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.

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.

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.

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.

3. Double-Entry Bookkeeping

Double-entry bookkeeping allows merchants to categorize historical events in such a manner that they can be quantified and numerically analyzed as a dynamic process. It preserves the before-and-after character of the events in such a manner that allows a previous financial state to be completely reproduced by the analyst.

Because of the invention of double-entry bookkeeping, financial information has become time-dimensional, giving us historical snapshots that can be sorted and summed into the analytical forms that we know as financial statements – the headlines that produce a quick snapshot of a company’s financial flow of resources.

We can maintain a financial balance by making single-entries in a ledger, in a manner similar to how we keep a balance in our checkbooks. However, to be able to identify and analyze the changes to our financial state over time, such as we do when we determine earnings and income, it is necessary for us to record both the origin and destination of a financial movement. The origin is what we refer to as the “credited” account and the destination is what we refer to as the “debited” account. See p. 65, The Tao of Financial Information.