Wednesday, January 2, 2013

From Mercantile Exchange to Railroads

We're looking at Double Entry: How the Merchants of Venice Created Modern Financeby Jane Gleeson-White, starting here.

So double-entry book-keeping served as a foundation stone of capitalist rationality and, on an individual level, business success. Luca Pacioli's advice would echo through generations of clerks laboriously maintaining ledgers.

In Pacioli’s view, three things are needed by ‘anyone who wishes to carry on business carefully. The most important of these is cash or any equivalent, according to that saying, Without this, business can hardly be carried on.’ The second thing necessary in business ‘is to be a good bookkeeper and ready mathematician’. The third ‘and last thing is to arrange all the transactions in such a systematic way that one may understand each one of them at a glance, ie, by the debit and credit method’. Not much has changed today.

Production and Decisions

Capitalism developed and changed in the eighteenth and nineteenth centuries, however. Book-keeping evolved into accounting. The medieval core of double entry proved durable for these new, much larger enterprises.

This vast new range of double-entry applications reflects the extraordinary expansion of business from the late eighteenth century to the close of the nineteenth, a period which saw the rise of the joint stock company (a business organisation which was funded by selling shares to investors who became partners in the venture), and marks the formative era of accountancy. During these decades, accountants transformed a mere system of recording exchanges into a method of managing and controlling business. The first signs that double entry would be equal to the task of monitoring and directing this new industrial world of factories, wage labour and large-scale capital investment were found in the north of England, in the pottery works of Her Majesty’s potter, Josiah Wedgwood (1730–95)—a factory called Etruria, named, by chance, after the ancient Italian region home to Pacioli’s Sansepolcro.

Wedgwood ran a large business that often did not make much money, for inscrutable reasons. So he decided to investigate.

During this period of scrutiny, Wedgwood made an important discovery—the distinction between fixed and variable costs—and he immediately understood the implications of their difference for the management of his business.

A new form of production - large factories - led to the beginnings of cost and management accounting. This was part of a much broader evolution from a system centered on mercantile exchange to one also suited for production and accountability.

The shift in outlook required to move Pacioli’s bookkeeping system beyond its mercantile origins in an exchange economy (where it recorded the exchange of goods, owing and being owed, paying and collecting debts) to manufacturing, where the emphasis is on the production of goods (the conversion of materials and labour into products) was huge.

The growth of railroads in the mid-nineteenth century brought a whole new set of issues. They required outside investment, which both meant more audit control to prevent fraud, and clearer distinctions between income and capital, so investors could be paid dividends out of actual income.

Not only did a new form of production—factories—challenge and alter double-entry bookkeeping from the 1770s, but the financing and managing of the vast investments required to build railways during the same period of industrial expansion brought new issues of accounting and accountability.

The key accounting issue in a corporation is the amount of profit available for dividends—which means that a corporation must properly distinguish between capital and income, because profits derive from income, not from capital. This new laser-like focus on profits and dividends brought two new accounting questions to centre stage: How to calculate income or profit? And how to value assets? These questions were rarely asked before 1850 but by the end of the century they had become the major preoccupations of practising accountants.


 

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