Lean Accounting with Event Types

In a period of economic downturn, competitive advantage goes to those companies that can reduce their expenses and operate more efficiently than their competitors. The purpose of this post is to investigate how companies can reduce their bookkeeping expenses, a burden that is common to every business in existence. Can most financial recording be made simple enough that it does not require a skilled financial worker to perform the chore and can it be done with a minimal amount of data-entry labor?

For most transactions within a typical company, the answer is an obvious “yes.” This is evidenced by the use of modern Point-of-Service (POS, i.e. cash registers) that are implemented with software that automatically records the critical accounting data of each revenue transaction as it occurs. Thousands of transactions are fully recorded for the company’s accounting system with the mere push of a button by a relatively untrained clerk at a check-out counter. Many business transactions are already fully automated and are nearly costless to the business.

But, there are many other forms of business transactions than the revenue-generating operations that occur essentially within a cash register. Expenses, capital investments, depreciation, and payment of credit are just some of the transactions that cannot be handled by the modern cash register. However, as we will see, these less automated transactions can also be reduced to a minimum effort by people who have no bookkeeping skills.

How can advanced bookkeeping be accomplished by people who do not understand debits and credits? To fully satisfy all of the requirements of the Generally Accepted Accounting Practices, the only thing that a worker would have to do is enter the amount of a transaction and select the type of event that the transaction represents. The selection process would be made easy with a user interface that presents the various “Event Types” in an intuitive and foolproof manner.

Hidden within each “Event Type” would be the identity of the accounts that are credited and debited. The person doing the bookkeeping could be an untrained clerk who has been given a simple introduction to the few Event Types that are affected by his role in the company. The selection of debit and credit is transparent to him, making the bookkeeping process simple.

The person entering data would also have control to set the date, but the default of the current date would suffice in the vast majority of cases. The Event Type would supply a default note about the transaction, which the user could also edit at his own will.

In summary, very advanced bookkeeping could be performed by the unskilled by simply selecting the type of the event and entering the amount. The particular Event Types and the accounts that they affect could be tailored to fit any business model in any industry. The resulting effect of the use of Event Types would be to reduce the most challenging bookkeeping operations to an operation requiring less skill than the operation of a cash register.

21. Finance is all about Flow

Essentially, double-entry bookkeeping is a process by which business entities track the flow of resources from one place to another. However, because accounting reports were developed when computational tools were limited or nonexistent, they do not report a measurement of this all important flow.

Contrary to myth, the recording of each transaction in two places is not a method of error checking; each of the two data entries of an accounting transaction has a specific meaning that allows businesses to maintain a record of their dynamic activity, rather than mere static positions. The two entries of double-entry bookkeeping, of course, are called “credit” and “debit.” The credit entry represents a withdrawal from the source of the transfer and the debit entry represents a deposit in the transaction’s ultimate destination. By entering both the credit and debit ends of resource transfer, the bookkeeper is actually producing a complete record of a movement of financial resources, a “flow” of resources from one place to another.

The standard GAAP reports are all produced from the balances that remain at the various source and destination accounts. With the exception of the Cash Flow Statement, they do not report the important record of what is originally recorded by the bookkeeper – the actual flow of resources that occurs between various accounts. This is surely a product of the crude and limited computational tools that were available to the originators of the reports. Perhaps with the recent invention of the Cash Flow Statement, however, this limitation is beginning to change.

The Cash Flow Statement represents a leap forward in accounting practices. It reports more than the existing balances within various accounts; it actually attempts to track the flow that changed those balances during a period. The Cash Flow Statement, however, is limited to only those flows that affect the Cash account, but it perhaps points to the potentially much greater amount of information that can be produced with modern automation.

With modern automation and data structures, the Cash Flow Statement, or even a more general flow report, should be the easiest to produce. That fact that it is problematic for most accounting departments is a result of the fact that financial reports are produced from the resulting balances in accounts rather than the potentially trivial process of measuring flow by simply totaling all transactions by the combination of the account that they credit and the account that they debit.

A complete report of the total amount of flow between all of the accounts can be done easily with modern data warehouse architecture and, from these total flows, we can measure the changes of balances that they cause and thereby produce all of the other GAAP reports. Furthermore, we can keep a database of daily flows that would allow us to produce dynamic reports for arbitrary windows of time, rather than the current practice of generating reports for specific periods only.

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.