20. Credits are Negative Debits

This entry is a short excursion into elementary number theory, an area of mathematics that would appear to have little to do with financial data, but which, in fact, lies at the heart of very heart of the process of keeping financial records.

Historically, numbers have represented magnitudes. The quantities of sheep in a flock, fish in a basket, or wives belonging to a rich husband were all magnitudes that required the invention of numbers to communicate. As a number, quantities were expressed simply as amounts, volumes, or other positive magnitudes. They had no meaning other than as positive amounts and they could only be combined with other positive amounts to produce new positive amounts, or compared with positive amounts, resulting in a ratio that was always positive.

All magnitudes can be fully expressed as positive numbers. The number zero is not needed because there is no such thing as a non-quantity. In a like manner, negative numbers are not needed to express magnitude because there simply is no such thing as a negative quantity. Historically, this purpose of expressing magnitudes defined what numbers were and determined the boundaries of numbers that made sense.

Eventually, the number zero was added as a place holder when larger numbers became expressed with a positional notation that aligned them in columns. This first occurred in India and eventually spread to Europe and became our modern number system. However, for centuries, only the concept of zero was added to positive numbers as they continued to only represent the magnitude of quantities.

Numbers continued to exist as positive expressions of magnitude until the nineteenth century when numbers, including integers, fractions (rational numbers), and amounts exacted with decimal points (“real” numbers), all morphed into something that has both a magnitude and a direction, a very elementary one-dimensional form of what engineers refer to as a vector. Today’s numbers have the magnitude that is expressed as the size of the number and a direction that is expressed as the number’s “sign.” A modern number has a sign that designates it as a positive or negative value, the negative values being those that are less than zero.

The significance of the revolution that gave the modern number a direction to go with its magnitude is that it is far more flexible and powerful to use. Where it once could only measure positive quantities and be combined and compared to other positive quantities, it can now be used to combine and compare opposition. The electrical engineer can use formulas that work with electricity of both positive and negative charge; the structural engineer can find the resulting force that is composed of both a left and right component, and the mathematician can find a valid answer when a larger sum is subtracted from a smaller. The modern idea of a number has given our industrial society a technical sophistication that was not possible with the numbers used by Isaac Newton and Galileo.

But, in the area of financial analysis, the idea of a number remains locked in its ancient manifestation as a magnitude without direction. The numbers that move our equity markets and shake our governments are the balances of accounts that are without a sign (until when a loss is reported to a general public that fully comprehends the negative direction of a number). Financial numbers come from obfuscating algorithms that are only necessary to compensate for the lack of numeric direction and that only accountants understand. The simplest and most intuitive business concepts are made difficult and obscure because modern accounting was invented before we gave numbers direction and they remain unchanged because of traditions and practices that are long past rendering a service to the world of information.

A credit is a withdrawal and is the negative of a debit that represents a deposit. Given its proper representation as a modern number the financial balance becomes a simple and intuitive concept that opens a whole new world of information to the information starved decision-maker.

19. Inventing Double-Entry Financial Analysis

All of the financial information in the world comes from double-entry data. Regardless if we are quantifying earnings, assets, or liquidity ratios, the underlying data that is the basis of our analysis is made up of the records of double-entry bookkeepers.

Accounting has been called the “language of business.” This business for which accounting provides a language is an activity, an ongoing process of trading goods and services to others. To serve as the language of business, accounting must provide the record of an activity rather than a simple status. The activity that is measured by the financial records of accountants is the flow of financial resources from one place to another. The purchase of a retail item involves the flow of cash from a customer into the company’s assets and the flow of inventory from the company’s stocks to the consumer. The payment of an expense involves the flow of cash, or its equivalent, for a service provided the company. All double-entry data is the record of the activity of financial resources flowing from one place to another.

The “double” in double-entry is the critical tracking of the flow of financial resources. Each transactions involves the record of a withdrawal (“credit”) from one place and a corresponding deposit (“debit”) to another. If bookkeepers are only going to keep the record of certain financial balances, single-entry bookkeeping would be sufficient, but, if they are going to keep track of an activity, they need to maintain a record of the “before” and “after” images of the financial state. This “double” in double-entry provides the record of an activity – the activity known as business.

However, because of a lack of automation, the summaries of these financial flows have been historically limited to the report of static balances and the changes to those balances occurring during certain time periods. The Balance Sheet reports the surplus of deposits over withdrawals in all of the permanent accounts. The Income Statement reports the differences between the balances accrued to the revenue accounts and those accrued to the expense accounts. Each statement reports the amount of accumulation in each account rather than the actual flow that has occurred between the accounts and was faithfully reported by the bookkeeper. While the data recorded is of dynamic flows, the reports that run our economy are of static balances.

