisite for an enterprise to have an asset if the enterprise otherwise will probably obtain the future economic benefit involved. For example, exclusive access to future economic benefit may be maintained by keeping secret a formula or process.

Some future economic benefits cannot meet the test of control. For example, public highways and stations and equipment of municipal fire and police departments may qualify as assets of governmental units but they cannot qualify as assets of individual business enterprises.

Similarly, general access to things such as clean air or water resulting from environmental laws or requirements cannot qualify as assets of individual business enterprises, even if the enterprises have incurred costs to help clean up the environment.

These examples should be distinguished from similar future economic benefits that an individual enterprise can control and thus are its assets. For example, an enterprise can control benefits from a private road on its own property, clean air it provides in a laboratory or water it provides in a storage tank, or a private fire department or private security force, and the related equipment probably qualifies as an asset even if it has no other use to the enterprise and cannot be sold except as scrap.

(3) Occurrence of a Past Transaction or Event:

Assets imply the future economic benefits of present assets only and not the future assets of an enterprise. Only present abilities to obtain future economic benefits are assets and these assets are the result of transactions or other events or circumstances affecting the enterprise.

For example, the future economic benefits of a particular building can be an asset of a particular entity only after a transaction or other event—such as a purchase or a lease agreement—has occurred that gives it access to and control of those benefits.

Similarly, although an oil deposit may have existed in a certain place for millions of years, it can be an asset of a particular enterprise only after the enterprise has discovered it in circumstances that permit the enterprise to exploit it or has acquired the rights to exploit it from whoever had them.

This characteristic of assets excludes from assets items that may in the future become an enterprise’s assets but have not yet become its assets. An enterprise has no asset for a particular future economic benefit if the transactions or events that give it access to and control of the benefit are yet in the future.

For example, an enterprise does not acquire an asset merely by budgeting the purchase of a machine, and does not lose an asset from fire until a fire destroys or damages some assets.

Once acquired, an asset continues as an asset of the enterprise until the enterprise collects it, transfers it to another entity, or uses it, or some other event or circumstance destroys the future benefit or removes the enterprises ability to obtain it.

In addition to the above, assets commonly have other features that help identify them—for example, assets may be acquired at a cost and they may be tangible, exchangeable or legally enforceable. However, those features are not essential characteristics of assets.

Their absence, by itself, is not sufficient to preclude an item’s qualifying as an asset. That is, assets may be acquired without cost, they may be intangible, and although not exchangeable they may be usable by the enterprise in producing or distributing other goods or services.

Objectives of Asset Valuation:

Financial accounting requires quantification of assets in terms of monetary units which is known as valuation. In other accounting such as managerial accounting, other measures, e.g., physical units may be useful for the managerial purposes. The questions of asset valuation, it is argued, should be decided in terms of user of the information, and the purpose for which the information is to be used.

In financial accounting the following are the objectives of asset valuation:

(1) Income Determination:

In accounting, valuation is a prerequisite in the income measurement. In the capital maintenance concept, valuation of assets is needed to compute income from the increase in these valuations over time. In behavioural accounting theory, valuations should help the decision-makers in making proper predictions and decisions.

Two basic approaches to valuation for income determination purposes are:

(a) The emphasis may be placed on the valuation of the inputs as they expire. For example, the cost of goods sold may be valued on a current basis, by the use of LIFO or current replacement costs, while the ending inventories are left in terms of residuals.

(b) The non-monetary assets may be restated at the balance sheet date or periodically during the year, permitting assumed matching as these assets expire.

(2) Determination of Financial Position:

A basic purpose of financial accounting is to determine the financial position of a business enterprise, and balance sheet determines the financial position. Balance sheet uses valuations for meaningful preparation of statement of financial position.

Investors are generally interested in predicting the future cash-flows to shareholders in the form of dividends and other distributions, in order to make proper decisions about purchase and sale of shares. Income statements, cash flow statements and funds flow statements are relevant for this purpose, and a position statement should also provide relevant information for the making of these predictions.

In order for a statement of financial position to provide information relevant to a prediction of future cash flows, it should include quantitative measurements of resources and commitments for comparisons with other periods or with other firms. Valuations of assets held by the firm can provide relevant information only if the investor can detect some relationship between such measurements and expected cash flows.

(3) Managerial Decisions:

Valuation figures are also useful to management in making operating decisions. However, the informational requirements of management are quite different from the informational requirements of the investors and creditors.

Investors and creditors are interested primarily in predicting the future course of the business from an evaluation of the past and from other information; but management must continually make decisions that determine the future course of action.

