Assets and Liabilities

No doubt you have all filled out forms at some time or other (especially when asking for a loan), which require you to list your assets and liabilities.

The standard definition is something like this:

Asset: Something you can sell to raise money.

Liability: Something you owe.

This is very simple, easy to understand, and in my opinion misleading.

Using this definition, a car is an asset, so is a house. A loan is a liability.

I’d like to turn this on its head and present a more business-like definition (accountants and economists, stop reading now before you get annoyed.)

Asset: Something that returns you an income.

Liability: Something that costs money to keep and maintain.

This definition helps to put purchase decisions into perspective.

Here are 3 simple examples:

CAR.

Classic definition: Asset.
My definition: Liability.

Reason: A car costs an up-front amount to purchase, and then you never stop spending. You have to feed it on petrol, service it, get it repaired, and it declines in value over time. With very rare exceptions you can never sell a car for more than you paid for it.

A car does not only cost the up-front purchase price and the ongoing cost. It also has the opportunity cost (the price you pay because you could not use that money for something else).

It is easy to show (in a subsequent post) that the opportunity cost can far exceed your wildest expectations, and make the cost of owning a car something truly horrifying.

In our modern society you probably have no choice in owning a car. So, if it is a necessary evil and you understand the economics, you can make an informed choice.

Buy a car that is:
- sufficient but not luxurious;
- does not cost an arm and a leg to run;
- is going to last you a long time (and better, a long, long, long time).

HOUSE.

Classic definition: Asset.
My definition: Probably an Asset, could be a Liability.

Reason:

Like a car, a house costs an up-front amount to purchase. Unlike a car (which is frequently but not always necessary), everybody needs to live somewhere. Therefore a house is a necessity. However, you have a choice, you could pay “dead money” in rent, or you could buy.

In some cases, you are better off renting, in other cases you should buy.

If your house appreciates in value, you probably have an asset. In general, all houses appreciate given a sufficiently long period of time. However, houses need maintenance to stop them falling apart. They need repairs, painting, cleaning. These all cost. In that sense, they are a liability.

If you can use your house to generate additional income, its status as an asset improves.

For example, if you use equity in your house to buy other income producingassets, then your house is more clearly an asset. But if you use equity in your house to go on a fancy holiday (as many people in Australia are doing), your house is more likely to be a liability.

A house is not clear-cut. It very much depends on where it is, what it’s value will do, and how you handle any borrowings associated with it.

MARKETABLE INVESTMENT.

This category covers shares, bonds, investment property, etc.

Classic definition: Asset.
My definition: Usually an Asset, occasionally a Liability.

Reason:

Mostly these assets pay an income stream (dividends, rent, etc). This makes them an asset. Mostly they are set up with the objective of returning something to their owners.

A share that pays a dividend is an asset – until the company goes bust, then it’s worthless.

A share that pays no dividend is only an asset if the value (and over time, the market price) goes up and up. A company that pays no dividends, and does not grow its value over time is plainly a liability.

If you can sell shares for less than you paid, does that owning those shares a liability? (Probably).

The various financial instruments available are usually assets if they pay an income stream, but even then you need to look carefully. If they pay no income stream, look very very carefully.

If they pay an income stream that depletes your capital over time (due to value lost to inflation and taxes), you may actually have a liability.

Sometimes shares, bonds, or rental property can be liabilities. Look, think and question before accepting conventional wisdom.

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