Accounting for Prudent Choice
3. Accounting for consumer choices

Back to Paul and that tempting low-end Gibson. Can he give up a new computer and a B- in History?

The answer will depend in part, obviously, on Paul's finances. Any economic decision is about the future, not the past. But the past of your income or your wealth is a guide, is it not, to at least your immediate future? That's why accounting figures in business so heavily, and why even our Paul could use a dose of it.

How much money does he have? The simplest, if slightly idiotic, way to look at it is to empty his pockets. He comes up with $24.65 in bills and coins. That's how much "money" he has on hand. But we said that is idiotic. Clearly, he needs to know what his earnings and expenditures will be in the immediate future. He looks in his checkbook to see how much he has in his checking account and what his spending habits have been recently. He has $140 in his account. That's not much. Or is it? The checkbook gives us an incomplete picture of his financial situation. It doesn't show everything he owns or owes, and does not even show precisely how much he has earned, spent, and saved over the past months. It's is not enough information to make a prudent decision.

Paul clearly needs to go beyond his pockets or his checkbook to consider the stocks of his possessions and debts and the flows of his income and expenses. By a "stock" we mean "a pile of stuff or money owned at any one time, like the level of water in a bathtub." By "flows" we mean the stuff or money flowing in or out of the stock during a period of time, say a month, like the faucet flowing in or the drain flowing out of a bathtub." In other words, Paul needs to do some accounting.

Stocks and flows: The bathtub analogy

The most fundamental idea in accounting is the distinction between stocks and flows. A stock, we said, is like the amount of water in a bathtub. The water coming through the faucet is a flow into the bathtub per unit of time. It adds to the stock. The flow of water going down the drain subtracts from the stock. In this analogy the cash Paul has in his pocket is a stock. He owns it until he decides to spend it. The cash he spends over time is a flow. It decreases his stock of cash. Likewise, the cash he receives over time is a flow. It increases his stock of cash.

Figure 2.2 The bathtub analogy of stocks and flows [HERE]

The bathtub illustrates the relationship between stocks and flows. The water in the bathtub is the "stock" of water. The "flow" through the faucet (gallons per minute) adds to the stock and the flow leaving through the drain (gallons per minute) diminishes it. The cash Paul owns is similar to the water in the tub. The dollar he spends on ice cream is like the flow that goes down the drain - a good cause, but still a reduction of his stock of dollars.

A stock is measured at one moment in time. A flow is measured over a period of time. A person's income is a flow. If you are asked, "What's your income?" your answer will refer to time: income per hour, per week, per year, or whatever.

As the bathtub analog suggests, the distinction between stocks and flows is crucial in many areas outside of accounting. Look at Table 2.1. In each case the stock is a snapshot of a particular situation at a point in time. The flow, remember, occurs over time. It's a video of the in- and out-movement.

Table 2.1 Stocks and flows are everywhere

(at a point in time)
Flows in
(over a period of time)
Flows out
(over a period of time)
Water in the bathtub Clean water from faucet Dirty water down drain
Cash on hand Income from job Expenses for daily life
Clothing in your closet Purchases of new clothes Discarding used clothes
Grocery store inventory Sales of groceries (Revenue) Cost of groceries (Expenditure)
Population of City of London Births and in-migration to City of London Deaths and out-migration from City of London
Warren Buffet's Wealth Warren Buffet's Income Warren Buffet's Expenses

The balance sheet measures stocks

Prudent consumers regularly take stock of their possessions and debts, especially when shopping for expensive items like a house or a guitar. It is a question of how well-off they are. What matters is the difference between their possessions and their debts. A woman possessing a six million dollar mansion in Boca Raton, Florida can have zero wealth if her debts are also six million dollars. The difference between what you own and what you owe is her wealth, also known as her "equity" or "net worth." In her case, zero.

Paul's wealth is like the level of the water in his bathtub. His wealth on, say, September 30 is the difference between what he owns and what he owes at that moment. The things he owns are called in accounting his assets, such as a car or money in the bank. They are the stock of his possessions. The amounts he owes are called his liabilities, such as the unpaid balances on student loan and credit card. So his wealth---also called his equity or net worth---is the difference between his assets and his liabilities.

Wealth (or equity or net worth) is the money value of total assets minus total liabilities.

Assets are the amounts owned (possessions) and liabilities are the amounts owed (debts).

