David Bholat recently wrote “How to Modernise Central Bank Balance Sheets: No Notes.” It is partly in response to this article. The idea is that banknotes (“dollar bills”/”pound notes” etc. issued by the government should not be classified as a liability, rather as some form of capital or possibly taken off the balance sheet. I have run into variants of this idea in the past (the stronger version being that all forms of the monetary base are not liabilities), and the root idea is that “monetary issue is good for the economy, so how can it be a liability?” Such a redefinition or removal of banknotes is either misleading or wrong.
Much as I agree with your assessment, you have to be a little careful with the definitions. Liabilities and Equity are not as you have described. There is no 'owners equity'. There is just 'equity' under the accounting standards.
Liability has a specific meaning under International Standards: "a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits."
The liability becomes contingent (and off balance sheet) if the obligation becomes a 'possible obligation' rather than a present one.
Equity is then 'not a liability' on the credit side (and includes contingent liabilities). Essentially the balancing item on the accounts.
An entity is required to classify its financial instruments according to the rules laid down in IAS 32: "The issuer of a financial instrument shall classify the instrument, or its component parts, on initial recognition as a financial liability, a financial asset or an equity instrument in accordance with the substance of the contractual arrangement and the definitions of a financial liability, a financial asset and an equity instrument."
Because of the explosion of financial contracts, where they go in the liability/equity divide is a matter of fierce debate. For example 16C of the standard states
"Some financial instruments include a contractual obligation for the issuing entity to deliver to another entity a pro rata share of its net assets only on liquidation. The obligation arises because liquidation either is certain to occur and outside the control of the entity (for example, a limited life entity) or is uncertain to occur but is at the option of the instrument holder. As an exception to the definition of a financial liability, an instrument that includes such an obligation is classified as an equity instrument if it has all the following features:"
And when you read the features, bank notes arguably fall into that category. Then you move onto 16D and there is a saving condition that is probably the 'get out of jail free' card that keeps bank notes as liabilities. ("If the entity cannot determine that this condition is met, it shall not classify the instrument as an equity instrument.")
Ultimately the government sector is akin to a singularity in physics. The standard rules start to break down. Almost certainly the best approach is to abandon 'assets' and 'liabilities' and stick to good old credits and debits. Being 'in credit' and 'in debt' is good enough to cover all the bases without endless arguments about largely meaningless boxes.
Although a discussion of international accounting standards might be of interest to many people, shareholder equity (or more generically, owner’s equity) certainly show up in accounting textbooks and on corporate accounting statements, where shareholder equity is broken up into retained earnings and the value of contributed capital.
Although I considered decomposing owner’s equity into retained earnings and contributed capital, I did not see it adding any value to the intended readers of this piece. If a reader truly understands what retained earnings are, they know enough about accounting to skip my explanation of how A = L + OE works.
If someone can demonstrate that banknotes should be classified as equity under international accounting standards, that just tells us that the bodies setting those standards have lost the plot when you examine my dollar carpet bombing scenario.
Neil Wilson said: "Almost certainly the best approach is to abandon 'assets' and 'liabilities' and stick to good old credits and debits. Being 'in credit' and 'in debt' is good enough to cover all the bases without endless arguments about largely meaningless boxes."
I fully agree. If you hold a credit balance, you are in credit, a creditor, and "shall have" something, as the Italians used to say 1000 years ago. Whether you get something is another thing and depends on seniority/security.
If you are in debt, a debtor (abbreviation Dr comes from 'debtor', Cr from 'creditor'), then you "shall give" something. These are the debit balances in the ledger. In the case of the Fed ledger, the more obvious debtors are the public (Treasury debt) and mortgagors (MBS). The less obvious (not for 1000 yr old Italians!) debtors are the agents running the Fed, who obviously do not own any of the real assets but are responsible for taking care of them, and who have to give those assets back/away to the creditors if the company is wound up. Their accountability towards the creditors is the reason they keep these records, with double entries. The Fed itself is no one - just a product of our imagination (an important one as such, though).
