I have just read “The Reckoning: Financial Accountability and the making and breaking of nations” by Jacob Soll.
This is a brilliant walk though history seen through the lens of double entry accounting. Accounting is without doubt very hard work and to most people very boring but Soll shows how morally directed accounting is essential for the functioning of trade and democracy.
For most of history people used single entry accounting. In its simplest form this is a big iron chest with gold in it. The owner keeps a book and writes an entry for each payment and purchase and keeps a running balance. This way he always know hows much money he has in his chest. On the whole, if there is lots of money in the chest that is a good thing, I suspect that is the way that most of us run our bank accounts and we get by.
This method works well enough for single owner companies but larger enterprises require several people to work together. A joint stock company needs better accounting so each person knows what share of the business belongs to them.
Double entry accounting
Italian merchants invented “double entry accounting” to solve this problem. Each transactions is recorded in a day book (Journal) but then copied into two accounts. So for example, if a merchant bought 1 ounce of pepper for 1 Florin he would record in his day book,
1 January 1500 purchased 1 ounce of Pepper in the market
- Increase Stock Account (asset) 1 Florin
- Decrease Cash Account (asset) 1 Florin
The pages for recording the Stock Account and Cash Account are in big book called a Ledger. He would then “post” the two entries to the Stock Account and Cash Account by writing them in. The page for each account has a line down the middle (often these accounts are called T accounts for this reason). The left side of the page is called the “debit” column, the right side is called the “credit” column.
These words do not have their normal English meaning. They are historic, they really mean “left” and “right”, if you try to make them mean anything else you will never understand accounting.
- Debits are written on the LEFT side of a T account
- Credits are written on the RIGHT side of a T account
Our Italian accountants decided that debits increase asset accounts and credits decrease them. Therefore,
- Stock Account is debited 1 Florin by writing the purchase on the left side
- The balance increases
- Cash Account is credited 1 Florin by writing the purchase on the right side
- The balance decreases
And we can rewrite our example as,
1 January 1500 purchased 1 ounce of Pepper in the market
- Debit Stock Account (asset) 1 Florin
- Credit Cash Account (asset) 1 Florin
The business owners can now quickly see how much money they have in the Stock Account and the Cash Account.
Types of Account
In this example both Cash and Stock are “Asset” accounts but this is not sufficient to track all the transactions in a business, the other types of account are Liabilities, Equity, Income and Expense.
Using double entry to populate these accounts from the Journal entries means that we can very easily work out Assets and Profits.
The accounting equation is,
Assets = Liabilities + Equity + (Income – Expenses)
Assets appear on the “Balance Sheet” and (Income – Expenses) is the “Profit and Loss” report.
Every transaction generates a debit (entry on the left side of ledger) and a credit (entry on the right side of a ledger) therefore consideration of the accounting equation and shows us that,
- a debit (increase) to an asset account implies
- a credit to a Liability account will increase its balance
- a credit to a Equity account will increase its balance
- a credit to a Income account will increase its balance
- a credit to an Expense account will decrease is balance
This is not obvious – it simply flows from the original definition that entries on the left of asset account increase its value and the application of the account equation.
Non-accountants easily get confused about “debits” and “credits”. To avoid this confusion is simply necessary to remember that debit = left side, credit = right side and whether this increases or decreased the balance of the account depends on the type of account.
When books are kept in this way it is easy to follow the money, management can make good investment decisions based on accurate data and fraud and theft is discouraged.
Lessons from history
History shows us that where ethical accounting is not practised, directors of companies steal from the investors, politicians steal from the people and bankers steal from everyone.
These powerful people therefore have an ambiguous relationship with accounting and accountants, because without good books they cannot make profits but good account books can prevent them stealing or misusing funds.
The author demonstrates that good accounting and good accountants are vital to protect the ordinary man in the streets and laments the trend over the last 40 years that has made the accounting industry complicit in the crimes of business and government rather than independently reporting them.
This is a fascinating read for anyone in the finance industry or, like myself, interested in the mercantile history of Europe.
Useful links on accounting
 The order of these entries “increase” first and “decrease” second is because this is an asset account. Entries in the left hand side of account pages (debits) are traditionally written first so if these were liability accounts, e.g. paying off a credit card with a bank loan, then the it would be the other way around
1 January 2016 pay off credit card with bank loan
- decrease credit card account £ 100
- increase bank loan account £100