Tuesday, January 1, 2013

Double Entry and the Modern World

I read Double Entry: How the Merchants of Venice Created Modern Financeby Jane Gleeson-White last week, largely motivated by wanting to know some of the deeper reasons behind the surface apparatus of Quickbooks, which for various reasons I have to figure out soon.

It sounds like a dry subject. But the book is historically colorful, thought-provoking and well-written. Accounting numbers rule much of our lives and way of seeing the world. But they have a history and limits and flaws.

Measurement and capitalism

She tells the story of how Italian monk and mathematician Luca Pacioli in 1494 first wrote down the methods Venetian merchants had used to keep accounts, possibly for several centuries before that. The invention of double-entry clarified notions of cost and profit. According to some historians perhaps it led to capitalism itself.

In six pages Sombart set out his belief that the emergence of capitalism and the appearance of double-entry bookkeeping in the thirteenth century are causally related. He wrote: ‘It is simply impossible to imagine capitalism without double-entry bookkeeping; they are like form and content.’

Weber’s definition of a ‘capitalistic enterprise’ is derived from the concepts of double-entry bookkeeping: ‘a rational capitalistic establishment is one with capital accounting’. Like Sombart, Weber argues that double entry is significant because it makes possible an abstract measure of income and expenses—and therefore enables the calculation of profit, the key component of capitalistic business practice. Weber also believed that the formal rationality of double entry made the world a cold and disenchanted place—and, ominously, predicted that double entry would continue its rule ‘perhaps until the last ton of fossilized coal is burnt’.

The new double-entry methods caused a deeper change in perception:

He calls Pacioli’s treatise on double-entry bookkeeping ‘a major innovation in economic history’. First, because double entry provided the means of discarding all information extraneous to decision-making, leaving behind only numbers. And second, because it translated these numbers into a common measuring tool called ‘profit’, which allowed a relatively precise evaluation of actions. Double entry thus transformed business books from mere memory aids into records which allow the calculation of profit—and which can therefore be used to measure the success of each individual transaction and of a business generally.

But this did not come without a price.

We are now so familiar with this once innovative (and largely arbitrary) cost-benefit way of thinking that we take it for granted and cannot imagine it otherwise. And yet, as we shall see, this profit-driven way of thinking encouraged by double entry is not only driving managers to drink, academics to pull their hair out, politicians to short-term opportunism and most human beings to suffer in some way, but it is also destroying the world beneath our feet.

She argues that accounting is poorly suited to count environmental damage, for example. This is a problem when accounting has become central to the practice of policy and government.

National statistics

One of the main extensions of accounting is modern national income accounting. It is so familiar (at least if you have studied economics) that we forget how relatively recent it is. Keynes and Kuznets largely invented it, and both were skeptical about its use.

As a thinker of great depth and complexity who saw economics above all as a moral practice, Keynes was suspicious of statistics and considered these quantitative measures of the national economy as exceptional, emergency measures demanded by the times. In the budget speech which presented these accounts for the first time, the British Chancellor expressed the same view, stressing that the publication of official estimates of national income and expenditure should not be regarded as setting a precedent.

That did not stop a massive increase in the use of techniques which had proved useful during the war.

In 1952, very few statisticians were familiar with the theory and practice of national accounting. This would soon change irrevocably. The work done by Stone, Kuznets and others became the foundation of international accounting, and their national income statistics used to measure economic growth would soon become the key indicator of national success and government performance.

But even the main originator of much national income accounting was skeptical of its application.

But the accuracy and usefulness of national income measures have been questioned from the beginning, by Keynes and others, including Simon Kuznets himself. For example, Kuznets believed the national accounts should include the value of unpaid housework, despite the fact that including this vast contribution to the national economy would present statisticians with the difficult task of making monetary estimates of this valuable work. The US Commerce Department refused to calculate these estimates—and as a result Kuznets broke his association with the department in the late 1940s. Kuznets was also concerned about the effects on people’s lives of the modern economic growth that these statistics encourage as an end in itself.

GNP continues to be questioned as an adequate measure, most significantly recently in the Stiglitz-Sen-Fitoussi study.

Perpetual scandal

The numbers can often conceal as much as they convey, and we can mistake a false impression of precision for truth. The numbers sometimes are outright lies, for one thing. Accounting is also inseparable from scandals, she says, and always has been. People have not lost confidence in accounting despite failure to detect fraud or indications of problems on a litany of cases from Enron to Worldcom to RBS.

However, not only has no such fall ensued but it turns out that these accounting scandals are a regular feature in the landscape of accounting. They are as old as the profession itself, dating back to the earliest days of the formalised use of collective capital: the corporation. Corporations and accounting scandals go together like Gordon Gekko and greed. The nineteenth and early twentieth centuries are rife with corporate collapses of the magnitude of Enron’s and comparable in their elements. And they all stem from significant accounting misstatements orchestrated by influential senior managers. Equally, the responses of lawmakers and watchdogs have been the same over the past one hundred years: tinker around the edges of the law, found new watchdogs, proclaim a new era of greater scrutiny and let accountants and auditors out to play with the managers of vast sums of other people’s money.

We'll look at more tomorrow.


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