With the age of automation and the ability to more finely summarize the double-entry record of flows, we have gained some insight into financial flows. In the 1980’s, the Cash Flow Statement was introduced, showing the sources and destinations of resources flowing into and out of the cash account. However, for no other reason than the clumsy methods of traditionally producing financial reports by hand, the Cash Flow Statement has been difficult for most companies to produce. This difficulty can be simply overcome by the application of appropriate information design techniques. With modern information technology, not only can the Cash Flow Statement be produced with a trivial single database command, but the quantifying of all flow, not just cash, can be reported and analyzed.

The technique of producing a summary of all of the flows in an accounting system will revolutionize financial information in the twenty-first century. A single database query can produce a report showing all of resources that have gone from every account to any other account. This simple process can provide not only a Cash Flow Statement and all the other standard reports, but also the financial profile of the complete activity of the business. Accounting, as it is recorded, is the language of business, but now, with modern automation and wise information design, it can also produce reports that will be the language of business – the true power of double-entry bookkeeping can be unleashed by double-entry reporting.

18. Obscuring the Obvious

Accounting is an intuitive and easy to understand subject when it is taught from its original principles. Its underlying mechanics, double-entry bookkeeping, is simply the process of recording both the source and destination of any flow of financial resources. Each financial transaction is recorded as a withdrawal from some account and a deposit into another.

In addition, the formal structure built atop double-entry bookkeeping, the financial reports proscribed by GAAP, is simply the sum of deposits and withdrawals into various categories of the accounts. These categories are based upon the basic concepts of business and finance. Revenue represents the money that was received by customers, expense accounts represent payments and obligations of the company in the course of earning revenue, and the difference between revenue and expenses represents the earnings of the company. These are things that every business person already works with and that the commercially naïve can grasped easily.

However, accounting, as it is taught in schools, is a difficult subject that cannot be comprehended logically and requires large amounts of rote memorization to be mastered. Why? Because today’s accounting teachers have learned the subject through rote memorization and have therefore fail to provide students the original meanings of the subject.

For example, Accounting students are taught that debit and credit simply mean respectively “left” and “right” and that any further reading into these concepts is unproductive. The bookkeeper must enter a “left” entry someplace as well as a “right” entry someplace else. Having no other meanings to guide him, he must memorize where to make the left entry and the right entry for every type of business transaction that the company enters into. In fact, debit has a Latin origin which specifies it as the destination of a flow of resources and credit, in turn, indicates the source of the flow.

This confusion is compounded by the so-called “accounting equation.” The accounting equation is, in fact, mathematically incorrect and its imprecision further obscures the bookkeeping process and the ultimate meaning of the data produced by bookkeepers and accountants. One of the unfortunate products of the accounting equation is that, like any equation, it has an equal sign with various terms on each side of the equal sign, and bookkeepers are told that the side of the equal sign that a term is on determines when to make the “left” and “right” entries for a transaction. Not only is the poor student required to memorize when to left and when to right, but he must memorize where an account is within the accounting equation to change left to right and right to left. In reality, the left entry indicates a deposit of resources and this meaning never changes. Likewise, the right entry indicates a withdrawal, regardless of the erroneous equation. See http://accounting-equation.blogspot.com.

These are the beginnings of serious obscurities that have kept the all-important financial data produced by accounting from investors, managers, and other resource allocators. We can make these concepts simpler by returning to their original meanings and doing so will make our economy more efficient while not changing the fundamental mechanics of double-entry bookkeeping.

17. Ancient Data Warehousing

Although it only now has become a common term as the core of business intelligence, the practice of data warehousing has been with us for over five-hundred years. Since the early Italian renaissance, merchants have kept databases of their business transactions wherein each transaction was related to the critical dimensions that characterized its type and the effect that it had on the business.

More specifically, each transaction, representing a transfer of financial resources from one place to another, was related to the source and destination of the transfer. Each transactions was related to the place from which it was withdrawn and the place to which it was deposited in what has come to be known as double-entry bookkeeping. The record of the withdrawal was referred to as the “credit” entry and the record of the deposit was referred to as the “debit” entry.

Like all data warehouses, each of transactions was also related to the date of its occurrence, allowing the merchant to sort and sum the transactions to measure the activity of the business during given periods of time. Furthermore, the financial state of a business could be determined by summing the deposits to a given account, then summing the withdrawals from the same, and finding the account’s “balance,” or state, by subtracting the withdrawals from the deposits.

This process of relating transactions to its critical factors (“dimensions”) and summing the transactions according to these critical factors is exactly how a modern data warehouse is used. The data warehouse, the central focus of the field of business intelligence, is universally implemented as a multidimensional database. The multidimensional database, like the bookkeeper’s journal, is made up of chronologically ordered records that represent business transactions with each transaction related to the customers, products, accounts, dates, and other “dimensions” of its existence. The data warehouse is, in effect, a journal of business transactions in the same way that the accountant’s book of original entry (his “journal”) is.

So, what is the difference between a traditional bookkeeping journal and a modern data warehouse? Only the existence of the SQL language (or some equivalent database query language). The modern query language, allows the user to sum and sort transactions by any combination of its many dimensions, including the transactions date and its debit and credit accounts.