A balance sheet is a record of all this on a specific date. Most businesses use balance sheets drawn up annually to keep track of their assets and liabilities, and to inform---or disinform, if run by unethical businesspeople---their investors and the tax man and the stock market. The balance sheet is one way of looking at a business's financial health.

But exactly the same accounting applies to Paul, even it he does not take the time to produce a formal balance sheet. He reckons that the value of his car at the end of the month will be about $650. (The car goes: that's all.) Selling his car (as Bayla did after quitting her insurance job) is always an option. His wallet tells him his stock of cash and his bank statement tells him what he has in his checking account. He also has $235 in a savings account that his grandmother gave him when he graduated from high school. His only debt is a $540 unpaid balance on his credit card.

Table 2.2 Paul's balance sheet on September 30, 2008

Assets Liabilities
Cash in his pocket $ 24 Unpaid credit card balance $540
Checking account $140
Savings account $235
Car $650
Total assets $1049 Total liabilities $540
Total wealth (= A - L) $509

According to basic accounting principles, Paul's current wealth is $509: the value of his assets minus the value of his liabilities. So now he knows how well off he is.

Paul: I still don't know what to do.

Rodney: You'd be silly to buy a $800 guitar if your wealth is only $509. You'd go broke.

McCloskey: Yup. Technically speaking, you'd be "bankrupt," which just means that your liabilities are greater than your assets, so your wealth is negative,

Rodney: Go to the Performing Arts building. They've got guitars you can borrow and use in the practice room.

Paul: But I could borrow the money.

McCloskey: And create a liability.

Rodney: Don't expect any loans from me!

Paul: I might sell my car. Or I could just use my credit card.

Rodney: That's irresponsible. How would you ever pay it off?

McCloskey: Another liability.

Paul: I'd work more.

McCloskey: So you have an asset not accounted for above: your labor power, so to speak. It can generate a stream of income. But working more for pay has itself an opportunity cost---say that B+ you hope for in Economics?

Even if he were to sell off his car, he still would not be able to buy the guitar he so badly wants. He could borrow the eight hundred dollars. The credit card company will not object to such an increase in his liabilities. After all, if he doesn't pay it off within the month the company earns about 20% per year on the balance. Nice return. If he keeps not paying it off for, say, six years his liability rises to . . . let's see. . . 1.2 times 1.2 times 1.2 times 1.2 times 1.2 times 1.2 times $800 equals a nice $2388.79.

The balance sheet does not provide the answer to Paul's dilemma automatically. It tells him, as economists put it, what his "constraints" are, that is, what means he has to achieve his ends. It's obviously prudent to know such things, instead of buying impulsively.

In fact Paul needs to know more about the constraints under which he is operating. Apart from the level in his bathtub, he also needs to know the flows in and out, that is, his monthly income and expenses. Who knows? Maybe his income from work and interest on his bank accounts and regular gifts from Mom is large enough to let him purchase the guitar.

Figure 2.3 A college student with a car and other luxury items [HERE]

Concept Check 4: Look at the snapshot. What is the student's most valuable asset?
Common confusion about the nature of "wealth":
Before Oprah and Bill there were the Hunt Brothers

The Hunt brothers of Texas-William Herbert Hunt (b. 1929) and Nelson Bunker Hunt (b. 1926)-were once among the wealthiest Americans. Like their friends in the George Bush family, they acquired wealth in the oil market. In the 1970s they decided with some Saudi Arabian associates that they'd try to "corner" the silver market. You "corner" a market by buying up a large enough part of the stock of what is to be sold in the market to drive up the price, at which point you sell, and make the profit from buying at the old price (low) and selling at the new, high price that you have arranged. By the late 1980s, after failing---there's a lot of silver out there in people's assets, and cornering the market was actually impossible---they had lost so much money that they filed for bankruptcy. They were beat by another kind of corner: government. Following an unexpected governmental change in trading rules early in 1980, silver prices plunged, 50% on a single day in March 1980---a day the Hunts and their Saudi associates will never forget.

But the Hunts still lived on a gigantic ranch in Texas, owned race horses, and drove expensive cars. Were they still rich? Many people would say yes. They would equate the Hunts' assets (cars, horses, estate) with wealth. But the value of assets is not wealth. Wealth is the value of assets minus the value of liabilities. Total assets in themselves are a misleading indicator of wealth. The Hunt brothers were actually very poor. Saddled with enormous debts to banks, their liabilities exceeded their assets by about a billion dollars. In other words, following the collapse of the silver market, their total wealth was negative one billion dollars.

