Debts owed you are an asset? Really?

It’s a fundamental part of accrual-based accounting, and our entire economic system depends on it. The idea that you can list as an asset not just what you actually have in hand, but what others owe you. But what happens when the debt is defaulted, uncollectable, etc.? I know that in accounting there are procedures where bad debts are written off presumably simply as bad luck like losing your wallet. But are debts owed you really a hard asset? If I loan fifty dollars to my good friend with the meth habit, can I really count the fifty dollars he owes me as an asset? It seems to me that at best you really have to count debts owed you as assets where the value owed you is multiplied by a probability of the debt being good- if someday you actually collect fine, but don’t count your chickens before they’re hatched. The ongoing gold standard thread debates the idea that fiat money is a fraudulent fiction, but if anything debt-assets seem on even shakier ground to me.

If you own a house or another building, that’s an asset–but your “asset” can burn to the ground (or be flooded). Even land itself can wind up getting hit by a prolonged drought–even a permanent shift in the climate–or some kind of environmental contamination, rendering it worthless or drastically less valuable.

If you own stock in a company, that’s an asset–but if the company goes bankrupt, your “asset” is now worthless.

Many commodities can rust, or tarnish, or be devoured by rodents–and even if they’re physically fine, someone can discover a vast new source of said commodity, reducing the value of your “asset” to almost nothing.

In short, I don’t see how debts as an asset are fundamentally different from any other asset. Certainly some assets are riskier than others; I would presume accountants have ways of accounting for that when they’re drawing up bottom lines.

The right to be paid in the future is a valuable asset. You correctly point out that under some circumstances, the face value of the debt might be more than the actual value, but it still has some value. Also, many debts can be bought and sold to third parties just like anything else.

Well, I don’t think fiat money is a fraudulent fiction, and I don’t think debt-assets are either.

First of all, the issue is what a debt owed to you is, if not an asset.

first, as MEBuckner point out, there are plenty of assets that can potentially lose value, not just bonds. that doesn’t make a debt someone owes you different.

Debts aren’t liabilities–you don’t owe the debtor anything–you’ve already paid the principal out (when you made the loan), and the possible outcomes are zero (if you get no money back), or a return. This is commonsense–if I loan you $10, there is no possible way I will owe you more money on that loan–all payments from then on will come from you to me.

And it makes no sense to call debts nothing–a bank with zero dollars in cash, but which is owed a million dollars, is very clearly better off than a bank with zero dollars in cash and no debts.

So it seems obvious that a debt someone owes you is an asset–it’s something that will be worth something to you later (and as we will see, in many cases can be sold for some value now) and the real question you raise is how it should be valued.

I think it entirely depends on the debt.

You give the example of a loan to a meth-head. That, as you rightly point out, isn’t worth much.

On the other hand, some debts are quite solid. For example, that fifty bucks I lent Warren Buffett, or the money a bank lends a reliable and solvent business, or a mortgage loan properly secured against a house of sufficient value are all almost guaranteed to be repaid.

I might (reasonably) argue most lenders would prefer to lend to those in category “b” than in category “A.” (although, in theory, it shouldn’t matter, with a proper interest rate to account for risk). From a theoretical point of view, I quite agree-a debt should be valued to take account of its likelihood of repayment.

One way of describing this is “mark-to-market” accounting–where companies have to value their assets at what they can be sold for now, not what they were worth at purchase. The idea is widely discussed–I have no idea what is required by accounting standards, but it’s a commonplace concept.

For most commercial loans, made in the form of bonds, this is done through the market. For example, you can buy a Ford bond, for $1,000 par value, maturing in 2028 (they have borrowed $1,000, and will pay it back at maturity), with interest of 6.6% for $580.

http://reports.finance.yahoo.com/z2?ce=5515249148511575917651&q=b%3D1%26is%3Dford%26so%3Dd

On the other hand, a GM bond, also 2028, a little higher interest (6.75%) goes for $111.20. http://reports.finance.yahoo.com/z2?ce=5514954147541556017548&q=b%3D1%26is%3Dgeneral%26so%3Dd

Why is this?

Risk. The market thinks the GM bond is riskier than the ford bond (shocking, isn’t it), and so it is worth less.

This points out another reason why debts owed to you are an asset-in many cases, you can sell them–you give me money now, and I give you the right to collect the $50 Warren Buffett owes me when it’s due next year. Again, the only issue is pricing.