Because the renaissance bookkeeper did not have modern database automation, he needed to first sort the transactions into individual databases (called “ledger accounts”) and then sort them again into rigid time frames (called “reporting periods”). Because of these once necessary and arduous sorting tasks, the business intelligence of times past was slow, expensive, error-prone, and untimely. And because we have not integrated financial reporting and analysis into common business intelligence practices, financial information has continued to be untimely to this day.

16. Flow, Measurement, and Analysis

There are three simple ideas that will revolutionize financial information in the twenty-first century. All financial information is derived from the fundamental data that is recorded by double-entry bookkeepers and reported by accountants in various GAAP reports. By going to the original meaning of fundamental double-entry data, more financial information will be produced and financial resources can be more wisely allocated.

1. Financial data has for over five-hundred years been stored in what is now called a data warehouse. The records of financial transactions in a traditional bookkeeping journal are fundamentally the same as a data warehouse, differing only because of the primitive forms of recording that existed before automation. We need to update the journal according to modern data warehouse techniques.
2. Financial data is far more intuitive and easy to understand in its original intent and has become complicated and obscure because that original intent has been lost by modern accountants. The most significant cause of this obscurity is the so-called accounting equation, which was developed with a primitive numbering system, is mathematical nonsense, and serves to make the simple concepts of finance nearly incomprehensible.
3. The primary thing that double-entry bookkeeping is doing is keeping track of the flow or movement of financial resources from one financial space to another. The GAAP reports report balances or changes in balances in those financial spaces rather than the flow. This is primarily due to the lack of automation during the development of traditional accounting. In the 1980’s, the financial world moved toward the tracking of flow with the addition of the Cash Flow Statement. This is an improvement in the right direction, but it is just a start to the real financial analysis that comes from studying the flow of all of the resources.

I have dealt with these ideas in my two books, Banking the Past and The Tao of Financial Information. Banking the Past addressed the first idea while The Tao of Financial Information addressed the last two. In following blog posts, I will summarize the powerful solutions offered in those two works. By returning to the foundation of financial information, we can profoundly increase the intelligence that we use in allocating our resources.

15. Financial History

Double-entry bookkeeping has been the traditional way of keeping track of a company’s revenue, expenses, and other financial categories for over five-hundred years. Proven by the test of time, double-entry bookkeeping is a powerful technique for recording the dynamic activity of trading wealth.

The importance of double-entry bookkeeping cannot be overstated. Because it allows the activity of trading to be accurately recorded, it actually makes trading more efficient and productive. As trading is made easier, the productivity of an economy is increased because its members are more able to exploit divisions of labor and the other comparative advantages that trading makes possible.

Why has double-entry bookkeeping been such an important part of our economic reasoning and why will continue to be in the future? Because the “double” in double-entry bookkeeping supports the recording of dynamic processes as opposed to simple static states. By relating each single transaction to two of its critical dimension, the bookkeeper memorializes the activity that occurs during a trade. Rather than just measuring the amount of wealth at a given location with single entries, double-entry measures the actual activity that occurs as financial resources are moved from one place to another.

The two entries that make up the double-entry record both the source and destination of a flow of resources (a trade). The entries record from where the resources are withdrawn (the “credit” entry) and to where they are deposited (the “debit” entry). From these two entries, enough information is recorded to allow an analyst to unwind a company’s history to any point in its existence. While a single entry may be sufficient to keep track of the balance in our checking account, two entries are necessary to keep track of the activity that creates those balances (see The Tao of Financial Information).

In later posts to this blog, double-entry bookkeeping will be explored as the foundation of our knowledge of commercial trades. Rather than question the efficacy of double-entry bookkeeping, we will show how this powerful technique can be expanded in the age of the computer to further empower the “knowledge is the business” company.

14. Daily Accruals

Accrual accounting attempts to match revenues and expenses to the time periods in which they are accrue, as opposed to the time when they are paid. For example, a machine might be purchased in one year and have a productive life of ten years. Rather than “expense” the cost of the machine during the year of its purchase, the company will accrue the expense of the machine over its expected life. With accrual accounting, the expense of the machine is matched to the ten years of its use by expensing a fraction of the machine’s total cost each year as it slowly “depreciates.”

For the bookkeeper, accrual accounting means that a single large expense transaction, such as the purchase of a machine, is recorded not once when it occurs, but many times as fractions of the total expense are “matched” to a time periods of the machine’s life. The machine with a useful life of ten years, purchased at, let’s say, $100,000.00, could be expensed as a cost of $10,000.00 per year over its ten year life (this assumes straight-line depreciation and no salvage value). At the end of the ten years, the total expense of the machine, the $100,000.00, will have been fully expensed.

