According to this ABS website, what you are doing seems to be "Horizontal double-entry bookkeeping" whereas my Banking articles would be based on "Vertical double-entry bookkeeping" or simply "double-entry bookkeeping". Or are you actually trying to develop what the ABS calls "Quadruple- entry bookkeeping"?
I found their rule 3.61 on "Change of ownership" interesting. It's connected with the accrual basis of "double-entry bookkeeping", which is what banks do.
I don't think I can actually reply in a comment: it's too long. But thanks for the inspiration for my next posts! I'll write some things about firms, and then discuss accounting.
For now, I'll just say that I'm absolutely convinced that the fundamental concepts are assets and liabilities (and their offspring, RNW). Bookkeeping is a way to record *changes* to a person's (or legal entity's) assets and liabilities. You can think of arrow diagrams as being like "horizontal double-entry bookkeeping": each arrow represents the effect on two different parties of a particular action.
(Vertical) double-entry bookkeeping follows certain conventions (e.g. every debit has a corresponding credit and vice-versa), for good historical reasons related to managing a business, and detecting errors or fraud. But those conventions require the person/entity to have a set of "nominal accounts", which in some cases are purely artefacts of those conventions, and shouldn't be taken at face value. An account is quite an abstract thing which doesn't closely relate to things in the real world. The key to understanding accounts is in being able to interpret what they say about changes to the person's/entity's assets and liabilities.
3.61 seems to me to be talking about the sale of tangible assets, and when to record that the sale has taken place (i.e. when to add an 'accrued revenue' asset). A common issue in accounting is when to "recognise" that an event has taken place i.e. to record it in the accounts. One example from my software development career was that my employer would recognise the revenue from a new system once the hardware was installed on-site, even if the system still needed some work done on it and no money had yet been paid by the customer. In principle the buyers could still have rejected the system at that point, but the assumption was that they wouldn't. That led to pressure to install it as early as possible, meaning developers had to be put up in hotels near the installation site, at high expense. (Revenue recognition was a prerequisite for awarding sales and management bonuses).
The imagined scenario of "Alice preparing to create a debt of one apple" doesn't seem intuitive or logical to me. When and how does she come to that frame of mind? It might help if you could, perhaps, link this to a "previously borrowed apple" as the cause of the debt., with Alice exchanging her green (+apple) half for a real apple (purple arrow) provided by Bob.
My logical point is that, "A debt is [NOT] just a promise to give something to, or perform a service for, someone in the future". That is simply a "promise", and such a unilateral promise is actually a free gift. On the other hand, a DEBT usually has its genesis in a previous "asset transfer" without "payment" in return. Such a *one-sided* transfer of 1 apple from Bob to Alice would generate Alice's motivation to give Bob an IOU in "exchange" for the borrowed apple, to ensure that "the books balance".
On their own, the pink and green halves of your imaginary torn paper represent only half of each person's individual accounting records describing this transaction.
In real life, Alice would need to record:
(a) receipt of the apple - as an increase in her assets (DEBIT) - and
(b) the pink (-apple) piece of paper - as an increase in her liabilities (CREDIT),
Bob would simultaneously record:
(c) his disappearing apple - as a decrease of his assets (CREDIT) - and
(d) the green (+apple) piece of paper - as an equal increase in his assets (DEBIT).
That way the two Balance Sheets of Alice and Bob both remain in balance. Alice's assets and liabilities both increase by the value of the apple, while Bob's total assets and labilities remain unaltered, as he simply swapped one asset for another of equal value.
Thanks for your very thoughtful comments on this. I'll readily admit that this approach is *very* different from other presentations I've seen, and it took me *many* years to settle on this analysis.
