In its simplest form, your balance sheet can be divided into two categories: assets and liabilities. Assets are the items your company owns that can provide future economic benefit. Liabilities are what you owe other parties. In short, assets put money in your pocket, and liabilities take money out!
Assets vs. Liabilities
Assets add value to your company and increase your company's equity, while liabilities decrease your company's value and equity. The more your assets outweigh your liabilities, the stronger the financial health of your business. But if you find yourself with more liabilities than assets, you may be on the cusp of going out of business.
Examples of assets are -
- Cash
- Investments
- Inventory
- Office equipment
- Machinery
- Real estate
- Company-owned vehicles
Examples of liabilities are -
- Bank debt
- Mortgage debt
- Money owed to suppliers [accounts payable]
- Wages owed
- Taxes owed
What is Liquidity?
Assets are often grouped based on their liquidity or how quickly the asset can be turned into cash. The most liquid asset on your balance sheet is cash since it can be used immediately to pay a liability. The opposite is an illiquid asset like a factory, because the selling process [converting the property to cash] will likely be lengthy.
The most liquid assets are called current assets. These assets can be converted to cash in less than a year and include cash, marketable securities, inventory, and accounts receivable. These assets generate revenue for your company.
Non-liquid assets are grouped together into the category of fixed assets. These include real estate, vehicles, and machinery. Fixed assets are owned by your company and contribute to the income but are not consumed in the income generating process and are not held for cash conversion purposes. Fixed assets are tangible items usually requiring significant cash outlay and lasting for an extended period of time.
Current vs. Long-Term Liabilities
Liabilities are also grouped into two categories: current liabilities and long-term liabilities. Current liabilities are those that are due in the next year, while long-term liabilities will not be due until at least a year later.
Current liabilities typically represent money owed for operating expenses, such as accounts payable, wages, and taxes. In addition, payments on long-term debt owed in the next year will be listed in current liabilities. For example, if you have a 30-year mortgage on your building, the next year's worth of payments owed will be listed in the current liabilities section while the remaining balance will be shown as a long-term liability.
As a small business owner, one of your most important goals will be to balance your books. That means you need a solid understanding of assets and liabilities in order to make good decisions and evaluate the health of your business. Once the terms are defined, understanding assets and liabilities is fairly easy, and the financial reports you've been generating will start to have more meaning!
Still have questions about assets and liabilities? Contact the team at Digit! We're happy to help!
Amendments could have a significant impact on classification of liabilities
Amendments could have a significant impact on classification of liabilities
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11 January 2021 [* updated on 29 November 2021]Highlights
Changes to how companies classify liabilities could affect loan covenants.
*Note: The International Accounting Standards Board [the Board] has subsequently proposed amending IAS 1 Presentation of Financial Statements to clarify how companies would classify debt with covenants. These proposals would change the requirements introduced in its amendments published in January 2020 and also defer the effective date of the 2020 amendments for at least one year. In view of the proposals, companies should carefully consider if early adoption of the 2020 amendments is appropriate.
To promote consistency in application and clarify the requirements on determining if a liability is current or non-current, the International Accounting Standards Board [the Board] has amended IAS 11.
Companies should revisit their loan agreements to determine whether the classification of their loan liabilities will change – for example, convertible debt may need to be reclassified as ‘current’. Any changes could have a knock-on effect on covenant compliance. With potentially significant impacts ahead, companies are encouraged to take action now.
Right to defer settlement must have substance
Under existing IAS 1 requirements, companies classify a liability as current when they do not have an unconditional right to defer settlement of the liability for at least twelve months after the end of the reporting period. As part of its amendments, the Board has removed the requirement for a right to be unconditional and instead, now requires that a right to defer settlement must have substance and exist at the end of the reporting period.
There is limited guidance on how to determine whether a right has substance and the assessment may require management to exercise interpretive judgement.
The existing requirement to ignore management’s intentions or expectations for settling a liability when determining its classification is unchanged.
Classification of debt may change
A company classifies a liability as non-current if it has a right to defer settlement for at least twelve months after the reporting period.
The Board has now clarified that a right to defer exists only if the company complies with conditions specified in the loan agreement at the end of the reporting period, even if the lender does not test compliance until a later date.
This new requirement may change how companies classify their debt. How the new requirements [in particular IAS 1.72A] will apply to financial liabilities is unclear. It may change current practice and result in more debt being classified as current.
In its recent tentative agenda decision2 , the IFRS Interpretations Committee clarifies how the amendments apply to term loans with covenants related to financial position and uses term loan examples to illustrate how a company would apply the amendments.
Convertible debt may become current
The amendments state that settlement of a liability includes transferring a company’s own equity instruments to the counterparty.
In light of this, the amendments clarify how a company classifies a liability that includes a counterparty conversion option, which could be recognised as either equity or a liability separately from the liability component under IAS 323. Generally, if a liability has any conversion options that involve a transfer of the company’s own equity instruments,
these would affect its classification as current or non-current. The Board has now clarified that – when classifying liabilities as current or non-current – a company can ignore only those conversion options that are recognised as equity.
Therefore, companies may need to reassess the classification of liabilities that can be settled by the transfer of the company’s own equity instruments – e.g. convertible debt.
Click to enlarge graphic [JPG 135 KB]
Practice may change – e.g. convertible debt may become current – because companies may have interpreted the current requirements differently, see the example [JPG 210 KB].
Effective date
The amendments apply retrospectively for annual reporting periods beginning on or after 1 January 2023. Earlier application is permitted.
Although the amendments are not effective until 2023, companies will need to consider including
IAS 84 disclosures in their next annual financial statements.
Visit our IFRS Standards – Better communication in financial reporting page for more information on KPMG’s insights into making financial information more useful.
1 IAS 1 Presentation of Financial Statements
2 Classification of Debt with Covenants as Current or Non-current [IAS 1]
3 IAS 32 Financial Instruments: Presentation
4 IAS 8Accounting Policies, Changes in Accounting Estimates and Errors, paragraphs 30-31
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