If the company only reports its expenses once a year, each year of the machine’s life will cause the bookkeeper to enter one transaction recording the $10,000.00 expense for that year’s depreciation. On the other hand, if the company wants its financial information to be more current, it might report its expenses on a quarterly basis. Since there are four quarters in a year, there would be forty quarters in the ten-year life of the machine. The bookkeeper would then have to produce forty accrual entries for the gradual depreciation of the machine, one expense entry of $2,500.00 for each quarter of the machine’s life. This quarterly reporting schedule has all of the advantages of the annual schedule in that, if someone wants to know the amount of depreciation for the whole year, they can simply ask a computer to sum all of the accrued expenses for the four quarters of the year. The arithmetic operation of addition is quite easy for a modern computer.

If we take this reporting schedule even further to provide daily reports to our information-starved executives, we need to produce accrual transactions each day of the ten-year period. This is possible with modern automation because the bookkeeping labor can be automated, allowing the entries to occur automatically each night of the machine’s life.

A daily accrual schedule offers the company the advantage of having an accurate daily expense report (and therefore, accurate daily earnings and balance sheets). In addition, the computation of the amount of accrual for a quarter or year can be accomplished by simply summing the appropriate daily accrual entries.

Most importantly, with daily accruals, a clever financial analyst could produce reports for particular weeks, months, or even sales periods without regard for any rigid fiscal reporting schedule. By having a busy executive simply enter the beginning and ending points of time, a computer program should be able to produce complete financial information about the intervening period.

13. Daily Account Balances

In the preceding post, the production of a trial balance on a daily basis was proposed. By simply using the power of the computer to add a few numbers together, a complete trial balance should be available as soon as the business transactions are recorded. It was also shown how to-date earnings and other information could be produced at little or no cost from this trial balance.

A trial balance, however, has the formality of being part of the official quarterly report preparation process and, since we are just trying to get critical information quickly to the company’s executives, we get dispense with formalities and just talk about producing real information on a real-time basis. Balance sheets, trial balances, and income statements aren’t as important as the information contained in them, and we can produce that information as easily as the dashboards in our car produce current information about speed and mileage. There is no reason why every detail of a company’s financial data could not be made available to corporate leaders on a daily basis.

The general ledger is made up of accounts; each account has entries in it that represent deposits (debits) or withdrawals (credits); and each account has a balance that represents the sum of the deposits and withdrawals. The account balances of the general ledger are really all that is needed to easily produce the information found in the formal GAAP reports.

Because this is the twenty-first century, we can assume that the general ledger is automated and that the entries in each account are recorded by a program. As easy as it is for the program to record the entry, it can also keep the running balance of the account, adding a ten dollar debit entry could automatically update the running balance ten dollars in the debit direction. An automated running balance means that the balance of every account in the General Ledger (representing all of the financial data in the company) is available to us as quickly as the data is posted.

This means that for any company large enough to have its bookkeeping on a machine of laptop power or greater, the account balances should be always available. The account balances are the details of the trail balance that was discussed in the previous post, so we are essentially where we were in the previous post, having the ability to present all of the critical GAAP quarterly report information to executives on a daily basis (see previous post).

More essentially, it can be shown that if we have the account balances available to us, it is simply a matter of grammar school arithmetic to produce totals of assets, liabilities, revenues, expenses, and earnings (revenues less expenses).

Quarterly reports can be converted into real-time dashboard information by simply performing trivial arithmetic on the ledger account balances that should be available and current at any point in time. Greater sophistication can be made real-time by making accrual entries daily (this will be the subject of a later post).

12. Daily Balance Sheet

In the preceding post, I proposed, as a thought experiment, the daily closing of the books, allowing for a computation of the earnings reports on a daily basis. Let us extends that thought experiment a little further and propose that a balance sheet, summarizing the financial position of the company, be produced on a daily basis.

With modern automation, all of the arithmetic of producing a balance sheet should take only moments and be relatively costless. It can be set to go off automatically, immediately after all of the day’s transactions are posted. To make the job easier, let us propose that we do not even have to close the books to prepare the balance sheet. We can, for example, obtain our up-do-date financial position from a daily “trial balance.”

The trial balance will give us an intact summary of critical parts of our financial position. For example, directly from the trial balance, before any accounts are closed, we can obtain the amount of the assets broken down by category. An accurate summary of all liabilities would also be available directly from the trial balance. What would be missing from the trial balance would be earnings information. For the earnings data to be directly in our balance sheet the closing operations would normally be performed, turning our trial balance into a true balance sheet.

However, our daily trial balance would include the balance of every account in the ledger and a complete and accurate earnings summary could be produced in milliseconds by simply adding the balances of the revenue and expense accounts together. Therefore, in effect, our trial balance could produce all of the information in a true balance sheet as well as the earnings data normally found in the income statement, without the closing of the books.

In summary, all of the data found in quarterly reports could be generated on a daily basis by simply summing the balance of each account and putting it into a trial balance. This, of course, could be done without closing the books. The key to producing real-time financial data in the age of automation is to simply allow a trivial computer program to perform addition on ledger accounts each night as soon as the day’s transactions are recorded.

