Short-Term Assets are Those Assets that are cash or will be converted to cash or consumed within a period of one year or less. Examples of these Assets in the bicycle company are Cash, Accounts Receivable, bicycle Inventory, and Prepaid Insurance.
Long-Term Assets are Those items that will be consumed or converted to cash after a period of one year. Examples of these Assets in the bicycle company are the truck, the building, and the land.
Referring to the Balance Sheet in Figure 1 bellow , let’s examine the transactions that created it.
Sam Invests Money in the Company (Owner’s Investment)
First, let’s assume that on January 1, 2006, Sam invests $60,000 in her bicycle company. In other words, she takes $60,000 out of her personal bank account and sets up a new account with the bank for the new business. After this transaction, the company’s Balance Sheet looks like the one presented in Figure 2:
Sam Purchases Land, a Building, and a Truck (Long-Term Assets)
Next, on January 1, the bicycle company buys a piece of land with a building and a truck in order to operate her business. The land has a value of $10,000, the building’s value is $25,000, and the truck that will be used for pick-ups and deliveries is $8,000.
All of these values are the actual amounts that the company pays. Because the company does not have sufficient cash to pay for all of these Assets at the current time, it decides to borrow some money. It pays $23,000 in cash and takes out a mortgage on the land and building for $20,000 to purchase these Assets. This is a twenty-year loan. One thousand dollars of this loan is due and payable within one year. After these transactions, the company’s Balance Sheet looks like the one presented in Figure 3:
As you can see in Figure 3 the cash balance has decreased by $23,000 (the amount of cash contributed to the purchase of the land, building, and truck), the other Assets have increased to $43,000 (the truck, building, and land), and two new Liabilities have appeared (the current and long-term portions of the mortgage loan). The loan of $20,000 has been divided up between the short-term portion of $1,000 and the long-term portion (due in a period of greater than one year) of $19,000. Also, notice that the Owner’s Equity is not affected.
What are the factors that change Owner’s Equity? The items below give us a summary of the only items that have an impact on the beginning balance of Owner’s Equity.
- The owner invests more money in the business
- The business makes a profit or loss
- The owner takes Assets out of the business.
Thus, when Sam invested the $60,000 into the bicycle company, this increased her Owner’s Equity in the company by this same amount. When the company makes a profit, this is also an increase to her Owner’s Equity.
Finally, if Sam decides to take any money or other Assets out of the bicycle company for her own use, this will reduce the Owner’s Equity as it shows up on the bicycle company’s Balance Sheet.
Sam Purchases Insurance (Short-Term Asset)
On January 3, the company purchases a three-year insurance policy on the building. The cost of this insurance is $1,500. Because this purchase covers three years and at the time of purchase has not been used up at all, the expenditure represents an Asset. We call this Asset, “Prepaid Insurance.” The company pays for this insurance with cash. After this transaction, the Balance Sheet looks like it does in Figure 4:
In Figure 4 the only change in the Balance Sheet after the purchase of the insurance is that one Asset (cash) has been exchanged for another Asset (Prepaid Insurance, between Short- and Long-Term Assets) for the exact amount of $1,500.
Sam Orders and Buys Bicycles (Short-Term Assets)
On January 5, Sam orders and buys two different brands of bicycles from two different companies. She buys eighty of one kind that cost $100 apiece, and twenty-five of the other kind that cost her $200 apiece. The total cost of the 105 bicycles to the company is $13,000. This purchase represents a Short-Term Asset known as Inventory.
Inventory is a Short-Term Asset because the company anticipates selling these 105 bicycles in one year or less. As above, with the purchase of the Long-Term Assets, the company does not want to pay for all of these bicycles with cash. It pays $10,000 in cash and agrees to pay the additional $3,000 to the seller at a later date from the sale. This $3,000 becomes an Accounts Payable of the business, and is shown in the Short-Term Liabilities section.
As we saw in last course , there are several different types of payables. The term Accounts Payable is reserved for the purchase of Inventory items that are going to be resold by the company
QUICK Tip : Keeping an Eye on Inventory: Having too little or too much Inventory in a small business will create problems for the company. Drawing up a budget is a critical part of the accounting process that will aid in the planning and control of the company’s expenditures and help the business owner to maintain control of all aspects of the business.
After this transaction, the Balance Sheet looks like the one in Figure 5:
Once again, the Balance Sheet stays in balance. Assets ($83,000) = Liabilities ($23,000) + Owner’s Equity ($60,000). You’ll note that the Balance Sheet in Figure 3.8 dated January 5, 2006, is quite different from the one dated December 31, 2006 in Figure 1. This demonstrates how the Balance Sheet can change, representing the company’s Assets, Liabilities, and Owner’s Equity at any given point in time.
GLOSSARY :
Accounts Payable : A Short-Term Liability (debt) incurred from the purchase of Inventory.
Assets: Items of value that are owned by the company and are represented on the Balance Sheet. In order for an item to be shown on the Balance Sheet, it must meet three tests : 1) the company must control it or own it, 2) the item must have some value to the company, and 3) this value must be measurable. Assets are categorized as short-term or long-term items.
Balance Sheet : This financial statement is a listing of the Assets (items owned), Liabilities (items owed), and Owner’s Equity (what belongs to the owner(s)). The relationships between all these items are represented by the accounting equation.
Creditors: Those individuals or companies to which money or other Assets are owed; for example, the supplier from whom Sam purchased the bicycles and to whom she owes an additional $3,000 is a creditor of the company
Equity : See Owner’s Equity
Historical Cost: The amount paid for an item owned by the business (Assets), or the amount incurred in a debt on the date of the agreement to enter into the obligation (Liabilities). Even though over time the values of these Assets and/or Liabilities may change, they will always be shown on the Balance Sheet at their historical cost.
Intangible Assets: Those Assets that are of value to a business and meet all tests of being an Asset, but do not have tangible qualities; for example, trademarks and patents.
Inventory: An Asset held by a business for the purpose of resale. In the case of Solana Beach Bicycle Company, Inventory is the bicycles that the company intends to sell.
Liabilities: Debts owed by a business. They can either be short-term or long-term depending upon when they become due. Short-Term Liabilities are to be paid within a year. Examples in the bicycle company are the Accounts Payable, and the current portion of the Mortgage Payable. LongTerm Liabilities extend beyond one year. An example in the bicycle company is the portion of the mortgage which is due to be paid beyond the current year.
Owner’s Equity : The difference between what is owned and what is owed; in a company, this amount belongs to the owners. The Owner’s Equity is made up of the original and additional investments by the owner, plus any profit that is retained in the business, minus any cash or other Assets that are withdrawn or distributed to the owner(s)
Retained Earnings : The amount of profit earned by the business since its inception, minus any money that is taken out or distributed to the owner(s). At Solana Beach, this is whatever the company earns in selling bikes, minus whatever Expenses are incurred; for example, electricity, gas for the truck, mortgage payments, salaries, etc.