Mar
5
Asset
Filed Under Loan Definition | Leave a Comment
This article is about the business definition. For other uses, see Asset (disambiguation).
In business and accounting, an Asset is defined as a probable future economic benefit obtained or controlled by a particular entity as a result of a past transaction or event.
Asset characteristics
Assets have three essential characteristics:
The probable future benefit involves a capacity, singly or in combination with other Assets, in the case of profit oriented enterprises, to contribute directly or indirectly to future net cash flows, and, in the case of not-for-profit organizations, to provide services;
The entity can control access to the benefit; and,
The transaction or event giving rise to the entity’s right to, or control of, the benefit has already occurred.
It is not necessary, in the financial accounting sense of the term, for control of Assets to the benefit to be legally enforceable for a resource to be an Asset, provided the entity can control its use by other means.
It is important to understand that in an accounting sense an Asset is not the same as ownership. In accounting, ownership is described by the term “equity,” (see the related term shareholders’ equity). Assets are equal to “equity” plus “liabilities.”
The accounting equation relates Assets, liabilities, and owner’s equity:
Assets = Liabilities + Owners’ Equity,
The accounting equation is the mathematical structure of the balance sheet.
Assets are usually listed on the balance sheet. It has a normal balance, or usual balance, of debit (i.e., Asset account amounts appear on the left side of a ledger).
Similarly, in economics an Asset is any form in which wealth can be held.
Probably the most accepted accounting definition of Asset is the one used by the International Accounting Standards Board. The following is a quotation from the IFRS Framework: “An Asset is a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise.”
Assets are formally controlled and managed within larger organizations via the use of Asset tracking tools. These monitor the purchasing, upgrading, servicing, licensing, disposal etc., of both physical and non-physical Assets.
Classification of Assets
Assets may be classified in many ways. In a company’s balance sheet certain divisions are required by generally accepted accounting principles (GAAP), which vary from country to country.
Current Assets
Main article: Current Asset
Current Assets are cash and other Assets expected to be converted to cash, sold, or consumed either in a year or in the operating cycle. These Assets are continually turned over in the course of a business during normal business activity. There are 5 major items included into current Assets:
Cash and cash equivalents — it is the most liquid Asset, which includes currency, deposit accounts, and negotiable instruments (e.g., money orders, cheque, bank drafts).
Short-term investments — include securities bought and held for sale in the near future to generate income on short-term price differences (trading securities).
Receivables — usually reported as net of allowance for uncollectible accounts.
Inventory — trading these Assets is a normal business of a company. The inventory value reported on the balance sheet is usually the historical cost or fair market value, whichever is lower. This is known as the “lower of cost or market” rule.
Prepaid expenses — these are expenses paid in cash and recorded as Assets before they are used or consumed (a common example is insurance). See also adjusting entries.
The phrase net current Assets (also called working capital) is often used and refers to the total of current Assets less the total of current liabilities.
Long-term investments
Often referred to simply as “investments”. Long-term investments are to be held for many years and are not intended to be disposed in the near future. This group usually consists of four types of investments:
Investments in securities, such as bonds, common stock, or long-term notes.
Investments in fixed Assets not used in operations (e.g., land held for sale).
Investments in special funds (e.g., sinking funds or pension funds).
Investments in subsidiaries or affiliated companies.
Different forms of insurance may also be treated as long term investments.
Fixed Assets
Main article: Fixed Asset
Also referred to as PPE (property, plant, and equipment), or tangible Assets, these are purchased for continued and long-term use in earning profit in a business. This group includes land, buildings, machinery, furniture, tools, and certain wasting resources e.g., timberland and minerals. They are written off against profits over their anticipated life by charging depreciation expenses (with exception of land). Accumulated depreciation is shown in the face of the balance sheet or in the notes.
These are also called capital Assets in management accounting.
Intangible Assets
Main article: Intangible Asset
Intangible Assets lack physical substance and usually are very hard to evaluate. They include patents, copyrights, franchises, goodwill, trademarks, trade names, etc. These Assets are (according to US GAAP) amortized to expense over 5 to 40 years with the exception of goodwill.