11. Daily Closings

Let’s consider the idea of closing the general ledger on a daily basis. I propose this idea as a thought experiment only, intended to open minds to new ideas and perhaps provoke further discussion. This is not suggested as the optimal solution on maximizing financial information available to corporate decision-makers

The closing of the books involves summing up the so-called “temporary accounts” (revenue, expense, and dividend accounts) and transferring their balances to the retained earnings account. This is typically done at the end of a business period, allowing the bookkeeper to determine the earnings for the period and leaving these temporary accounts with a zero balance to begin the next period accumulating new earnings data.

Since most corporations use the closing operations to prepare their income statement and other periodic reports, the closing operations determines the reporting period. Valid reports are only available after the period’s closing operations and the only reported metrics available are for the period itself. It is hard to imagine how important financial information is reported in such a limited and rigid manner in today’s age of automation, but the method was designed in the middle ages when addition was done with beads and the practice has been dogmatically accepted as necessary regardless of the mounting evidence of its archaic absurdity.

If we choose to continue the process of closing the books before preparing the reports, let us now consider amplifying the amount of information available and increasing its timeliness by closing the books every day and then producing earnings reports for each day.

Since we are working with computers, the closing operations can be easily automated to kick-in at midnight each day and run at little or no cost to the company to summarize the day’s activity. This means that every day the people who run the company could have daily earnings statements as well as more detailed reports on specific types of revenues and expenses. The effects of marketing plans, weekend sales, and work interruptions could be easily gauged just as they happen, allowing the alert helmsman to adapt his company by quickly making necessary corrections and adjustments.

But, if the temporary accounts begin each day with a zero balance, how would a company ever be able to produce a quarterly earnings report? Simple, the earnings for one week is the sum of the earnings for each day of that week; the earnings for a given month is the sum of the earnings for each of its days; and the earnings for a quarter can easily be produced by summing the appropriate daily reports.

Therefore, there is no reason why account closing must await the end of a fiscal period. For the company unwilling to forego the whole wasteful process of closing the books, the process of doing daily closes is a simple way of freeing financial information from the limitations of a rigid fiscal period.

10. Financial History

The financial history of a company is potentially its primary source of business information. It can easily be expanded to provide more information on a much timelier basis. It even can be used to formally measure the rates of change that are occurring in the company (true “financial calculus”).

However, before the financial history of the company can be a truly useful tool for investors and managers, it needs to be unfettered from the constraints of the traditional accounting model. Today’s accounting is limited by its attachment to the fiscal period and its inability to adapt itself to the specific informational needs of the company. Neither of these limitations is necessary in the age of the ubiquitous computer.

We need to rediscover the fundamental information of a company’s financial history – the record of simple transactions in the bookkeeper’s journal. By exploiting this information in its fundamental form, a company can use its experience of the past as a powerful analytical tool that will guide it and its investors into the future. See Banking the Past, page 218.

9. The Journal

The journal, the accountant’s “book of original entry,” is the chronological record of the financial events of the business. The events, referred to as transactions, are recorded in the journal as a financial quantity and the relationships that this quantity has components of the company. Within the journal, all of the data that is every used by accountants is recorded in one place. Everything other piece of data in the financial world is simply a copy or a summation of the data found in the journal.

From the primitive information found in the journal, accounting is able to generate new information that tells managers and investors:

1. The total income that was made by the business in a new given time period;

2. The total assets and liabilities of the business at a given point in time;

3. The flow of the company’s cash assets during a given time period;

4. The relative growth of the business during a given time period.

Given a journal, and no general ledger, an automated program is able to produce all of the data used in financial analysis. And, without the burden of a general ledger, the journal can produce this information for any arbitrary period of time.

See Banking the Past, page 43.

8. The Virtual Fiscal Period

We measure business success by unit of time. Earnings and cash flow, for example, are a business’s most important measures of success and they can be expressed meaningfully only as amounts per quarter, month, year, or some other unit of time. Business is an activity and its failure or success can only be measured by the rate of activity through a period in time.

The activity of a business expands and contracts from year to year, quarter to quarter, and even day to day, however, the critical financial measures of a company’s activities is currently only available on a quarterly basis. This schedule of measurement does not allow the company to gain insight about the effects of sales and marketing campaigns, for example, which occurred during certain weeks of that quarter. Determining which weeks were the best during the quarter, or which days of the week brought the best revenues, or how much better revenues were during a particular campaign, are all critical pieces of business information that are typically not available to a company. Financial reporting is limited to a fixed fiscal period and the only unit of time that can be report on is the company’s official fiscal period (typically a three month quarter).

Almost important as the rigidity of measurable time unit is the delay in reporting. While decision-makers are desperate for information, they must often wait months for a report on the company’s earnings and cash flow to help guide them in allocating resources.

This critical limitation of financial reporting by time unit is simply not necessary and is a product of a reporting technique that is five-hundred years old and was designed to assist the manual bookkeeper who worked with quill and parchment and without the assistance of even a slide-rule. In today’s computer age, earnings can be speedometer on an executive’s dashboard that is providing him with a real-time view on the activity of the business and the changes that they are causing.

