Understanding the difference between assets and liabilities
Managing Your Money: Financial Statements Made Simple
In the world of financial education, there are fundamental principles that are impossible to omit when we’re talking about money and investing. It begins with the financial statement: the income statement, the balance sheet, and the statement of cash flow.
You’ll notice that the financial statement shown here is not your traditional accounting financial statement. That is because we like to keep things simple.
The Income Statement
The Income Statement is made up of:
Income (money flowing in), and
Expenses (money flowing out).
All income that flows into your household flows through the income column of your income statement. This includes all three types of income:
1. Ordinary earned
This is income that you work for and includes your wages, tips, salaries, and commission from your job or business.
Portfolio income includes profits from any investment sales. These capital gains can come from the sale of stocks, businesses, and real estate.
This is income from rental properties, limited partnerships in which you invest money but are not actively involved, and other similar enterprises. Passive income can also come from interest on savings accounts, bonds, certificates of deposit (CDs), stock dividends, patent royalties from inventions, and royalties from books, songs, and other original works.
It’s important to note that each of these types of income is taxed at a different rate. Ordinary income is taxed at the highest level. The government takes the biggest chunk from the money you work so hard for in your job or business. Portfolio income is taxed at a lesser rate. Passive income is taxed at the lowest rate. When you invest for passive income, your money is working for you, plus you get to keep more of that money since it will be taxed at a lower rate.
These are the monthly expenses you pay out each month, including such things as your mortgage payment (or rent payment), car payment, student loans, food, car and gas, utilities, insurance, clothes, eating out, medical bills, and so forth.
The Balance Sheet
The Balance Sheet is made up of:
Assets (things that put money in your pocket), and
Liabilities (things that take money out of your pocket).
My definition of an asset is not the definition you’ll hear from your traditional accountant. The conventional accountant will tell you that an asset is “something of monetary value that is owned by an individual or company.” By that definition, your alarm clock and your everyday dishes could be considered assets!
Most accountants go crazy with this definition because they want to classify your shares of stock, your jewelry, your personal residence, your cars, and your mutual funds as assets. To me, none of these things have any value until the day you sell them.
Using my definition: An asset is something that puts money in your pocket, whether you work or not.
Why use such a definition? Because a clock and some plates and bowls will not get you closer to your financial dream, but something that is putting money in your pocket whether you work or not will.
Again, I go to battle with the traditional definition of a liability. Most accounting professionals will tell you that a liability is “an obligation to pay an amount you owe to creditors, be it an individual or an organization.”
My definition begs to differ: A liability is something that takes money out of your pocket.
You can see the dilemma. Most would list their Mercedes as an asset or something of value. However, I would list the Mercedes as a liability because every month it takes money out of your pocket. “But it’s paid for!” you argue. The car loan may be paid for, but what about gasoline, tune-ups and repairs, and insurance?
The biggest fight we get at The Rich Dad Company is when we tell people your home, your personal residence, is not an asset. We received a lot of flack for that, especially when times were booming and people were taking out loans against their home, sometimes two or three times. It wasn’t until the real estate market crashed and people found out that they owed more on their house than it was worth before they started to understand their home was not an asset.
Why understanding financial statements is important
The problem with people calling their liabilities assets is that they believe they are financially better off than they really are. When the economy turned, many people were forced to face reality. They are now realizing what they have and how long they actually can survive financially.
This is why the concept of “net worth” means very little in the real world. When accountants calculate your net worth, they list everything but the kitchen sink. In most cases, to have the dollar amount your accountant attaches to your net worth, you would have to sell just about everything you own—at whatever the market will bear at the time.
This does not mean you shouldn’t buy a house or a BMW or a new Cartier watch. It just means you shouldn’t fool yourself into thinking that your liabilities, items that take money out of your pocket, are assets.
Once you understand the difference between assets and liabilities, and how to classify them on your financial statement, it becomes very easy to see where you actually are financially…and how to build a road map for your financial heaven.