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.

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.