Further, in many cases, there is a major practical problem–how to calculate the likelihood of repayment. This is (not easy, but) possible for major corporate loans. But how about John Smith, 1422 Wisteria Drive? Actuaries can give you a statistical answer-- a fairly good answer for a group of a thousand such loans. But for any individual loan, it’s much harder.

One other problem with a market-based valuation, and mark-to-market accounting–it’s affected by traders. There are two reasons to buy a bond–(1) in the hope that you can sell it for more, or (2) to wait till it’s paid off. The problem is that what we care about is (2)–the value of the bond when paid off, taking risk into account. But (1) affects the market price as well–and so mark-to-market accounting might overvalue or undervalue debts.

Not to say it’s not worthwhile–but that this is an ongoing debate in the financial community—valuing debt to take account of risk isn’t new to them.

When I read threads like this I become very disturbed that most people really don’t seem to have any idea of basic accounting or finance. Understanding these concepts is not just for corporate MBA types. If more people understood this there would be less issues with people spending themselves into oblivion.

It works both ways. Debt owed you is an Asset but debt you owe others is a Liability. It’s like this, if you have a house worth $700,000 and you took out a mortage that has $500,000 left on in, you aren’t worth $700,000. You are worth the current market value of the house minus the mortage or $200,000. From the bank’s perspective, they have a $500,000 asset which is what you owe them.

You are correct though that it does not become an actual “hard” (liquid actually) asset until you recieve cash and can enter it onto your Income Statment. That’s actually the reason that Net Income (cash flow) is considered more important than Net Worth (Assets - Liabilities). As long as you have money coming in, it doesn’t matter as much if you are in debt because theoretically you can eventually pay it down.

Now clearly cash flow can be affected if a significant amount of your revenue is generated from other people’s repayment of debt. That’s in a sense, what happened to the banks. This is typically why you should be careful about who you lend money to and not lend it out to meth heads.

Sure. For example, a US Treasury bond - if you hold one of them, that’s an asset in your hands, but it’s a debt owed to you. You’ve loaned the US Treasury the amount of the bond, and it’s promised to pay that debt back to you, plus interest.

And, it’s one of the most secure assets you can have, out-ranking other things like equities, because it’s backed by the US government, which has never defaulted on its debts.

That’s a nice post. Except the part about fiat money, of course, but we’ll leave that for another thread.

I would also note that consumer assets also sell for above par (e.g. a $100 loan sells for $115) not only because the purchaser thinks they are extremely low risk, but because the purchaser thinks there is additional value to be had…by cross-selling, or a line increase (often via debt consolidation) or some other thing.

Marketing and selling the extra stuff to that customer from a dead start might cost $30, for example, but because you already have rights to collect their loan (and thereby, have a legitimate reason to speak to them) it’s worth it for you to pony up $15 over par.

I appreciate the compliment–though I will point out that you haven’t mentioned the most common reason for securities to be sold over par–and it has nothing to do with cross-selling, or debt consolidation, or any of that stuff. (for one thing, people buying loans (outside of default) generally don’t want to deal with the burden of servicing–they want to get a check.

The reason bonds sell above par has to do with interest.

Let’s imagine we have a bond, that matures in a year, at 6% coupon. It has a face value of $100. So you buy the bond for $100 from the borrower, and a year later you get $100 principal and $6 interest.

Clearly, if there’s risk, it will sell below par–if you think there’s a 50% chance of default, it will sell for around $50.

But what if the bond is riskless?

You have to look a the market rate of interest. Let’s imagine that the market rate is 6%.

Then, you’d pay just under $100 to buy the bond in the secondary market. Why? Because you could borrow at 6% to buy the bond–if you borrowed $100, you’d break even–so if you paid a little less than $100 for the bond, you’d make a profit.

Now let’s say the market rate of interest is 1%.

You could borrow $100 for a year, and pay $1 in interest. So how much would you pay for the bond?

A little under $104.95. Why? Because if you borrow $104.95 at 1%, you owe $106 in interest and principal a year from now. You’re buying a bond that will give you $106 in total a year from now. So, again, the price you’ll be willing to pay is just below the break-even point. (even though it’s above the par price of the bond.

I don’t think I need to do the math if the market rate is 12%–hopefully, it’s easy to see how a riskless 6% bond will sell below par in such a situation.

But anyway–this effect interacts with the risk to determine the market price for a given bond (i.e. the right to collect on a given debt). Hence, bonds selling above par are (usually) relatively low-risk and have an interest rate above market.

I get all of that. Thanks for the follow up.

In extremely liquid markets for consumer securities, there are many similar strategic buyers for similar types of consumer paper, so that there is no margin to be made from the transaction you describe above.

