So InKleined
by Linda B. Klein, M.Tax., J.D., R.F.P
(Send your questions on any aspect of financial planning c/o this
publication. Please include your name, address, and phone number.)
UNDERSTANDING SOME ACCOUNTING AND FINANCIAL FUNDAMENTAL
Whether as an investor, a lender, or a borrower, we bear a natural
inquisitiveness about the financial well being of various entities, including
ourselves. There are many different kinds of economic units, the simplest
being an unmarried wage-earner and perhaps the most complex being a
conglomerate corporation. Because all maintain definite similarities,
however, examining the terminology and the financial statements for the
simple version can facilitate a better understanding of the publicly-traded
elaborate giants.
An asset is anything of value, even if it cannot be seen, touched, or
even easily priced -- such as an idea, one's reputation, a professional
license, the skill of a major league pitcher. For financial accounting
purposes, however, an asset's value must be reasonably ascertainable.
Once the pitcher's salary has been negotiated, the value of his talents has
been quantified into dollars and can even be insured against loss. This
resource can now also be analyzed, and valued, as a fairly predictable
source of revenue -- earned income for the pitcher, and gate receipts for \
the team owners.
In a free-trading marketplace of willing buyers and willing sellers
(who ideally possess equal bargaining power and awareness of all the
significant facts and circumstances about the asset), the price arrived
upon through "arms' length" negotiation establishes the asset's "fair
market value." More commonly we use the term "price," such as for
securities traded regularly on an exchange. When this set of conditions is
not present, then the asset must be valuated by some other means, such
as by expert appraisal.
Now let's address the other side of the balance sheet. A balance
sheet is a formal statement of net worth as of a particular date. It sets forth
the relationship between an entity's assets and liabilities. A liability is
something that is owed, a debt. For most practical and immedi- ate
purposes, the amount in absolute dollars owed by the debtor is all that
needs to be taken into account. If you add up everything you own and then
subtract everything you owe (essentially, various creditors' claims on
those assets), then the difference is your net worth, also called your equity.
Most people readily associate the term "equity" to the amount of
proceeds they would receive from selling their house -- what it's worth
minus the mortgage balance. In this example, the mortgage is a special
liability linked (secured) to the specified asset, because the debt was
incurred to purchase it. Similarly, when you finance a car, the lender keeps
a security interest in the purchased vehicle to protect against loss on the
amount of the loan. If a loan agreement is breached, then the secured
creditor may recover its investment from that asset, and its right to do so,
its claim on that asset, is superior to all other creditors' claims. What other
creditors? The majority of bills we pay every day are to general creditors --
the doctor, credit card companies, utilities, etc. -- who rely on our overall
financial responsibility and general solvency to make timely and adequate
payments. Until their accounts are paid in full, any of these general
creditors can seek satisfaction against any or all of your assets.
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