A company’s dependence upon a rigid quarterly report is based upon the use of database known as the general ledger that performs the simple algorithm of sorting transactions so that an ancient bookkeeper can manually perform addition upon the transactions that affect each account. This sorting can be done in seconds with the modern computer and the general ledger can now be a simple algorithm that provides, upon demand, the same information as the stored database (see the previous post where this algorithm is referred to as a Virtual General Ledger).

As a process, rather than a stored database, the virtual general ledger can produce earnings and cash flow statements for any day, month, year, or other period of time that the user is interested in (he can produce fiscal periods from deep in the past as well as to the current moment). In other words, the virtual general ledger provides the business executive with a perfectly accurate virtual fiscal period.

See Banking the Past.

7. The Virtual General Ledger

Each of the Entries made in the Journal must be posted twice in the Ledger, one
to the debit and the other to the credit.
Luca Paciolo, Particularis de Computis et Sripturis

The general ledger, or just “ledger,” is made up of a set of accounts, each account representing a source or destination of resource flows within a company’s accounting system. The information in each account is a repetition of the information that has already been recorded in the accountant’s journal. The duplication of information in the general ledger allows the balances of each account to being manually computed. By copying the amounts of each transaction into the account that it is related to, the human bookkeeper needs to only go to the account to be balanced and add up the sums recorded therein.

For example, a transaction is first recorded in the journal with a note that the transaction has a credit (source) effect upon the revenue account and a debit (destination) effect upon the cash account. After this initial recording, the details of the transaction’s record is “posted” to the general ledger by copying the transaction amount to the credit column of the revenue account and then copying the same amount to the debit column of the cash account. When the bookkeeper wants to find the balance of any account, he adds up its debit column and its credit column and the difference between the two sums is the account’s balance (the net balance can be a debit balance or a credit balance, depending upon which sum was greater).

However, using the fundamental principles of software engineering, the general ledger should be an algorithm, a series of steps that are performed by a computer program, rather than a separate database containing data that is already recorded in the journal. The reasons supporting this statement include the following:

1. The general ledger helps with the manual computation of balances; it serves no similar purpose for automated computation.

2. Duplicating the same information in more than one place violates the most fundamental principles of information design (keeping backups of data on tape and other media is not relevant to this argument).

3. The finding of an account balance is a matter of first sorting and then summing data. The traditional general ledger performs the function of the sorting part of this process. Modern computers can do this sorting almost instantaneously and without cost. Therefore, to have the data in a pre-sorted state is of no economic value. Determining account balance is efficiently a simple algorithm that first sorts and then sums.

4. The maintenance of a general ledger as a separate database performs no other function on the computer than to place an artificial boundary upon the data, limiting its availability in both time and semantics. The general ledger limits the data to the time of a single fiscal period and it limits the various ways that the data can be correlated with other dimensions of the transaction, such as business units, products, customers, etc. (this will be detailed in the next post here).

The general ledger should be, by this analysis, virtual data. Modern accounting practices should use the power of the automation to make the general ledger a Virtual General Ledger, implemented as a program that sorts and sums the data already stored in a powerful database.

See Banking the Past.

6. The On-Demand Cash Flow Statement

The cash account should always have a debit balance or be equal [zero balance].
Otherwise, the account will be in error.
Luca Paciolo, Particularis de Computis et Scripturis

The Cash Flow Statement is nothing more than a summary of activity in the company’s cash account. It summarizes how the cash account was debited and credited by the company’s operating, investing, and financial activities during a particular period of time. The debits are referred to as “input” in the report while the credits are therein referred to as “output.”

Typically, a Cash Flow Statement, like an Income Statement, summarizes activity for a particular fiscal period. However, unlike the Income Statement, the Cash Flow Statement does not require that the company’s books be closed before its preparation. This means that, although the Cash Flow Statement summarizes a time period, it is not locked into the constraints of a fixed fiscal period such as the Income Statement is. A Cash Flow Statement could, theoretically, be prepared at any time without the closing of the books and the use of temporary accounts that exist only for the company’s fiscal period.

The Cash Flow Statement could be prepared on a weekly, monthly, or even daily basis. The only impediment to this powerful ability to create useful information is the intensive labor that is required to create the Cash Flow Statement and the only solution to this impediment is to store all of the financial transactions in a data warehouse. A Cash Flow Statement for any time period desired can be prepared effortlessly in seconds with a simple command to a well-designed financial data warehouse.

The use of a data warehouse to back up an accounting system (or be the accounting system) is the key to producing real-time financial statements for arbitrary time periods. This fact is most apparent in the case of the Cash Flow Statement and its growing importance within the company. See Banking the Past, p. 169.

5. 21st Century Financial Computation

At a very early stage in human history, then, we have encountered the
fundamental currency of the capital markets: information.
William J. Bernstein, The Birth of Plenty

The computer is a tool that the accountant can use to do accounting, but it is such a powerful tool that, to use it wisely, the accountant needs to step back from his profession and take a second look at how accounting solves its problems, why it solves them that way, and how the new tool may actually change the way that problems are solved.

