I thought we’d revisit some important balance sheet terminology again. Understanding the accounting meaning of the words which define balance sheet elements is essential to more fully understanding what the balance sheet communicates about the company’s financial position.

Balance sheet elements include assets, liabilities, and equities. Today, I’ll write briefly about the nature of assets. Assets are formally defined by the Financial Accounting Standards Board (FASB) as “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events” (FASB Concept 6). Note that an asset is not simply “cash in hand” but includes any claim to likely future benefits that have economic substance.

For example,if a company sells its goods on account to another party today, it immediately records an accounts receivable asset for its claim to receive future payment from the customer even though there’s no guarantee the customer will pay. However, if a company sells to someone, it’s expected that collection will occur at that time; why would it sell to a party not expected to pay? I’m trying to key in on the FASB’s word “probable” in the asset definition. The future benefit doesn’t have to be legally certain in order to record the asset, but probable. This word “probable” is why when you read SEC financial filings (10Qs and 10Ks) you see companies carry a provision for uncollectible or doubtful accounts. Subsequent to making sales on accounts, it inevitably occurs that some customers don’t satisfy their payment responsibility. Thus, companies have to adjust the net realizable value of the asset “accounts receivable” downward because the gross receivable balance is no longer “probable.”

After teaching accounting to college students for almost three decades, in my view, the challenge of doing accounting (note I’m not speaking of using accounting information but rather learning how to account for businesses) is not crunching numbers but rather learning the language of accounting. That is, the challenge is not math but words. The numbers actually lack precision while the language is very precise. Consider that word probable. Clearly deciding what’s probable involves judgment and estimation; so the numerical values of assets listed on the balance sheet involve substantive judgment. That word probable that introduces judgment to the asset numbers also reflects great precision in the definition of “asset.”

From an investor’s perspective, I favor generally looking at balance sheet assets as items which represent a company’s ability to generate future revenues. However, understanding the accounting meaning of assets is important. For example, if a company in its corporate earnings filings reflects a significant and growing percentage of bad debt provision (provision for uncollectible or doubtful accounts receivable), it suggests concern over the company’s client base and thus its ability to generate future revenues.

I’ll see you next time.