Hi - I'm Chris from the Money View symposium. I thought I'd check in on your work.
Mind if I criticise your use of a couple of phrases related to equity? I hope not, because I'm doing it now... :-) I think there's a crucial conceptual point here.
"Beta carries [$10 of] equity against this exposure". Beta doesn't have any exposure. It has a (debt) asset, which may or may not involve Beta being paid in future. The worst that can happen is that Beta gets nothing. Beta's $10 equity liability means that, on the assumption that Beta is paid the $10 it is owed by Alpha, it will ultimately give that $10 to its owners.
"Alpha also holds $9 in assets, supported by equity." Again, equity doesn't support anything. It is a note in the accounts that the difference between its $19 of assets and its $10 of liabilities is owed to Alpha's owners.
I think the source of confusion is the thinking that led to the (IMO awful) uses and sources of funds model. The underlying assumption is that every economic action is part of a transaction with an equal and opposite transfer of money. So if a Walmart offers a customer a $5 voucher as a goodwill gesture because they didn't like the flavour of some cheese they bought there, that counts as a *source of funds* for Walmart, even though that doesn't make any sense at all. The underlying assumption is that the customer bought a $5 voucher with $5 of cash.
You get the same with equity. Normally, a firm gains equity when its owners transfer money to the firm. It's the money (the asset) which supports the firm, not the equity. Equity represents the fact that the firm owes that money to the owners.
All in all, I think it's really important to keep in mind that there can be individual economic actions (assignment [tangible/debt], issuance, set-off and novation) which are not part of a transaction. They transfer some of one party's (raw) net worth to the other.
Hi Chris, and thanks for reading. I do not agree that sources and uses always presupposes a transaction or a transfer of money. S&U is a way of looking at double-entry accounting, neither more nor less.
The "support" given by the equity, in my view, is specifically that of loss absorption. In the first example, if Alpha's $9 asset depreciates, the equity cushion can absorb it. In the second example, if the asset depreciates, then Alpha has to default on its debt to Beta.
Thanks for the reply, Daniel. Maybe you can clarify something for me.
I came across sources and uses accounting in Perry Mehrling's lecture 4 part 6 (https://www.youtube.com/watch?v=5Fa-9RTK8zc&list=PLmtuEaMvhDZYfVv95KDQWd8-7UrJCJ9Pm&index=6). There, his Rule 1 was that (for a single agent) every use has a corresponding source and vice-versa. Would you agree with that? If so, how would my example appear in a shop's S&U accounts when it issues a new $5 voucher to a customer as a goodwill gesture? From what I understood, the new liability would appear as a source (called "borrowing" in the lecture). But I can't see what use entry there would be, because it's not a transaction - it's a single one-way action.
The same question goes for a bank where a borrower defaults ("decumulation" source but no use). And for a miner who digs up 100kg of coal ("expenditure" use but no source).
The way I think of these situations is to say that any of these examples causes a change to (raw) net worth (or to equity in the case of a corporation). Is that the way that this gets resolved with S&U accounting too?
When the voucher is created, the new liability is a source of funds as you say, and the use of funds is the flow category of expenses, recorded on the income statement but with no cash flows associated. When the voucher is destroyed, the source of funds is income (sales), and the use of funds is the destruction of the liability.
In the T accounts, I showed what the same transaction looks like in balance sheet terms.
That's a very helpful explanation, Daniel - thanks!
There's a lot I could say about this topic, because I've been interested for decades (ever since I first read about double-entry bookkeeping as a teenager, and wondered how a firm can make a profit if every debit has an equal and opposite credit), but let me know if you think this isn't the best forum for it.
I started off saying I didn't like the use of the expression that equity "supports" the assets. The reason is that it feels backwards: it's the assets which support the equity. Equity is a debt owed to the owners, equal to what would be left over once all the other liabilities have been paid - it's not really a thing in its own right.
Similarly, even though it's a very common expression to say that equity absorbs losses, (and I know exactly what you mean), I think there's a stock/flow mismatch in that terminology, which makes it look like having large liabilities allows a firm to take losses without problem. Of course that would be absurd. I'd say that it's the ability of a firm to *reduce its equity* (a flow) which allows it to absorb losses (another flow). In practice what this means is that the losses of a corporation flow through to its owners, whose net worth decreases as a result of the reduced equity.
In my opinion, attempting to replicate double-entry bookkeeping in economic models is unnecessarily complex, and causes more confusion than it's worth. If you look at just the assets and liabilities (and net worth which is a function of them), and how they change, you get a far cleaner economic model, which directly reflects the reality of what's happening in the real world rather than some strange artefacts which result from accounting practice.
One quick example: as I understand it, accounting practice is to value production at cost until it is sold. This makes it *look* as though profit occurs at the point of sale. That may be appropriate for financial statements, but for an understanding of economics I think it's profoundly misleading. It misses the essence of wealth creation which occurs in the production process itself. (It's more valuable to have a computer than a pile of all its components in a heap for example).
Hi - I'm Chris from the Money View symposium. I thought I'd check in on your work.