Therefore, management has greater need for information regarding valuations arising from different courses of action. For example, opportunity costs, marginal or differential costs, and present values from expected differential cash flows are relevant for many types of managerial decisions.

But just because they are relevant to managerial decisions does not necessarily mean that they are also relevant to the decision of investors and creditors. Therefore these valuations do not need to be reported in the position statement; they can be made readily available to management in supplementary reports.

Types of Assets:

Different assets possessed by a business enterprise appear on the balance sheet.

These assets are classified as follows:

(1) Fixed Assets:

Fixed assets are tangible assets and refer to a firm’s property, plant and equipment. Fixed assets are assets held with the intention of being used for the purpose of producing or providing goods or services and is not held for sale in the normal course of business.

(2) Investments:

Investments are created by a firm through purchase of shares and other securities. Investment by a firm can be made for long term or short term.

(3) Intangible Assets:

Intangible assets do not have physical substance but they are the resources that benefit an enterprise’s operations. Intangible assets provide exclusive rights or privileges to the owner. Examples are patents, copyrights, trademarks. Some intangible assets arise from the creation of a business enterprise—organisation costs or reflect a firm’s ability to generate above normal earnings—that is goodwill.

The term intangible assets is not used with cent per cent accuracy and precision in accounting. By convention, only some assets are considered as intangible assets. For example, some resources lack physical substance such as prepaid insurance, receivables, and investments, but are not classified as intangible assets.

Intangible assets are of different types such as goodwill, patents, copyrights, trademarks, franchises, deferred charges and the like.

(i) Goodwill:

Goodwill arises when a business enterprise buys another firm and pays-more than the fair market value of the firm’s net assets. The excess amount that the buyer pays, is known as goodwill and is recorded as an asset in the books of buying firm.

Goodwill represents the potential of a business to earn above a normal rate of return on the investments made. When compared to similar competing firms, if a particular firm consistently earns higher profits, then such a firm is said to possess goodwill.

A firm may be said to have goodwill due to many factors such as superior customer relations, advantageous location, efficient management, high quality of goods and services, exceptional personnel relations, favourable financial sources, superior technology.

Furthermore, goodwill cannot be separated from entity and sold separately. Goodwill is created internally at no identifiable cost and it can stem from any factor that can make return on investment high.

Because measuring goodwill is difficult, it is recorded as an intangible asset only when it is actually purchased at a measurable cost, i.e., only when another firm is purchased and the amount paid to acquire it exceeds the market value of identifiable net assets involved.

(ii) Patents:

A patent is an exclusive right and privilege, given by law, which provides the patent holder (owner) the right to use, manufacture and sell the subject of patent and the patent itself.

According to AS-10 (Accounting for Fixed Assets), patents are normally acquired in two ways:

(i) By purchase, in which case patents are valued at the purchase cost including incidental expenses, stamp duty, etc. and

(ii) By development within the enterprise, in which case all costs identified as incurred in developing patents are capitalized.

The patents as per the Standard 10 should be amortized over their legal term of validity or over their working life, whichever is shorter. Patent laws aim to protect the inventors by protecting them from unfair imitators who might (mis) use the invention for commercial gain.

A patent that is purchased is recorded at its cash equivalent cost. A patent which is developed internally by a business firm is recorded, at its registration and legal costs.

(iii) Copyrights:

A copyright is similar to a patent. A copyright gives the owner the exclusive right to publish, use and sell a specific written work, musical or art work. It protects the owner against the un-authorised reproduction of his literary or other work. Copyright is recorded at the purchase price, if purchased, or at registration and legal fees, if acquired internally.

(iv) Trademarks:

Trademarks and trade names give the owner—company the exclusive and continuing right to use certain teens, names or symbols, usually to identify a brand or family of products. Trademarks are recorded at purchase price, if purchased and at registration and legal costs, if not purchased but acquired internally within a firm.

(v) Franchises and Licences:

Franchises and licences give exclusive rights to operate or sell a specific brand of products in a given geographical area. They represent investments made to acquire them. If they are purchased, they are recorded at the cost paid for it. Alternatively, they are recorded at registration and legal costs.

(vi) Know-How:

Know-how-, according to the AS-10, should be recorded in the books only when some consideration in money or money’s worth has been paid for it.

Know-how can be of two types:

(i) Relating to manufacturing processes and

(ii) Relating to plans, designs and drawings of buildings or plant and machinery.

Know-how costs relating to manufacturing process are usually charges off to expenses in the year in which it is incurred. The know-how related to plans, designs and drawings of building or plant and machinery should be capitalized under the relevant assets heads. Where the know-how is so capitalized, depreciation should be calculated on the total cost of such assets including the cost of know-how.

