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.

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.

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.