Everybody is doing the same math, so in a robust auction the ‘winner’s curse’ will ensure the margin from interest or risk arbitrage will be competed to zero. Unless a financial buyer comes in with some special funding edge…and those are usually temporary.

The winner is usually willing to pay above the odds because they believe they can get a little extra on top from some extra angle. And cross-selling or some other ‘value play’ is usually the reason. But it’s also usually a mirage.

Now, (unlike in your first post, where you were discussing bonds selling above par), you’re talking here about why bonds sell above e their theoretical break-even price.

Of course in the real world, as you note, the bonds will usually sell with nominal profit at the then-current interest rates, But that’s no good for an illustration. However, there is plenty of money to be made in interest rate or risk arbitrage–it’s just made by predicting where the interest rate/risk of a given industry will go. To make money, you buy 6% paper for $100, and hope the interest rate drops–Although you can make money with a source of inexpensive funding, the money is really in an informational advantage.

Yes, my first post was not meant to explain why the entire premium above par existed. I was adding a little bit of extra explanation for the above-par price.

I bought and sold securities for many years. Most large strategic buyers of consumer securities do not do so to play risk or interest arbitrage. In fact, most of them have corporate policies in place that explicitly forbid them from doing that.

They need to prove to their audit committees in excruciating detail that they are doing the exact calculations you describe above, and then also need to come up with a valid reason for why they should be allowed a bit of an extra budget for a ‘strategic purpose’.

On the other hand, in my experience it’s common to not allow beginning finance students to use banks as their investment analysis project because the balance sheets are confusing. My college Investments text book had an entire chapter on how to value banks or other lending companies whose assets are primarily in the form of loans. There’s nothing fundamentally wrong with the system but I don’t think it’s as simple a concept as other people in this thread are making it out to be.

One way to look at the value of an asset is to look at typically what type of advance rate a bank would lend on it. For example, a bank might be said to typically lend an 80% advance rate against a house because most conforming loans won’t lend more than 80% of the value of the house.

For an asset such as accounts receivable, a typical bank advance rate is 80% whereas for inventory a typical advance rate is 50%. In this case, a bank is essentially saying that they trust the value of a debt more so than a hard asset. This is of course because it is more easily convertible to cash.

Looking through, I see no acknowledgement that reducing known assets by amounts determined through experience is utterly routine. The classic case of this is accounts receivable, where you may be owed money. However, you discount AR based on the time passed and your knowledge of customer paying patterns.

For example, you may only record 90% of the value of AR’s that are past three months due, and only 50% of the value of those past six months due.

Certain assets have impairment tests that are undertaken to see if any amount needs to be written off. Also, certain assets need to be marked to market.

Debts are no more vulnerable to loss than assets. Car today, none tomorrow. It’s called theft.

If someone already mentioned this and I missed it, I apologize. The simple answer to the OP’s question is that a properly developed balance sheet in which loans receivable form an important element of the asset side is a reserve for potential losses. As I recall (IANAA), this is taken as an adjustment to the asset, rather than being entered on the liability side of the ledger. Of course, these are averages and assume an otherwise normally functioning market. If those assumptions prove untrue, the balance sheet may become inaccurate. But it’s normal accountancy to assume that not all loans receivable will be paid when due. One of the main concerns of bank examiners is whether adequate reserves have been taken for potential defaults.

Isn’t that depreciation?

No. Depreciation associated with an assets declining value over time or matching the cost of items over their useful lives.

Accounts receivable (money owed to you) is an asset. Allowance for bad debts is a contra asset that is recorded as an estimation of what will not be collected. GAAP requires that for all accounts receivable, an estimate must be made at the time the receivable is recorded for the amount that will not be collected. This estimate can be made in a variety of ways. A percentage of total sales, historical rates of deliquencies, a percentage of aged receivables, etc.

Pretend you sell an item to someone for $100 on credit, and 10% of the time people dont pay. When a receivable is recorded and the allowance is made, the entries would look like this:

DR A/R 100
CR Revenue 100

(to record credit sale)

DR Bad debt expense 10
CR Allowance for doubtful accounts 10

(to record allowance)

The allowance and the A/R are typically netted together in financial presentation, so even though you sold an item for 100, you only present the asset as 90. If your discount rate or whatever methodology used to estimate the amount is greater, the asset would be reduced accordingly.

This is a long standing accounting principle.

If you loan somebody money and they do not pay it back, once you give up you can declare it as a loss on your income tax. They will then have to pay taxes on it. You will get a write off. So it is an asset.