Does Buying an Asset Increase Liability?
One of the first steps in the financial planning process is to record your household's current balance sheet. By understanding how the balance sheet works, you can record the financial impact of a transaction. Buying a new asset can either increase your total liabilities or decrease your total assets, depending on how you finance the transaction.
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Balance Sheet
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Your balance sheet gives a snapshot of your current financial position. The balance sheet lists your current assets, your current liabilities and your current net worth. Your assets are everything you own, such as your home, car, bank accounts and investments. Your liabilities are everything you owe, including your total mortgage, car loans, student loans and credit card debt. Your net worth is your total remaining value if you paid off all your debts in full.
Balance Sheet Equation
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The balance sheet equation records the connection between your total assets, liabilities and net worth. The equation states that your assets must equal the sum of your liabilities and your net worth. If your total assets increase, there must be a corresponding increase in your liabilities and net worth. By using this equation, you can record how a transaction impacts your household. Update your balance sheet with the impact of all transactions.
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Liability Increase
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There are two ways to finance a new purchase. The first way is to finance the purchase through debt. If you completely pay for a new asset with debt, your total liabilities increase by the full value of the new asset. This occurs when you buy a home with a full mortgage, or a car with a car loan and no down payment. Increasing your liabilities by the value of the new asset is one way to fulfill the balance sheet equation.
Asset Decrease
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The other way to purchase a new asset is to pay for it out of your own resources. When you fully finance an asset purchase with your own funds, your total assets remain the same but you replace one type of asset with the new asset. An example of this transaction is buying a car with cash. Your cash assets decrease, but your total assets are increased by the value of the car. Note that your purchase may be financed by a combination of assets and liabilities. In this case, the combination of the increase in liabilities and decrease in assets must equal the value of the new asset.
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References
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