Mind if I criticise your use of a couple of phrases related to equity? I hope not, because I'm doing it now... :-) I think there's a crucial conceptual point here.
"Beta carries [$10 of] equity against this exposure". Beta doesn't have any exposure. It has a (debt) asset, which may or may not involve Beta being paid in future. The worst that can happen is that Beta gets nothing. Beta's $10 equity liability means that, on the assumption that Beta is paid the $10 it is owed by Alpha, it will ultimately give that $10 to its owners.
"Alpha also holds $9 in assets, supported by equity." Again, equity doesn't support anything. It is a note in the accounts that the difference between its $19 of assets and its $10 of liabilities is owed to Alpha's owners.
I think the source of confusion is the thinking that led to the (IMO awful) uses and sources of funds model. The underlying assumption is that every economic action is part of a transaction with an equal and opposite transfer of money. So if a Walmart offers a customer a $5 voucher as a goodwill gesture because they didn't like the flavour of some cheese they bought there, that counts as a *source of funds* for Walmart, even though that doesn't make any sense at all. The underlying assumption is that the customer bought a $5 voucher with $5 of cash.
You get the same with equity. Normally, a firm gains equity when its owners transfer money to the firm. It's the money (the asset) which supports the firm, not the equity. Equity represents the fact that the firm owes that money to the owners.
All in all, I think it's really important to keep in mind that there can be individual economic actions (assignment [tangible/debt], issuance, set-off and novation) which are not part of a transaction. They transfer some of one party's (raw) net worth to the other.
Hi Chris, and thanks for reading. I do not agree that sources and uses always presupposes a transaction or a transfer of money. S&U is a way of looking at double-entry accounting, neither more nor less.
The "support" given by the equity, in my view, is specifically that of loss absorption. In the first example, if Alpha's $9 asset depreciates, the equity cushion can absorb it. In the second example, if the asset depreciates, then Alpha has to default on its debt to Beta.
Thanks for the reply, Daniel. Maybe you can clarify something for me.
I came across sources and uses accounting in Perry Mehrling's lecture 4 part 6 (https://www.youtube.com/watch?v=5Fa-9RTK8zc&list=PLmtuEaMvhDZYfVv95KDQWd8-7UrJCJ9Pm&index=6). There, his Rule 1 was that (for a single agent) every use has a corresponding source and vice-versa. Would you agree with that? If so, how would my example appear in a shop's S&U accounts when it issues a new $5 voucher to a customer as a goodwill gesture? From what I understood, the new liability would appear as a source (called "borrowing" in the lecture). But I can't see what use entry there would be, because it's not a transaction - it's a single one-way action.
The same question goes for a bank where a borrower defaults ("decumulation" source but no use). And for a miner who digs up 100kg of coal ("expenditure" use but no source).
The way I think of these situations is to say that any of these examples causes a change to (raw) net worth (or to equity in the case of a corporation). Is that the way that this gets resolved with S&U accounting too?
See T accounts I made in response to this question, here: https://twitter.com/dhneilson/status/1511694031142756354
When the voucher is created, the new liability is a source of funds as you say, and the use of funds is the flow category of expenses, recorded on the income statement but with no cash flows associated. When the voucher is destroyed, the source of funds is income (sales), and the use of funds is the destruction of the liability.
In the T accounts, I showed what the same transaction looks like in balance sheet terms.
That's a very helpful explanation, Daniel - thanks!
There's a lot I could say about this topic, because I've been interested for decades (ever since I first read about double-entry bookkeeping as a teenager, and wondered how a firm can make a profit if every debit has an equal and opposite credit), but let me know if you think this isn't the best forum for it.
I started off saying I didn't like the use of the expression that equity "supports" the assets. The reason is that it feels backwards: it's the assets which support the equity. Equity is a debt owed to the owners, equal to what would be left over once all the other liabilities have been paid - it's not really a thing in its own right.
Similarly, even though it's a very common expression to say that equity absorbs losses, (and I know exactly what you mean), I think there's a stock/flow mismatch in that terminology, which makes it look like having large liabilities allows a firm to take losses without problem. Of course that would be absurd. I'd say that it's the ability of a firm to *reduce its equity* (a flow) which allows it to absorb losses (another flow). In practice what this means is that the losses of a corporation flow through to its owners, whose net worth decreases as a result of the reduced equity.
In my opinion, attempting to replicate double-entry bookkeeping in economic models is unnecessarily complex, and causes more confusion than it's worth. If you look at just the assets and liabilities (and net worth which is a function of them), and how they change, you get a far cleaner economic model, which directly reflects the reality of what's happening in the real world rather than some strange artefacts which result from accounting practice.
One quick example: as I understand it, accounting practice is to value production at cost until it is sold. This makes it *look* as though profit occurs at the point of sale. That may be appropriate for financial statements, but for an understanding of economics I think it's profoundly misleading. It misses the essence of wealth creation which occurs in the production process itself. (It's more valuable to have a computer than a pile of all its components in a heap for example).