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.

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.

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.