01 Nov 2008

Accounting Basics & the Financial Crisis

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I’ve had a few conversations with “Pepe,” my man on Wall Street. It had been many years since my undergraduate class in accounting, and I just wanted to clarify a few things to make sure I really understood the typical press stories about the financial crisis.

It occurred to me that some Free Advice readers are similarly rusty. So over the next few weeks I will be posting a series of these refreshers. Ultimately, I want to address such issues as:

* The difference between solvency and liquidity.
* How mark-to-market exacerbates the “panic selling.”
* What all this talk of “de-leveraging” means.
* Why it can hurt a hedge fund if clients withdraw their money (as opposed to just scaling down the operations).
* How recapitalization works. Specifically, what is going on when they say Firm XYZ lost $8 billion last quarter and so it needs to “raise capital.”
* Why a “sick” firm can raise outside capital to cover losses, but that same firm wouldn’t have taken extra investment in itself if it had been profitable.

One last thing before we dive in: I am of course coming to these issues as an economist with a specialty in capital & interest theory. At times, I may analyze something the way an economist would, rather than treating it as an accountant would. So if anyone spots an inaccuracy, please correct me.


For something like this, I think it’s best to use a concrete example so it clicks:

Let’s say that a guy saves up $80,000 of his own money, and then wants to start a laundromat. He goes to his bank and opens a new checking account for his business, and puts the $80k in there. He also goes to his father-in-law and borrows $20,000. The father-in-law agrees, but insists on a monthly interest rate of 2.5%. This $20k too is deposited into the business checking account.

Armed with a checkbook showing a balance of $100,000, our protagonist buys $60,000 worth of washing machines, dryers, coin dispensers, etc. by writing checks on this business account. He writes a check for $5,000 to pay for his monthly rent (including utilities) of the building he uses for his business. He doesn’t have any employees. During that first month of operations, assume that his customers spend a total of $18,000 doing their laundry. In the process, they use up $700 worth of the laundry detergent and dryer sheet single-servings in the vending machines.

At the end of the month, the guy pulls up his QuickBooks file to see the state of his business. He first looks at the Profit & Loss statement. It shows him that during the month, he incurred $6,200 in expenses. Note that we’re not counting the entire $60k as an operating expense, only the $700 of it that went towards the purchase of single-serving detergent and dryer sheets that were used up during the month. (Strictly speaking, we could include a depreciation expense reflecting the fact that he couldn’t resell the washing machines for the price he paid, but let’s ignore that complication.) We also count the $500 interest expense on the loan from his father-in-law.

On the other hand, the P&L statement shows that his revenues were $18,000. So his net income for the month was $18,000 – $6,200 = $11,800.

Next the guy pulls up his balance sheet. (Here, remember the tautology that Total Assets = Total Liabilities + Owner’s Equity.) On the assets side, the guy lists all of his machines and the packets of detergents etc. that are still in his possession. When multiplying each of these by their prices (again, let’s assume he values them on his books at the price he paid), he sees that his assets in this category are worth $59,300. (Remember, $700 was “consumed” by his customers during the period.)

But there is another asset, namely the money in the checking account. Right now his balance at the bank is $53,000. He started with $100k initially, which got knocked down to $40k after he bought all of his machines and other items. Then it got knocked down to $35k after he wrote his monthly rent check to his landlord. But then during the month, the owner deposited the $18,000 in revenues from his customers, so the checking account balance stands at $53,000 at the end of the period.

This makes the Total Assets for the company equal to $112,300, i.e. the sum of $59,300 and $53,000.


On the Liabilities section, the man sees the IOU to his father-in-law, which is priced at $20,500. That leaves the Equity section. Here, the initial Owner’s Equity was $80,000 (i.e. the money the guy originally saved up to launch his new business). To this we add the Net Income from the period, i.e. $11,800. This brings Total Equity to $91,800.


To make sure we did everything correctly, let’s check the accounting identity. Total Assets are $112,300. Total Liabilities + Total Equity are $20,500 + $91,800 = $112,300. So we are now reassured that we probably didn’t screw anything up in our above calculations.


I think that’s plenty for today. Once we get these basics down, it will be easy to discuss the more exotic things happening in the financial sector. But as I said in the beginning, I myself had to go through these dumbed down scenarios before getting into scenarios of firms suffering billions in losses on mortgage-backed securities and then having to raise capital.

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