Some Assets such as websites are treated differently in different countries and may fall under either tangible or intangible Assets.
Other Assets
This section includes a high variety of Assets, most commonly:
Long-term prepaid expenses
Long-term receivables
Intangible Assets (if they represent just a very small fraction of total Assets)
Property held for sales
In a lot of cases this section is too general and broad, because Assets could be classified into four above categories.
Mar
4
Debt
Filed Under Loan Definition | Leave a Comment
Debt is that which is owed; usually referencing assets owed, but the term can cover other
obligations. In the case of assets, Debt is a means of using future purchasing power in the present
before a summation has been earned. Some companies and corporations use Debt as a part of their
overall corporate finance strategy.
A Debt is created when a creditor agrees to lend a sum of assets to a debtor. In modern society,
Debt is usually granted with expected repayment; in many cases, plus interest. Historically, Debt
was responsible for the creation of indentured servants.
Payment
Before a Debt can be made, both the debtor and the creditor must agree on the manner in which the
Debt will be repaid, known as the standard of deferred payment. This payment is usually denominated
as a sum of money in units of currency, but can sometimes be denominated in terms of goods. Payment
can be made in increments over a period of time, or all at once at the end of the loan agreement.
Types of Debt
There are numerous types of Debt, including basic loans, syndicated loans, bonds, and promissory
notes. Debt, especially large sums of Debt, can also be secured through a mortgage or other security
interest over some of the debtor’s property, in which case the creditor will have some rights over
that property in the event that the debtor becomes unable to repay the Debt and defaults on the
loan. And it may not work out as it seems
A basic loan is the simplest form of Debt. It consists of an agreement to lend a principal sum for a
fixed period of time, to be repaid by a certain date. In commercial loans interest, calculated as a
percentage of the principal sum per annum, will also have to be paid by that date.
In some loans, the amount actually loaned to the debtor is less than the principal sum to be repaid;
the additional principal has the same economic effect as a higher interest rate (see point
(mortgage)).
A syndicated loan is a loan that is granted to companies that wish to borrow more money than any
single lender is prepared to risk in a single loan, usually many millions of dollars. In such a
case, a syndicate of banks can each agree to put forward a portion of the principal sum.
A bond is a Debt security issued by certain institutions such as companies and governments. A bond
entitles the holder to repayment of the principal sum, plus interest. Bonds are issued to investors
in a marketplace when an institution wishes to borrow money. Bonds have a fixed lifetime, usually a
number of years; with long-term bonds, lasting over 30 years, being less common. At the end of the
bond’s life the money should be repaid in full. Interest may be added to the end payment, or can be
paid in regular installments (known as coupons) during the life of the bond. Bonds may be traded in
the bond markets, and are widely used as relatively safe investments in comparison to equity.
Accounting Debt
In national accounting, debts are added according to those who are indebted. Household Debt is the
Debt held by households. “National” or Public Debt is the Debt held by the various governmental
institutions (federal government, states, cities …). Business Debt is the Debt held by businesses.
Financial Debt is the Debt held by the financial sector (from one financial institution to another).
Total Debt is the sum of all those debts, excluding financial Debt to prevent double accounting.
These various types of Debt can be computed in Debt/GDP ratios. Those ratios help to assess the
speed of variations in the indebtness and the size of the Debt due. For example the USA have a high
consumer Debt and a low public Debt, while in eastern European countries, for example, the opposite
tends to be true.
There are differences in the accounting of Debt for private and public agents. If a private agent
promises to pay something later, it has a Debt, and this Debt is enforceable by public agents. If a
public body passes a law stating that it’ll pay something later (a kind of promise), it keeps the
right to change the law later (and not to pay). This is why, for instance, the money governments
promised to pay for retirements does not show up in the public Debt assessment, whereas the money
private companies promised to pay for retirements do.
