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.

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.

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.

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.

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.