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.