Securitization
Main article: Securitization
Securitization occurs when a company groups together assets or receivables and sells them in units
to the market through a trust. Any asset with a cash flow can be securitized. The cash flows from
these receivables are used to pay the holders of these units. Companies often do this in order to
remove these assets from their balance sheets and monetize an asset. Although these assets are
“removed” from the balance sheet and are supposed to be the responsibility of the trust, that does
not end the company’s involvement. Often the company maintains a special interest in the trust which
is called an “interest only strip” or “first loss piece”. Any payments from the trust must be made
to regular investors in precedence to this interest. This protects investors from a degree of risk,
making the securitization more attractive. The aforementioned brings into question whether the
assets are truly off balance sheet given the company’s exposure to losses on this interest.
Debt, inflation and the exchange rate
As noted above, Debt is normally denominated in a particular monetary currency, and so changes in
the valuation of that currency can change the effective size of the Debt. This can happen due to
inflation or deflation, so it can happen even though the borrower and the lender are using the same
currency. Thus it is important to agree on standards of deferred payment in advance, so that a
degree of fluctuation will also be agreed as acceptable. It is for instance common to agree to “US
dollar denominated” Debt.
The form of Debt involved in banking accounts for a large proportion of the money in most
industrialized nations (see money and credit money for a discussion of this). There is therefore a
complex relationship between inflation, deflation, the money supply, and Debt. The store of value
represented by the entire economy of the industrialized nation itself, and the state’s ability to
levy tax on it, acts to the foreign holder of Debt as a guarantee of repayment, since industrial
goods are in high demand in many places worldwide.
Inflation indexed Debt
Borrowing and repayment arrangements linked to inflation-indexed units of account are possible and
are used in some countries. For example, the US government issues two types of inflation-indexed
bonds, Treasury Inflation-Protected Securities (TIPS) and I-bonds. These are one of the safest forms
of investment available, since the only major source of risk — that of inflation — is eliminated. A
number of other governments issue similar bonds, and some did so for many years before the US
government.
In countries with consistently high inflation, ordinary borrowings at banks may also be inflation
indexed.
Debt ratings, risk and cancellation
Risk free interest rate
Lendings to stable financial entities such as large companies or governments are often termed “risk
free” or “low risk” and made at a so-called “risk-free interest rate”. This is because the Debt and
interest are highly unlikely to be defaulted. A good example of such risk-free interest is a US
Treasury security – it yields the minimum return available in economics, but investors have the
comfort of the (almost) certain expectation that the US Treasury will not default on its Debt
instruments. A risk-free rate is also commonly used in setting floating interest rates, which are
usually calculated as the risk-free interest rate plus a bonus to the creditor based on the
creditworthiness of the debtor (in other words, the risk of him defaulting and the creditor losing
the Debt). In reality, no lending is truly risk free, but borrowers at the “risk free” rate are
considered the least likely to default.
However, if the real value of a currency changes during the term of the Debt, the purchasing power
of the money repaid may vary considerably from that which was expected at the commencement of the
loan. So from a practical investment point of view, there is still considerable risk attached to
“risk free” or “low risk” lendings. The real value of the money may have changed due to inflation,
or, in the case of a foreign investment, due to exchange rate fluctuations.
The Bank for International Settlements is an organization of central banks that sets rules to define
how much capital banks have to hold against the loans they give out.
Ratings and creditworthiness
Specific bond debts owed by both governments and private corporations is rated by rating agencies,
such as Moody’s, A. M. Best and Standard & Poor’s. The government or company itself will also be
given its own separate rating. These agencies assess the ability of the debtor to honor his
obligations and accordingly give him a credit rating. Moody’s uses the letters Aaa Aa A Baa Ba B Caa
Ca C, where ratings Aa-Caa are qualified by numbers 1-3. Munich Re, for example, currently is rated
Aa3 (as of 2004). S&P and other rating agencies have slightly different systems using capital
letters and +/- qualifiers.
A change in ratings can strongly affect a company, since its cost of refinancing depends on its
creditworthiness. Bonds below Baa/BBB (Moody’s/S&P) are considered junk- or high risk bonds. Their
high risk of default (approximately 1.6% for Ba) is compensated by higher interest payments. Bad
Debt is a loan that can not (partially or fully) be repaid by the debtor. The debtor is said to
default on his Debt. These types of Debt are frequently repackaged and sold below face value. Buying
junk bonds is seen as a risky but potentially profitable form of investment.
