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.

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.

13. Daily Account Balances

In the preceding post, the production of a trial balance on a daily basis was proposed. By simply using the power of the computer to add a few numbers together, a complete trial balance should be available as soon as the business transactions are recorded. It was also shown how to-date earnings and other information could be produced at little or no cost from this trial balance.

A trial balance, however, has the formality of being part of the official quarterly report preparation process and, since we are just trying to get critical information quickly to the company’s executives, we get dispense with formalities and just talk about producing real information on a real-time basis. Balance sheets, trial balances, and income statements aren’t as important as the information contained in them, and we can produce that information as easily as the dashboards in our car produce current information about speed and mileage. There is no reason why every detail of a company’s financial data could not be made available to corporate leaders on a daily basis.

The general ledger is made up of accounts; each account has entries in it that represent deposits (debits) or withdrawals (credits); and each account has a balance that represents the sum of the deposits and withdrawals. The account balances of the general ledger are really all that is needed to easily produce the information found in the formal GAAP reports.

Because this is the twenty-first century, we can assume that the general ledger is automated and that the entries in each account are recorded by a program. As easy as it is for the program to record the entry, it can also keep the running balance of the account, adding a ten dollar debit entry could automatically update the running balance ten dollars in the debit direction. An automated running balance means that the balance of every account in the General Ledger (representing all of the financial data in the company) is available to us as quickly as the data is posted.

This means that for any company large enough to have its bookkeeping on a machine of laptop power or greater, the account balances should be always available. The account balances are the details of the trail balance that was discussed in the previous post, so we are essentially where we were in the previous post, having the ability to present all of the critical GAAP quarterly report information to executives on a daily basis (see previous post).

More essentially, it can be shown that if we have the account balances available to us, it is simply a matter of grammar school arithmetic to produce totals of assets, liabilities, revenues, expenses, and earnings (revenues less expenses).

Quarterly reports can be converted into real-time dashboard information by simply performing trivial arithmetic on the ledger account balances that should be available and current at any point in time. Greater sophistication can be made real-time by making accrual entries daily (this will be the subject of a later post).

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.