I'll start with an imperfect, but hopefully useful analogy. We can reason about protons and their properties (e.g. positive charge), even though the vast majority of them which we encounter are part of an overall-neutral atom. In the same way, we can reason about debts and their properties, even though most of them are created when the new debtor receives something in exchange. You're absolutely correct that if Alice promises to give Bob an apple tomorrow, and receives nothing in exchange, that would be a free gift. But even if it is part of a transaction like you suggest (Bob gives Alice an apple today; Alice promises to give Bob an apple tomorrow), we can consider the two actions separately.
In my experience, separating transactions into their component actions is an extremely helpful thing to do: the effects of the actions are extraordinarily simple, and their composition is linear i.e. the effect of a set actions is simply the sum of the effects of the individual actions. This is incredibly useful in macroeconomics when we can recompose the actions in different ways, which I intend to write about soon. As a quick preview, we can group together all of the actions related to a single tangible asset (to form a chain), and we can group together all of the actions related to a single debt (to form a loop). The state of the whole economy is simply the superposition of all these chains and loops. If you've ever done electrical circuit analysis or studied waves, you may see the significance of this.
The idea of balance between credits and debits is a very interesting one, but it can actually be misleading in an extremely subtle way. Since you've obviously been thinking about this topic a lot, I think it's worth trying to explain what I mean. Essentially, there's no reason why a person can't have more assets than liabilities (or vice-versa). For example, when Robinson Crusoe recovered food and tools from the shipwreck, he gained some assets but didn't lose any other assets or gain any liabilities. His net worth (assets minus liabilities) increased, but this increase to the liabilities column of his balance sheet doesn't mean he lost anything. The credit to net worth is an accounting fiction.
So I would divide the full transaction you give into two separate actions like this:
As a quick follow-up, in reality I wouldn't write it out in full like this. All of the description of debits, credits, pseudo-debits and pseudo-credits is encapsulated with two arrows: a purple arrow from Bob to Alice for action 1, and a pink-to-green arrow from Alice to Bob for action 2.
Don’t confuse the “matching rule” with the “balance sheet rule”. Just to be clear, "matching" Credits and Debits (for a single transaction) doesn't say Assets and Liabilities have to "balance".
The "matching" rule only applies to a single transaction, not to the summary of all transactions contained in the accounting system, which is called the balance sheet.
The "balance" rule applies to the accounting equation, "Assets = Liabilities + Owner's equity", which must always be true (for a given entity).
Applying the "matching rule" to each and every "transaction" within an organization should ensure that the accounting equation will always "balance", because there are now only 4 possible ways the accounting equation can be altered:
1. Credit & Debit in two diff Asset accounts [equal '-' & '+' on same side];
2. Credit & Debit in two diff Liability accounts [equal '+' & '-' on same side];
3. Credit an Asset a/c & Debit a Liability a/c [ same '-' on each side]; or
4. Credit a Liability a/c & Debit an Asset a/c [same '+' on each side].
The accounting equation "Assets = liabilities + owner's equity" is (mostly) fine for a firm, but doesn't really work for a human being who doesn't have an owner. Equity is a type of liability, so with the accounting equation, assets and liabilities do always match.
That doesn't reflect reality, where it's possible to have more assets than liabilities, as in the Robinson Crusoe example. The difference between a person's assets and liabilities is their (raw) net worth, and it's not owed to anyone else. Treating net worth as a liability (as owner's equity in a firm is) is what I call an accounting fiction.
Ah, I think I misunderstood your previous comment. I would say that the equity of a company *is* a debt owed by that company to its owners. But that the net assets of an individual is (raw) net worth. I wouldn't call an individual's net assets "equity" because an individual doesn't have owners.
I like Wikipedia's introduction to Equity:
"In finance, equity is an ownership interest in property that may be offset by debts or other liabilities."
When Robinson Crusoe gained a huge bunch of valuable assets from the ship by a tiny expenditure of his energy (asset) and incurred no liabilities, he just increased his “Equity”.
I don't follow what you mean by "... but this increase to the liabilities column of his balance sheet doesn't mean he lost anything. The credit to net worth is an accounting fiction."