Cancellation
Short of bankruptcy, it is rare that debts are wholly or partially forgiven. Traditions in some
cultures demand that this be done on a regular (often annual) basis, in order to prevent systemic
inequities between groups in society, or anyone becoming a specialist in holding Debt and coercing
repayment. Under English law, when the creditor is deceived into forgoing payment, this is a crime:
see Theft Act 1978.
International Third World Debt has reached the scale that many economists are convinced that Debt
cancellation is the only way to restore global equity in relations with the developing nations.
Effects of Debt
Debt allows people and organizations to do things that they would otherwise not be able, or allowed,
to do. Commonly, people in industrialized nations use it to purchase houses, cars and many other
things too expensive to buy with cash on hand. Companies also use Debt in many ways to leverage the
investment made in their assets, “levering” the return on their equity. This leverage, the
proportion of Debt to equity, is considered important in determining the riskiness of an investment;
the more Debt per equity, the riskier. For both companies and individuals, this increased risk can
lead to poor results, as the cost of servicing the Debt can grow beyond the ability to pay due to
either external events (income loss) or internal difficulties (poor management of resources).
Excesses in Debt accumulation have been blamed for exacerbating economic problems. For example,
prior to the beginning of the Great Depression Debt/GDP ratio was very high. Economic agents were
heavily indebted. This excess of Debt, equivalent to excessive expectations on future returns,
accompanied asset bubbles on the stock markets. When expectations corrected, deflation and a credit
crunch followed. Deflation effectively made Debt more expensive and, as Fisher explained, this
reinforced deflation again, because, in order to reduce their Debt level, economic agents reduced
their consumption and investment. The reduction in demand reduced business activity and caused
further unemployment. In a more direct sense, more bankruptcies also occurred due both to increased
Debt cost caused by deflation and the reduced demand.
It is possible for some organizations to enter into alternative types of borrowing and repayment
arrangements which will not result in bankruptcy. For example, companies can sometimes convert Debt
that they owe into equity in themselves. In this case, the creditor hopes to regain something
equivalent to the Debt and interest in the form of dividends and capital gains of the borrower. The
“repayments” are therefore proportional to what the borrower earns and so can not in themselves
cause bankruptcy. Once Debt is converted in this way, it is no longer known as Debt.
Arguments against Debt
Some argue against Debt as an instrument and institution, on a personal, family, social, corporate
and governmental level. Islam forbids lending with interest even today, while the Catholic church
allowed it from 1822 onwards, and the Torah states that all debts should be erased every 7 years and
every 50 years.
Debt will increase through time if it is not repaid faster than it grows through interest. This
effect may be termed usury, while the term “usury” in other contexts refers only to an excessive
rate of interest, in excess of a reasonable profit for the risk accepted.
In international legal thought, Odious Debt is Debt that is incurred by a regime for purposes that
do not serve the interest of the state. Such debts are thus considered by this doctrine to be
personal debts of the regime that incurred them and not debts of the state.
Levels and flows
Main article: Debt levels and flows
Global Debt underwriting grew 4.3% year-over-year to $5.19 trillion during 2004. It is expected to
rise in the coming years as the spending habits of millions of people worldwide continue the way
they do.
Mar
4
Loan
Filed Under Loan Definition | Leave a Comment
A loan is a type of Debt. All material things can be lent; this article, however, focuses exclusively on monetary loans. Like all Debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower.
The borrower initially receives an amount of money from the lender, which they pay back, usually but not always in regular installments, to the lender. This service is generally provided at a cost, referred to as interest on the Debt. A borrower may be subject to certain restrictions known as loan covenants under the terms of the loan.
Acting as a provider of loans is one of the principal tasks for financial institutions. For other institutions, issuing of Debt contracts such as bonds is a typical source of funding. Bank loans and credit are one way to increase the money supply.
Legally, a loan is a contractual promise of a debtor to repay a sum of money in exchange for the promise of a creditor to give another sum of money.