If know-how is paid as a composite sum for manufacturing processes and other plans, designs and drawings, then the amount should be apportioned amongst the various purposes on a reasonable basis. Where the consideration for the know-how is a series of annual payments such as royalties, technical assistance fees, contribution to research etc., then such payments are charged to the profit and loss statement each year.

(vii) Deferred Charges:

Deferred charges are the expenses paid in advance and are like prepaid expenses. Deferred charges are long term prepaid expenses and benefit several future years. They are also known as organisation costs, i.e., costs incurred in organising a company and related pre-operating or start-up costs of preparing the company.

Some examples of deferred charges are:

(1) Legal fees.

(2) Fees paid to the government agencies.

(3) Preliminary expenses incurred in the formation of a company.

(4) Pre-operating expenses incurred from the commencement of business up to the commencement of commercial production.

(5) Advertisement and sales promotion expenditure incurred on the launch of a new product. These expenditures are likely to be quite large and the revenue earned from the new product in the initial years may not be adequate to write off such expenditure.

(6) Research and development costs.

It should be noted that during the pre-operating or start-up period, no revenue is earned and is therefore nothing against which to match these costs. Generally, deferred charges are capitalized and amortized over a (relatively short) period of time when the benefits are expected to be earned over a number of future periods. Some business firms show them as expenses in the period when they are incurred.

(4) Current Assets:

Current assets include cash and assets that will be converted into cash or used up during the normal operating cycle of the business or one year, whichever is longer.

Examples are debtors, closing stocks, marketable securities, besides the cash. The normal operating cycle of a business is the average period required for raw materials merchandise to be converted into finished product and sold and the resulting accounts receivables to be collected.

Prepaid expenses such as rent, insurance etc. are normally consumed during the operating cycle rather than converted into cash. These items are considered current assets, however because the prepayments make cash outflows for services unnecessary during the current period.

(i) Plant and Equipment:

Plant, equipment’s and other property cover a wide range of assets which are generally carried at cost, less depreciation. For plant and equipment, historical cost has generally been found to be a satisfactory basis, partly because there is no objective basis for any different value and partly because such assets are in reality deferred charges against future production and could not or normally would not, be sold separately.

Historical cost is defined as the aggregate price paid by the firm to acquire ownership and use of an assets including all payments necessary to obtain the asset in the location and condition required for it to provide services in the production or other operations of the firm.

The main disadvantage of historical cost is that it does not continue to reflect either the value of its future services or its current market price if economic conditions or prices change in subsequent periods. Even if prices remained constant, it is unlikely that the expectations regarding future services would remain constant.

Expectations may change because of greater certainty as the remaining life of the asset becomes shorter or because of changes in technology or in economic conditions.

Price changes affect the relevancy and comparability of historical costs applied to non- current assets to a greater extent than costs applied to current assets, because of the longer period from the date of acquisition to the average period of use. The longer this period is, the greater is the cumulative effect of price changes since the date of acquisition.

Frequently, current valuations have been suggested as a means of obtaining better measurement of capital resources than can be obtained by using historical costs, particularly when the difference between the two is caused by relatively permanent changes in the structure of prices or changes in the price level rather than by ephemeral changes caused by temporary shortages in supply.

Current values are generally suggested as a means of obtaining current measurements of depreciation. However, it should be noted that the allocation of current costs is just as arbitrary as the allocation of historical costs.

The current cost of plant and equipment means the current market price of a similarly used asset in the same condition and of the same age as the assets owned. It is, therefore, the price that would have to be paid for the assets if it were not already owned by the firm.

Alternative costs include:

(a) The acquisition costs of an identical new items purchased in current market adjusted for depreciation to date

(b) The current price or reproduction cost of new improved asset adjusted for technological differences and depreciation, and

(c) Historical cost restated by specific price level indexes.

(ii) Investments:

In financial accounting investments are defined as shares and other legal rights-acquired by a firm through the investment of its funds. Investments may be long-term or short-term, depending upon the intention of the firm at the time of acquisition.

Where investment are intended to he held for a period of more than one year, they are in the nature of fixed assets; where they are held for a shorter period they are in the nature of current assets. Shares in subsidiaries and associated companies are usually not held for resale and hence would be classified as being of the nature of fixed assets.

It is the practice, however, to show investments separately in the balance sheet and not to include them under the heading of ‘fixed assets.’ Investments are recorded at their cost of acquisition and whilst substantial decreases in value may be written off against current income, appreciations in value are not recognised until realised.