At the heart of finance is a reckoning of assets and liabilities. Both take their place on the left and right of a balance sheet, and the total value of the assets minus the cost of the liabilities is then determined to be the net value of the portfolio—which can be the value of a fund, a company, or an individual.
Determining which is which is really quite easy. An asset is a resource with an economic value: it is something that can be turned into another kind of asset through a sale or exchange with another economic agent. It is something fungible and useful: something that can go from one entity to another and provide value in the transfer.
In accounting, there are several different types of assets: current assets are things that can be converted into cash very quickly: things like Treasuries, money market funds, and balances in savings accounts are types of current assets. Fixed assets are things that take a bit longer to sell: things like real estate, factories, and equipment. These are fundamentally different than current assets in two ways: they depreciate (i.e., they lose value over time) and it takes a long time to translate them into cash.
This distinction is obviously quite important. When dealing with current assets, one does not need to worry about “carry”—that is, the time with which one holds the assets. For the most part, having a large amount of money in a bank account isn’t going to cost the account holder money over time (that is changing as low, zero, and negative interest rates become more common, but we can set that aside for now). With a fixed asset, the rate of depreciation and the associated expenses associated with the asset need to be less than the return the asset provides, or else the asset is a negative yielding one—in other words, it has negative carry.
Let’s take an example of a house. Many in the middle class around the world count their house as their largest and most important asset, yet in some cases the costs of this asset exceed the rate of return they are getting. If taxes, insurance, maintenance, and other housing-related costs exceed the rate of appreciation, the house provides negative carry. A house that has 5% in annual costs and 3% price growth will offer negative carry.
Negative carry assets need to be thought of differently, and many personal finance experts urge people not to think of their houses as assets but as liabilities for this reason (the first and most famous instance of this was in the classic book “The Millionaire Next Door”). Unlike assets, liabilities are an obligation to pay a creditor in the future. In typical accounting style, something tends to be considered a liability if it is a promise or obligation to pay a certain amount of cash in the future.
But the negative carry on liabilities isn’t included in the tally. If a company borrows $1 million at a 5% interest rate over 10 years, its liability is $1 million despite the promise to pay $5,000 per year over 10 years. There’s $50,000 in future obligated outlays that aren’t being captured in the standard, textbook definition of assets and liabilities.
This is one of the hidden fuzziness in the way accounting standards have developed that financial analysts look out for. Finding obligations and costs that aren’t on the balance sheet but will inevitably come is a way analysts decide whether a company is overvalued or undervalued: there’s something that doesn’t exist on the books that will be very important in determining the company’s future. Finding new and inventive ways to think about assets and liabilities differently is one of the key skills of an analyst.