The computer offers the accountant brand new ways of doing the things that he has been doing basically the same way for over five hundred years, and, if these new ways of doing things are accepted, it will not only be more efficient, but will also provide businesses with new kinds of information.

Currently, the prevailing paradigm of accounting is limited by the past and the techniques that were formed by the tools of the past, but the computer expands the horizons of the adventurous thinker, removing old limitations and providing new opportunities. Rather than use a new tool to do an old solution, the accountant can use the new tool for new solutions, and, in the process, discover new opportunities for creating business intelligence.

4. Virtual Balances

The smallest operations can now afford financial control programs that
account for their finances with greater speed and sophistication that even the
largest corporations could have achieved through their production hierarchies a
few decades ago.

James Dale Davidson and Lord William Rees-Mogg

Financial sums are most essentially the finished product of an arithmetic process. For example, the balance of a particular account is really the result of adding all of the deposits (debits) and subtracting all of the withdrawals (credits). It is just a matter of addition and subtraction, an operation that humans do laboriously and erratically but which is done effortlessly and flawlessly my machines.

The same can be said for the other monetary amounts that we use to determine the value of a business and its success or failure. Income is the sum of all of the revenues and expenses that occur to a business during a given period of time; the term “assets” is the sum of all of the resources available to the company; and the term “retained earnings” is the owner’s book value based upon the simple sum of the company’s assets and liabilities (liabilities are actually subtracted from the company’s assets). Financial data is basically the finished product of some very simple arithmetic operations.

The importance of this observation lies in the disparity between the computer’s ability to perform millions of arithmetic operations perfectly each second while humans must struggle to do the same in many months of effort with a paper and pencil. Because of computer’s computational power, the value of the finished product of the arithmetic approaches zero. If you can perform a million operations effortlessly and in virtually no time, you can perform those same operations again and again at no cost, making the value of sums as free as air. The sums of the operations become valueless while the value of the input data to those operations (the amounts of simple financial transactions) increases in value (since they can be reused effortlessly in many different combinations to produce unique new sums).

In the twenty-first century, only the simple data that summarizes the simple atomic financial transactions needs to be stored in the computer. The sums and balances that affect our financial markets will be produced upon demand by machines that are imbued with the intelligence of how those sums and balances can be produced from the rawest of data.

3. Double-Entry Bookkeeping

Double-entry bookkeeping allows merchants to categorize historical events in such a manner that they can be quantified and numerically analyzed as a dynamic process. It preserves the before-and-after character of the events in such a manner that allows a previous financial state to be completely reproduced by the analyst.

Because of the invention of double-entry bookkeeping, financial information has become time-dimensional, giving us historical snapshots that can be sorted and summed into the analytical forms that we know as financial statements – the headlines that produce a quick snapshot of a company’s financial flow of resources.

We can maintain a financial balance by making single-entries in a ledger, in a manner similar to how we keep a balance in our checkbooks. However, to be able to identify and analyze the changes to our financial state over time, such as we do when we determine earnings and income, it is necessary for us to record both the origin and destination of a financial movement. The origin is what we refer to as the “credited” account and the destination is what we refer to as the “debited” account. See p. 65, The Tao of Financial Information.

2. Debit and Credit

Although the financial information that has so much power over our lives is ultimately recorded in the binary language of debits and credits, very few people, including many accountants, actually understand what these terms mean.

For most accounting departments in academia, it is sufficient to disregard any meaning that the inventors of double-entry bookkeeping may have intended for the concepts of debit and credit and to have their students simply memorize the position where the debits and credits are placed in the books. No regard is made for the possibility that the terms were selected by the ancients because of a true conceptual significance.

The term “debit” is derived from a Latin root that means “to owe,” while the term “credit” is from a Latin root meaning “to be owed.” As this etymology indicates, the debit of a transaction is applied to the account that receives a financial resource and a credit is applied to the account that is the source of that financial resource, the “debtor” and “creditor” respectfully.

During the time when a business is viable, the accounts that represent the resources that are available to the business, it assets, are net receivers of resources. The company has existing assets because it has received more than it has distributed – it is a net receiver and the accounts that represent what it has received typically have debit balances.

During this time of business viability, the outside world is the source of the company’s assets, either through ownership contribution, loans, sales, or some other form of internal flow of resources into the company. The accounts that represent these outside sources therefore have net credit balances, indicating that they have served as sources and, in the case of the business’s liquidation, may possibly have returned what they contributed and are owed as “creditors” or “owners.” See The Tao of Financial Information.

1. The Accounting Equation

The accounting equation, which forms the basis all of our financial reporting, contradicts the basic tenants of double-entry bookkeeping. If we follow the principles of double-entry accounting, we violate the accounting equation, and, if we follow the directions implied by the accounting equation, we violate the principles of double-entry accounting.