Types of loans
Secured
A secured loan is a loan in which the borrower pledges some asset (e.g. a car or property) as collateral for the loan.
A mortgage loan is a very common type of Debt instrument, used by many individuals to purchase housing. In this arrangement, the money is used to purchase the property. The financial institution, however, is given security – a lien on the title to the house – until the mortgage is paid off in full. If the borrower defaults on the loan, the bank would have the legal right to repossess the house and sell it, to recover sums owing to it.
In some instances, a loan taken out to purchase a new or used car may be secured by the car, in much the same way as a mortgage is secured by housing. The duration of the loan period is considerably shorter – often corresponding to the useful life of the car. There are two types of auto loans, direct and indirect. A direct auto loan is where a bank gives the loan directly to a consumer. An indirect auto loan is where a car dealership acts as an intermediary between the bank or financial institution and the consumer.
A type of loan especially used in limited partnership agreements is the recourse note.
A stock hedge loan is a special type of securities lending whereby the stock of a borrower is hedged by the lender against loss, using options or other hedging strategies to reduce lender risk.
Unsecured
Unsecured loans are monetary loans that are not secured against the borrowers assets. These may be available from financial institutions under many different guises or marketing packages:
credit card Debt,
personal loans,
bank overdrafts
credit facilities or lines of credit
corporate bonds
The interest rates applicable to these different forms may vary depending on the lender, the borrower. These may or may not be regulated by law. In the United Kingdom, when applied to individuals, these may come under the Consumer Credit Act 1974.
Abuses in lending
Predatory lending is one form of abuse in the granting of loans. It usually involves granting a loan in order to put the borrower in a position that one can gain advantage over him or her. Where the moneylender is not authorized, it could be considered a loan shark.
Usury is a different form of abuse, where the lender charges excessive interest. In different time periods and cultures the acceptable interest rate has varied, from no interest at all to unlimited interest rates. Credit card companies in some countries have been accused by consumer organizations of lending at usurious interest rates and making money out of frivolous “extra charges”
Abuses can also take place in the form of the customer abusing the lender by not repaying the loan or with an intent to defraud the lender.
United States taxes
Most of the basic rules governing how loans are handled for tax purposes in the United States are uncodified by both Congress (the Internal Revenue Code) and the Treasury Department (Treasury Regulations – another set of rules that interpret the Internal Revenue Code). Yet such rules are universally accepted.
1. A loan is not gross income to the borrower. Since the borrower has the obligation to repay the loan, the borrower has no accession to wealth.
2. The lender may not deduct the amount of the loan. The rationale here is that one asset (the cash) has been converted into a different asset (a promise of repayment). Deductions are not typically available when an outlay serves to create a new or different asset.
3. The amount paid to satisfy the loan obligation is not deductible by the borrower.
4. Repayment of the loan is not gross income to the lender. In effect, the promise of repayment is converted back to cash, with no accession to wealth by the lender.
5. Interest paid to the lender is included in the lender’s gross income. Interest paid represents compensation for the use of the lender’s money or property and thus represents profit or an accession to wealth to the lender. Interest income can be attributed to lenders even if the lender doesn’t charge a minimum amount of interest.
6. Interest paid to the lender may be deductible by the borrower. In general, interest paid in connection with the borrower’s business activity is deductible, while interest paid on personal loans are not deductible. The major exception here is interest paid on a home mortgage.
Income from discharge of indebtedness
Although a loan does not start out as income to the borrower, it becomes income to the borrower if the borrower is discharged of indebtedness. Thus, if a Debt is discharged, then the borrower essentially has received income equal to the amount of the indebtedness. The Internal Revenue Code lists “Income from Discharge of Indebtedness” in Section 62(a)(12) as a source of gross income.
Example: X owes Y $50,000. If Y discharges the indebtedness, then X no longer owes Y $50,000. For purposes of calculating income, this should be treated the same way as if Y gave X $50,000.
For a more detailed description of the “discharge of indebtedness”, look at Section 108 (Cancellation of Debt (COD) Income) of the Internal Revenue Code.