The Accounting Equation and Risk

The following post was written and contributed by Cornelis ("Kees") A. Los, PhD, Professor of Finance. Faculty of Management, The University of Lethbridge (Alberta, Canada).

Reading your comments, it occurred to me that the "controversy" is only about how you define the terms A, L and E of the equation. Of course, it is useful to view liabilities (L) and equity (E) as negative assets (A), which is what the traditional Accounting Equation states A=L+E, thus A-L-E=0, a balance equation. What you did was defining first a balance equation A+L+E = 0, so that, in reverse, A=-(L+E) or L+E = -A. In the traditional case L and E are positive numbers, while they are negative numbers (negative assets) in your presentation.

In fact, that's how I programmed the assets and liabilities and equity of ING bank, when, as the Economic Advisor and Chief US Economist of ING bank, I proposed a financial risk management system, based on optimizing the ledger-portfolio of ING Bank in New York, using monthly departmental revenue and expense data. That project resulted in the elimination of ING bank's Chicago office, since it took too much risk and did not deliver enough return. But the Distressed Debt trading department was high-return-high-risk, while the Treasury was low-return-low-risk and that was fine, since both were lying on the Markowitz ledger-portfolio frontier.

That was a revelation to most ING bankers at that time (in 1993), since the Distressed Debt Department Head, who was also the Head Strategist of ING Bank in New York at that time, wanted to eliminate the Treasury because it did not earn enough on its invested capital. I argued that that would result in the elimination of the whole bank.....! My picture of ING Bank's ledger-portfolio frontier "saved" the Treasury of ING Bank in New York (true story!)