|property||asset_liability||account,derivative,derivative cash flow,loan,security|
An account is either an asset, a liability, an equity or pnl (Profit & Loss) from the firm’s point of view.
An account is considered an asset if it is a present economic resource controlled by the entity as a result of past event. For example, a loan loan is an asset from the issuing entity’s point of view, as the issuing entity expects inflows of economic benefits as a result of issuing a loan, as the account holder pays interest and penalties (if applicable).
An account is considered a liability if it is a present obligation of the entity to transfer an economic resource as a result of past events. For example, a savings account is a liability from the issuing entity’s point of view, as the issuing entity expects the issuance of a savings account to lead to an outflow of future economic benefits from the entity, as the issuer pays interest on the funds in the account to the account holder.
An account is considered an equity if it represents a residual interest in the firm’s assets after all of its liabilities have been deducted. For example, a firm may allocate certain amounts of its profits to a reserve account for specific purposes (e.g. a revaluation reserve or a share plan reserve). This reserve account would be recognised as equity on the firm’s balance sheet. Equity is typically split in to two types of accounts, capital and reserves.
An account is considered [Profit and Loss (pnl)][pnl] if it represents income or expenses attributable to the firm over the period defined by the start and end dates.
Derivatives can be either a financial asset or a financial liability on a firm’s balance sheet.
A derivative is an asset on the firm’s balance sheet if it has a positive value with regard to the underlying variable (rate, price, or index).
A derivative is a liability on the firm’s balance sheet if it has a negative value with regard to the underlying variable (rate, price, or index).
A derivative cash flow is where two parties exchange cash flows (or assets) derived from an underlying reference index, security or financial instrument. This will represent either an asset or a liability on the firm’s balance sheet.
Another term for this exchange is a ‘swap’. (Swaps are contracts to exchange cash flows as of a specified date or a series of specified dates based on a notional amount and two different underlying financial instruments. Many times a swap will occur because one party has a comparative advantage in one area such as borrowing funds under variable interest rates, while another party can borrow more freely as the fixed rate.)
A derivative cash flow exchange (swap) that results in a net positive value after the transaction with regard to the underlying reference index, security or financial instrument is an asset on the firm’s balance sheet.
A derivative cash flow exchange (swap) that results in a net negative value after the transaction with regard to the underlying reference index, security or financial instrument is a liability on the firm’s balance sheet.
A loan is either an asset or a liability for a firm that offers a loan.
A loan is an asset on a firm’s balance sheet when future economic benefits are expected to flow to the firm as a result of issuing the loan. For example, a mortgage offered by a bank is an asset on the bank’s balance sheet as repayments are expected in the future.
A loan is a liability on a firm’s balance sheet if future economic benefits are expected to flow out of the firm. For example, if a bank has a mortgage loan on its balance sheet, and repayments are made which are greater than the required repayments, then the bank expects to return the overpayments to the borrower leading to an outflow of future economic benefits.
A security is valued using either...
amortised cost: amortised cost is calculated using the effective interest method. The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument to the net carrying amount of the financial asset or liability. Financial assets that are not carried at fair value though profit and loss are subject to an impairment test. If expected life cannot be determined reliably, then the contractual life is used;
fair value: the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.
If the valuation leads to expected outflows of economic benefits, then the security is a liability on the firm’s balance sheet. For example if an equity security was purchased by a firm expecting to receieve future inflows of economic benefits through dividend payments, but a market downturn caused a negative fluctuation in dividend payments, the security may have cost more than its expected future value in terms of economic benefit flows and becomes a liability on the firm’s balance sheet.
If the valuation leads to expected inflows of economic benefits, then the security is an asset on the firm’s balance sheet. For example, if an asset backed security (e.g. collateralised mortgage obligation) was purchased by a firm expecting to receieve future inflows of economic benefits through repayments of those mortgages, and the security was purchased at a value lower than the expected income from those mortgage repayments over the lifetime of the security, then the security will have a net positive fair value and be an asset on the firm’s balance sheet.
If the security comes from own funds, it will then be classified as equity
pnl is used to identify non-balance sheet information relevant for the firm’s Profit & Loss financial statements