I like to draw a distinction between net worth and equity. As I'm sure I've seen you write, a firm's equity is a type of liability. It's what's left over once the firm's other liabilities have been settled, and it's owed to the firm's owners. Because the firm's equity is a liability, its net worth (assets minus liabilities) is zero.
But an individual doesn't owe anyone the residual assets after all of their liabilities have been settled. What's left over is theirs. This is their (raw) net worth, which you can think of as their savings.
If you attempt to draw a balance sheet for an individual, you'll find it doesn't actually balance. You can only get it to balance by putting net worth in the liabilities column, as though it's owed to someone else, even though it's not: it's an accounting fiction to make the balance sheet balance.
An alternative way of thinking about it, I suppose, relates to idea that each human being has a "straw man" corporation associated with them, and this corporation's equity is owed to the real human being. Either view works as far as I'm concerned, but for economic analysis, I don't think the straw man corporation view adds any explanatory power.
My mistake. Liabilities are obligations owed to entities "*outside* the organization"; owner's don't fit that description. I'm glad you caught that.
I have just edited that post to remove those words from that sentence, and I agree that, considering "a person" as an accounting 'entity', Equity = RNW.
It took me years of thinking to get to the point where I understood the subtle distinction between equity and net worth. This is one of those terminology problems, where lots of people treat them as synonymous (e.g. https://en.wikipedia.org/wiki/Net_worth#Companies), and to be fair they are very closely related.
I just discovered this on the Australian Bureau of Statistics [ABS] website and thought you might find it interesting.
https://www.abs.gov.au/statistics/concepts-sources-methods/australian-system-national-accounts-concepts-sources-and-methods/2020-21/chapter-3-stocks-flows-and-accounting-rules/accounting-rules
According to this ABS website, what you are doing seems to be "Horizontal double-entry bookkeeping" whereas my Banking articles would be based on "Vertical double-entry bookkeeping" or simply "double-entry bookkeeping". Or are you actually trying to develop what the ABS calls "Quadruple- entry bookkeeping"?
I found their rule 3.61 on "Change of ownership" interesting. It's connected with the accrual basis of "double-entry bookkeeping", which is what banks do.
I don't think I can actually reply in a comment: it's too long. But thanks for the inspiration for my next posts! I'll write some things about firms, and then discuss accounting.
For now, I'll just say that I'm absolutely convinced that the fundamental concepts are assets and liabilities (and their offspring, RNW). Bookkeeping is a way to record *changes* to a person's (or legal entity's) assets and liabilities. You can think of arrow diagrams as being like "horizontal double-entry bookkeeping": each arrow represents the effect on two different parties of a particular action.
(Vertical) double-entry bookkeeping follows certain conventions (e.g. every debit has a corresponding credit and vice-versa), for good historical reasons related to managing a business, and detecting errors or fraud. But those conventions require the person/entity to have a set of "nominal accounts", which in some cases are purely artefacts of those conventions, and shouldn't be taken at face value. An account is quite an abstract thing which doesn't closely relate to things in the real world. The key to understanding accounts is in being able to interpret what they say about changes to the person's/entity's assets and liabilities.
3.61 seems to me to be talking about the sale of tangible assets, and when to record that the sale has taken place (i.e. when to add an 'accrued revenue' asset). A common issue in accounting is when to "recognise" that an event has taken place i.e. to record it in the accounts. One example from my software development career was that my employer would recognise the revenue from a new system once the hardware was installed on-site, even if the system still needed some work done on it and no money had yet been paid by the customer. In principle the buyers could still have rejected the system at that point, but the assumption was that they wouldn't. That led to pressure to install it as early as possible, meaning developers had to be put up in hotels near the installation site, at high expense. (Revenue recognition was a prerequisite for awarding sales and management bonuses).