The accounting equation states that resources available to the business (its assets) must be equal to the claims of its financial sources (its equities). In algebraic terms, it is generally expressed as:

Assets = Liabilities + Owner’s Equity

The Assets term represents the resources available for the company to make use of, typically buildings, equipment, and other valuables. The terms on the right of the equation, the Liabilities and the Owner’s Equity terms, represent the claims of parties outside the company to the assets of the company. The Liabilities term represents the claims of creditors upon the company’s assets and the Owner’s Equity term, as its name implies, represents the claims of the owners to the assets that remain after the creditors have been satisfied. For simplicity of expression, we will combine these two terms, referring to them as the “External Claims” or, more simply, “Externals.” This leaves the accounting equation as this simple expression:

Assets = Externals

However, for the purpose of this paper, this expression is preferred because of its simplicity and the fact that the distinction between different types of external claims does not change the underlying problem with the equation itself.

The importance of this accounting equation cannot be overstated. The balance found between the two sides of the equal sign forms the foundation of the balance sheet financial statement. Furthermore, the other traditional financial statements are also derivations of this critical mathematical expression.

Despite its critical importance to the financial world, the accounting equation is invalid and this invalidity can be illustrated by a simple example of an investment made by an owner of a business. In this example, the owner of the business invests $100.00 in cash to his business. His accountant keeps track of the transaction by making an entry in his journal. Following the rules of double-entry accounting, the journal reflects the following changes to the financial state of the company:

• The Cash account is debited $100.00, and
• The Owner's Equity account is credited $100.00.

Together, these changes assure us that the balance of all of the accounts in the business are equal to zero – a debit made to the Cash account is balanced by a credit to the Owner's Equity account. Double-entry accounting assures us that the books remain in balance because every debit made to one account is countered by a credit made to some other account -- subtracting all of the credits from the debits leaves a total balance of zero. This pure balance of zero maintained on the accounting books reflects the grace and credibility of double-entry bookkeeping.

However, the accounting equation contradicts this. According to the equation, the transaction in our example should have reflected the following changes to the financial state of the company:

• The Cash account is debited $100.00, and
• The Owner's Equity account is debited $100.00.

According to the accounting equation, both accounts must be debited to properly record the owner's investment in his business and here is why:

• Again, the accounting equation states the following:

Assets = Externals

• According to the rules of algebra, the equality of the equation remains valid after I have added new terms to the equation as long as I add the same terms to each side of the equation. "When thinking about equations, consider an old-fashioned balance scale. To keep the scale balanced, whatever you do to one side must be done to the other. If you add 2 pounds to one side, you must add 2 pounds to the other." [Brita Immergut and Jean Burr Smith, Arithmetic and Algebra ... Again (New York: McGraw-Hill, 1994) p. 198] Applying this mathematical principle to the accounting equation, I can do the following:

Assets + 1 = Externals + 1

• More to the point, I can, following the rules of algebra, do the following:

Assets + Debit = Externals + Debit

• However, what I cannot do is the following:

Assets + Debit = Externals + Credit

This last expression cannot be done using the rules of algebra. We can change an equation by doing equal things to both side of the equal sign, but we cannot do unequal things to both sides of an equal sign and maintain the state of equality. But this last expression is exactly what is done in double-entry accounting, leaving us with only one of two possible conclusions, either:

1. the accounting equation is a correct application of algebra and we must abandon double-entry accounting, or
2. there is something wrong with the accounting equation and double-entry accounting remains unchallenged and as credible as ever.

We can relax in the comfort of knowing that the problem is not with double-entry accounting -- the contradiction found between it and the equation can be resolved by recognizing that it is the equation that is wrong. The expression:

Assets = Externals

appears correct only because it is comparing the quantities of the Assets and Externals and ignoring the fact that they are opposing qualities -- the Assets are normally debit in nature while the Externals are normally credit in nature. By disregarding the opposing natures on each side of the equation, accountants have assumed equality where equality has never existed.

If Assets are not equal to Externals because they are in opposing directions (debits vs. credits), what is the correct form of the accounting equation? Since debits and credits are opposite in direction from each other and cancel each other out in accounting's use of arithmetic, the proper form of the accounting equation is as follows:

Assets + Externals = 0

This expression states correctly that the two terms are equal in magnitude but opposite in direction. They cancel each other out and leave the books in the state of perfect balance at zero.

Furthermore, when we perform the double-entry bookkeeping of our example, we make the following algebraic manipulation:

Assets + Externals + (Debit + Credit) = 0 + (Debit + Credit)

which again means that, after we cancel out the effects of our debit and credit additions, we are left stating that Assets and Externals remain equal in magnitude but opposite in direction:

Assets + Externals = 0

This form of the accounting equation is correct algebraically and it supports the double-entry accounting process, assuring us that, regardless of the type of commercial transaction we record, the amount of resources available to a business is equal in magnitude to the claims upon its financial sources. The financial world remains secure in knowing that a properly maintained accounting system will always have a perfect balance – the sum of all of its accounts will always equal zero. See The Tao of Financial Information.