From this hit they never recovered, though they didn't die in the poorhouse. For years they tried to conceal their assets from the people they owed millions to. Finally, CBS News reported on November 1, 1994: "Eight years ago, the Hunt brothers, Nelson Bunker and William Herbert, pitched their corporations into bankruptcy. Six years ago, they declared personal bankruptcy. But only late on Friday did the family of Herbert Hunt finally agree in a court filing to hand over the bulk of his property -- more than $40 million in real estate, with back interest, that creditors say he had fraudulently transferred shortly before filing for personal bankruptcy. In August, Nelson Bunker Hunt's relatives quietly agreed to a similar settlement, worth about $14 million."

The income statement measures flows

To measure the flows in and out of his bathtub Paul needs to know all of the income he has received and all of the expenditures he has made during a certain period of time. Remember: flows are measured over time - a week, a month, a year - and stocks at a particular point in time. Paul's record keeping is most likely a mess. But suppose he can reckon the flows in and out during the month of September, at least. After much data-gathering and calculating, he comes up with the following income statement.

Table 2.3 Paul's income statement for the month of September, 2008

Expenses Income
Room and board $ 600 Salary $400
Interest on credit card $ 8 Gift from parents $800
Books, notebooks $ 250 Interest on savings $ 1
Entertainment $ 160
Depreciation (car) $ 20
Gas $ 40
Total expenses $1078 Total income $1201
Total savings (= I - E) $123

Some of the items on Paul's income statement correspond to entries in his checkbook. He paid for other items with cash or a credit card. The $600 for room and board was paid for with a gift from his parents, but it is really Paul's expense. Since his parents do not expect him to pay back the $800 they gave him ($600 of which went for room and board), he has entered it as a gift on the income portion of his statement.

Notice that he's entered an expense of $20 for the depreciation of his car. That's correct. Think of this for now as the slow, steady evaporation of the car as it is used, or even as it merely grows older, even if unused. Appreciation is an increase in the value of an asset. If Paul's car became a collector's item he should enter the amount of its appreciation in his income statement as income. The commonest case of appreciation is an increase in the value of a home. The "capital gain" on a family's asset, the rise in the value of its home, is counted as part of income. If the appreciation doesn't get spent, then the family is in essence investing in the asset side of its balance sheet.

Depreciation is a fall in the market value of an asset; it appears as an expense on the income/expenditure statement.

Appreciation is an increase in the market value of an asset; it appears as income.

Maria: But Paul isn't paying anybody anything when he drives his car. So how could the use of his car be an expense, or a flow out of his bathtub?

Klamer: When Paul's car goes down in value simply because it is getting older, the overall level of his bathtub goes down. After all, the level of the bathtub is his net wealth. So a fall in the market value of an asset---which is what depreciation is---is a fall in his net wealth. It is therefore just like water flowing out the drain. In business accounting it is described in the expressive phrase, "capital consumption." It is an imagined flow that we need to include on the income statement to account for the change in the level of the bathtub.

Maria: Got it.

Paul saved. Savings equals all income minus expenses during the month. It's on "the bottom line" people are always talking about: $123. Savings measures the net inflow into Paul's bathtub during September. So it is the increase in his wealth---just as the difference between a nation's total births and total deaths each year measures the net yearly increase in its population. When total expenses exceed total income, we speak of dissaving. Dissaving is a decrease in wealth.

Savings is income minus expenses. It is an increase in wealth.

Dissaving is negative savings. It is a decrease in wealth.

Concept Check 5: "Wait a minute," says Paul. "How could I have saved anything? I didn't put a dime into my savings account, and you're telling me I saved $123?" Straighten Paul out.

The fact that Paul has been saving may convince him to go ahead with the purchase of the guitar. Let's be clear about it: Paul can "afford" to buy the guitar, so long as we take the wretched, non-economist's word "afford" to mean that he is able to buy it. Even though he does not have the cash, he could sell his car and borrow the rest, or just borrow the whole $800. Whether he wants to do any of these things is still a matter of choice. The balance sheet and income statement provide the information necessary for a prudent decision. But they don't tell him what to do. After all, he can want to go bankrupt!

Consumption versus investment

Suppose Paul was considering merely a purchase of an ice cream cone. Would this make any difference in our analysis of his decision? It surely would. In economic terms it is the difference between consumption and investment.