The imagined scenario of "Alice preparing to create a debt of one apple" doesn't seem intuitive or logical to me. When and how does she come to that frame of mind? It might help if you could, perhaps, link this to a "previously borrowed apple" as the cause of the debt., with Alice exchanging her green (+apple) half for a real apple (purple arrow) provided by Bob.
My logical point is that, "A debt is [NOT] just a promise to give something to, or perform a service for, someone in the future". That is simply a "promise", and such a unilateral promise is actually a free gift. On the other hand, a DEBT usually has its genesis in a previous "asset transfer" without "payment" in return. Such a *one-sided* transfer of 1 apple from Bob to Alice would generate Alice's motivation to give Bob an IOU in "exchange" for the borrowed apple, to ensure that "the books balance".
On their own, the pink and green halves of your imaginary torn paper represent only half of each person's individual accounting records describing this transaction.
In real life, Alice would need to record:
(a) receipt of the apple - as an increase in her assets (DEBIT) - and
(b) the pink (-apple) piece of paper - as an increase in her liabilities (CREDIT),
Bob would simultaneously record:
(c) his disappearing apple - as a decrease of his assets (CREDIT) - and
(d) the green (+apple) piece of paper - as an equal increase in his assets (DEBIT).
That way the two Balance Sheets of Alice and Bob both remain in balance. Alice's assets and liabilities both increase by the value of the apple, while Bob's total assets and labilities remain unaltered, as he simply swapped one asset for another of equal value.
Thanks for your very thoughtful comments on this. I'll readily admit that this approach is *very* different from other presentations I've seen, and it took me *many* years to settle on this analysis.
I'll start with an imperfect, but hopefully useful analogy. We can reason about protons and their properties (e.g. positive charge), even though the vast majority of them which we encounter are part of an overall-neutral atom. In the same way, we can reason about debts and their properties, even though most of them are created when the new debtor receives something in exchange. You're absolutely correct that if Alice promises to give Bob an apple tomorrow, and receives nothing in exchange, that would be a free gift. But even if it is part of a transaction like you suggest (Bob gives Alice an apple today; Alice promises to give Bob an apple tomorrow), we can consider the two actions separately.
In my experience, separating transactions into their component actions is an extremely helpful thing to do: the effects of the actions are extraordinarily simple, and their composition is linear i.e. the effect of a set actions is simply the sum of the effects of the individual actions. This is incredibly useful in macroeconomics when we can recompose the actions in different ways, which I intend to write about soon. As a quick preview, we can group together all of the actions related to a single tangible asset (to form a chain), and we can group together all of the actions related to a single debt (to form a loop). The state of the whole economy is simply the superposition of all these chains and loops. If you've ever done electrical circuit analysis or studied waves, you may see the significance of this.
The idea of balance between credits and debits is a very interesting one, but it can actually be misleading in an extremely subtle way. Since you've obviously been thinking about this topic a lot, I think it's worth trying to explain what I mean. Essentially, there's no reason why a person can't have more assets than liabilities (or vice-versa). For example, when Robinson Crusoe recovered food and tools from the shipwreck, he gained some assets but didn't lose any other assets or gain any liabilities. His net worth (assets minus liabilities) increased, but this increase to the liabilities column of his balance sheet doesn't mean he lost anything. The credit to net worth is an accounting fiction.
So I would divide the full transaction you give into two separate actions like this:
1. Bob gives Alice an apple.
Alice:
(a) Debit (increase in tangible assets)
(b) Pseudo-credit (increase in RNW)
Bob:
(a) Credit (decrease in tangible assets)
(b) Pseudo-debit (decrease in RNW).
2. Alice promises to give Bob an apple tomorrow.
Alice:
(a) Credit (increase in liabilities)
(b) Pseudo-debit (decrease in RNW).
Bob:
(a) Debit (increase in debt assets)
(b) Pseudo-credit (increase in RNW).
As a quick follow-up, in reality I wouldn't write it out in full like this. All of the description of debits, credits, pseudo-debits and pseudo-credits is encapsulated with two arrows: a purple arrow from Bob to Alice for action 1, and a pink-to-green arrow from Alice to Bob for action 2.