Do you follow me? The ones who say that debtor/creditor no longer makes sense when it comes to accounting are wrong. They just have to see things differently and forget the imaginary person which is the company.
Much as I agree with your assessment, you have to be a little careful with the definitions. Liabilities and Equity are not as you have described. There is no 'owners equity'. There is just 'equity' under the accounting standards.
Liability has a specific meaning under International Standards: "a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits."
The liability becomes contingent (and off balance sheet) if the obligation becomes a 'possible obligation' rather than a present one.
Equity is then 'not a liability' on the credit side (and includes contingent liabilities). Essentially the balancing item on the accounts.
An entity is required to classify its financial instruments according to the rules laid down in IAS 32: "The issuer of a financial instrument shall classify the instrument, or its component parts, on initial recognition as a financial liability, a financial asset or an equity instrument in accordance with the substance of the contractual arrangement and the definitions of a financial liability, a financial asset and an equity instrument."
Because of the explosion of financial contracts, where they go in the liability/equity divide is a matter of fierce debate. For example 16C of the standard states
"Some financial instruments include a contractual obligation for the issuing entity to deliver to another entity a pro rata share of its net assets only on liquidation. The obligation arises because liquidation either is certain to occur and outside the control of the entity (for example, a limited life entity) or is uncertain to occur but is at the option of the instrument holder. As an exception to the definition of a financial liability, an instrument that includes such an obligation is classified as an equity instrument if it has all the following features:"
And when you read the features, bank notes arguably fall into that category. Then you move onto 16D and there is a saving condition that is probably the 'get out of jail free' card that keeps bank notes as liabilities. ("If the entity cannot determine that this condition is met, it shall not classify the instrument as an equity instrument.")
Ultimately the government sector is akin to a singularity in physics. The standard rules start to break down. Almost certainly the best approach is to abandon 'assets' and 'liabilities' and stick to good old credits and debits. Being 'in credit' and 'in debt' is good enough to cover all the bases without endless arguments about largely meaningless boxes.
Although a discussion of international accounting standards might be of interest to many people, shareholder equity (or more generically, owner’s equity) certainly show up in accounting textbooks and on corporate accounting statements, where shareholder equity is broken up into retained earnings and the value of contributed capital.
Although I considered decomposing owner’s equity into retained earnings and contributed capital, I did not see it adding any value to the intended readers of this piece. If a reader truly understands what retained earnings are, they know enough about accounting to skip my explanation of how A = L + OE works.
If someone can demonstrate that banknotes should be classified as equity under international accounting standards, that just tells us that the bodies setting those standards have lost the plot when you examine my dollar carpet bombing scenario.
Neil Wilson said: "Almost certainly the best approach is to abandon 'assets' and 'liabilities' and stick to good old credits and debits. Being 'in credit' and 'in debt' is good enough to cover all the bases without endless arguments about largely meaningless boxes."
I fully agree. If you hold a credit balance, you are in credit, a creditor, and "shall have" something, as the Italians used to say 1000 years ago. Whether you get something is another thing and depends on seniority/security.
If you are in debt, a debtor (abbreviation Dr comes from 'debtor', Cr from 'creditor'), then you "shall give" something. These are the debit balances in the ledger. In the case of the Fed ledger, the more obvious debtors are the public (Treasury debt) and mortgagors (MBS). The less obvious (not for 1000 yr old Italians!) debtors are the agents running the Fed, who obviously do not own any of the real assets but are responsible for taking care of them, and who have to give those assets back/away to the creditors if the company is wound up. Their accountability towards the creditors is the reason they keep these records, with double entries. The Fed itself is no one - just a product of our imagination (an important one as such, though).
Do you follow me? The ones who say that debtor/creditor no longer makes sense when it comes to accounting are wrong. They just have to see things differently and forget the imaginary person which is the company.
I will have to re-read this and think about it again. For now I think of bank notes as a government liability because they are tax credits.