Buying ice cream is consumption. Paul eats it up and that's it. The cost would appear as an expense on his income statement. Consumption, in other words, is a flow out, "money down the drain." A guitar, on the other hand, will last. Five or ten after purchasing it Paul can still enjoy playing it. It's just like a house, a car, or a computer. Economists call these "durable goods." Buying them is an investment. Once owned, they are added to the assets on a person's balance sheet.

To draw the line between consumption and investment we use the conventional measure of one year. The purchase of a good or service whose value is fully used up within one year is called consumption; the purchase of something whose value lasts longer than one year is called investment.

Consumption consists of all the goods and services that people buy and use up, or "consume," within one year. Consumption is an expense on an income statement.

Investment is the purchase of a durable good that lasts over one year. It yields a stream of future benefits. Investment is an addition to assets on a balance sheet.

When Paul buys ice cream, the level of his wealth bathtub goes down. The money spent on ice cream is money down the drain - an expense. There are no offsets to the money gone. But when he purchases a guitar, an investment, the level in his bathtub stays the same. You might not think so. After all, Paul's liabilities would increase by $800 (suppose against Rodney's advice he does pay with his credit card) so the level in his bathtub should go down by the same amount. But the guitar is an investment and therefore would be added to Paul's assets. Accordingly, his assets and liabilities would both go up by $800. His wealth would not change. Buying the guitar simply reshuffles his assets (more guitar, a rise in assets, in exchange for more debt, a fall in assets, a liability).

Speaking economics: "Investment"

Most people associate the term "investment" with banks, money, and Wall Street. In economics, however, the term refers to the purchase of any durable assets such as a new refrigerator or a new building or a new machine - new physical assets. Note the word "new." When the purchased asset is an IOU like a government bond or a share of General Electric stock, economists speak of financial investment. In contrast, "real" investment means new purchases of factories, machines, cars, farm fencing, roads, educations, and the like, "new" from the point of view of the society as a whole. When you graduate the society gets another educated---all right, sheep-skinned---person as a result of the investment by you or the college or your parents or the bank. A new real asset, your educated brain, has come into existence. Bonds and stocks are merely financial claims on the stream of income that flows from such real assets. Factories and machines and educations and the like by contrast make the stream of future benefits. To count the value of the IOUs as well as the underlying assets would be to count the same asset twice, once as paper and once as a factory, a machine, or-for the Dave Matthews' of the world-a guitar.

The purchase of a guitar isn't consumption, but playing the guitar is. Similarly, typing on a computer and living in a house are forms of consumption. The guitar, the computer, and the house all decrease in value with time and use. So, strictly speaking, Paul should enter the cost of using his guitar under Expenses on his monthly income statement. This is depreciation once again. From an economic (and accounting) point of view, depreciation is the loss (the consumption loss) of asset value.

Paul: How would I determine the monthly depreciation for my guitar? Would I look for new scratches or what?

Klamer: Calculating depreciation is often tricky. As you suggest, measuring the actual evaporation of the benefit-producing capacity of the asset is seldom easy. There are various ways of settling the issue. Putting any particular tax law to the side, the simplest, most mechanical method is to guess in years the expected lifetime of the guitar, say ten years, and depreciate it equally over each of the ten years. If the depreciation rate is 10% per year it would yield a depreciation of $80 per year or a little less than $7 per month. Of course the method doesn't track the actual evaporation, which may be uneven---rising as a percentage of the asset value as the guitar gets older, say (this would be very true of cars, for example).

The difference between consumption and investment has important implications beyond accounting. When you buy an ice cream cone, all you care about is the immediate situation: sweet gratification. You pay for the ice cream and eat it before it melts. But when you make an investment, such as buying a car or a guitar (or a college education), you have to think ahead and consider the future. Will you still want to play the guitar two years from now? Will you still be earning enough to make your car payments three years from now? In other words, the financial constraints associated with an investment purchase often stretch out over many years.

Concept Check 6: Paul says, "I have a good $200 suit that I'll use over the next four years when I go to job interviews and church." Is that an investment or consumption purchase?
Concept Check 7: Paul says, "You say I'm just shuffling my assets when I make an investment, like when I buy a car (more car in exchange for less cash). But my wealth will not stay the same if I buy a new car, since it'll be worth less as soon as I drive it off the lot. In that case my wealth goes down when I make the investment." Set Paul straight.

Roderick: Yo, Paul-you gonna buy the Gibson or what?

Paul: [Laughs] Ask me later.