Don’t confuse the “matching rule” with the “balance sheet rule”. Just to be clear, "matching" Credits and Debits (for a single transaction) doesn't say Assets and Liabilities have to "balance".
The "matching" rule only applies to a single transaction, not to the summary of all transactions contained in the accounting system, which is called the balance sheet.
The "balance" rule applies to the accounting equation, "Assets = Liabilities + Owner's equity", which must always be true (for a given entity).
Applying the "matching rule" to each and every "transaction" within an organization should ensure that the accounting equation will always "balance", because there are now only 4 possible ways the accounting equation can be altered:
1. Credit & Debit in two diff Asset accounts [equal '-' & '+' on same side];
2. Credit & Debit in two diff Liability accounts [equal '+' & '-' on same side];
3. Credit an Asset a/c & Debit a Liability a/c [ same '-' on each side]; or
4. Credit a Liability a/c & Debit an Asset a/c [same '+' on each side].
The accounting equation "Assets = liabilities + owner's equity" is (mostly) fine for a firm, but doesn't really work for a human being who doesn't have an owner. Equity is a type of liability, so with the accounting equation, assets and liabilities do always match.
That doesn't reflect reality, where it's possible to have more assets than liabilities, as in the Robinson Crusoe example. The difference between a person's assets and liabilities is their (raw) net worth, and it's not owed to anyone else. Treating net worth as a liability (as owner's equity in a firm is) is what I call an accounting fiction.
See my comment above. Equity is NOT a liability, as I mistakenly wrote. I've corrected that sentence in my post as result of your comment.
As I progressed through your articles I was coming to the conclusion that your RNW was, in fact, simply the Equity part of the accounting equation.
Ah, I think I misunderstood your previous comment. I would say that the equity of a company *is* a debt owed by that company to its owners. But that the net assets of an individual is (raw) net worth. I wouldn't call an individual's net assets "equity" because an individual doesn't have owners.
I like Wikipedia's introduction to Equity:
"In finance, equity is an ownership interest in property that may be offset by debts or other liabilities."
When Robinson Crusoe gained a huge bunch of valuable assets from the ship by a tiny expenditure of his energy (asset) and incurred no liabilities, he just increased his “Equity”.
I don't follow what you mean by "... but this increase to the liabilities column of his balance sheet doesn't mean he lost anything. The credit to net worth is an accounting fiction."
I like to draw a distinction between net worth and equity. As I'm sure I've seen you write, a firm's equity is a type of liability. It's what's left over once the firm's other liabilities have been settled, and it's owed to the firm's owners. Because the firm's equity is a liability, its net worth (assets minus liabilities) is zero.
But an individual doesn't owe anyone the residual assets after all of their liabilities have been settled. What's left over is theirs. This is their (raw) net worth, which you can think of as their savings.
If you attempt to draw a balance sheet for an individual, you'll find it doesn't actually balance. You can only get it to balance by putting net worth in the liabilities column, as though it's owed to someone else, even though it's not: it's an accounting fiction to make the balance sheet balance.
An alternative way of thinking about it, I suppose, relates to idea that each human being has a "straw man" corporation associated with them, and this corporation's equity is owed to the real human being. Either view works as far as I'm concerned, but for economic analysis, I don't think the straw man corporation view adds any explanatory power.
My mistake. Liabilities are obligations owed to entities "*outside* the organization"; owner's don't fit that description. I'm glad you caught that.
I have just edited that post to remove those words from that sentence, and I agree that, considering "a person" as an accounting 'entity', Equity = RNW.
It took me years of thinking to get to the point where I understood the subtle distinction between equity and net worth. This is one of those terminology problems, where lots of people treat them as synonymous (e.g. https://en.wikipedia.org/wiki/Net_worth#Companies), and to be fair they are very closely related.