JANUARY 6, 2013
FINANCIAL STATEMENTS TELL A STORY. Depending on the circumstances, including the underlying motivations of the author, the accounts of an industrial company or a financial institution or a high tech start-up or a national government can be crafted to serve as either a biography, a fantasy, a romance, or a mystery. Too often, though, the four principal financial statements that drive modern financial markets — balance sheet, income statement, cash flow statement, and statement of retained earnings — are as impenetrable as the pristine copy of Finnegans Wake that sits unread on so many bookshelves around the world.
The practice of accounting that has developed over the past 600 years, as well as the highly remunerated professionalization of accountants over the past 150 years, is driven by a deep-seated human desire to measure things. As Joseph Stiglitz once observed, “What we measure effects what we do, and better measurement will lead to better decisions, or at least different decisions.”
Jane Gleeson-White’s survey of the history of accounting and the challenges it faces today, Double Entry: How the Merchants of Venice Created Modern Finance, draws a series of interesting and interconnected conclusions about both the early successes and the recurring failures of attempts to systematically reduce the hurly-burly of real-time economic activity to numerical form.
Her story begins in earnest during the Renaissance, a period when unprecedented successes in commerce in northern Italy were supporting and promoting grand artistic and literary endeavors. A few decades after the fall of Constantinople and the final demise of the ideal that was the Roman Empire, math teachers in Italy began to turn their attention to the practice of double-entry bookkeeping that had taken root in Italy in recent years. Armed with the recently arrived Hindu-Arabic numbers that would soon usurp the more cumbersome Roman numerals that still held sway in Europe, these practical mathematicians were led by Luca Pacioli, a monk whose impact on accounting can still be seen and felt to this day.
Pacioli set in motion a revolutionary change in how economic activity was viewed by its practitioners and by the world at large. In 1494, he published the first systematic explanation of the “Italian method” of double-entry bookkeeping, where every transaction is recorded twice, first as a credit and then as a debt, and ultimately all transactions can be reconciled together and the overall health and well-being of the business can be measured and judged. Pacioli quickly gained international fame and his work was translated into many other languages.
Gleeson-White explores the birth and initial triumph of double-entry accounting with sharp attention to the cultural and historical context of the times, and follows it briskly through subsequent centuries, as its acceptance and expansion steadily continued. When the industrial revolution arrives and the corporation appears on the scene as this new era’s vehicle-of-choice, Gleeson-White shows in concise and compelling detail how the “Italian method” of accounting evolved from its roots in simple trading and exchange to embrace and describe the minutiae of industrial production at a level of detail and with an analytic power never seen before.
The adoption of limited liability corporations as the dominant business form of the past 200 years was not inevitable. Many of the flaws of the corporate model remain as clear today as they appeared when the adoption of the first corporation statutes were being emotionally debated in parliaments across Europe. Accounting, however, accepted the challenge that the industrial corporation put before it and adapted itself effectively and efficiently to its peculiar needs. In particular, accounting enabled corporations to better tell their stories in a way that investors (and nervous governments) thought they could understand.
In telling the story of the Great Depression bearing down on the West, and the application in the 1930s and 1940s of accounting’s skills and temperament to the economies of entire nations under the leadership of John Maynard Keynes and others, Gleeson-White’s particular focus is on the gradual, incremental nature of this endeavor. Properly accounting for the manufacturing of clothespins, or Internet-enabled hand-held tablet computers, is difficult enough. Attempting to reduce an economy in which millions of employees, investors, owners, and savers participate, alongside thousands of competing firms operating in hundreds of overlapping industries, is, at the very least, a very ambitious undertaking.
Gleeson-White ends by unpacking and analyzing many of the financial conundrums facing the contemporary world, still shuddering in fear and confusion from the global financial crisis that erupted with a vengeance in 2008. The high profile corporate failures that have been so well reported recently, together with the inconsistencies and ambiguities of the accounting rules and principles that ultimately allowed these frauds and malfeasances the space and time to metastasize and grow, are described in colorful and compelling terms.
Any system that attempts to reduce countless commercial and financial transactions to mathematical certainty is inherently incomplete, a problem Gleeson-White shows has followed accounting from its beginning. Today, the question is being asked again: What exactly do financial records and statistics cover, and what do they omit?
For example, what is reflected as “capital” in the financial statements? To a Venetian trader in the 1500s, it was clear: his currency and goods, he would have said, although he probably should have included the labor that was shuttling those goods among various foreign ports. The Manchester mill owner in the 1880s understood more clearly that capital included his work force, as well as the value of the products being crafted or refined or assembled in his factories. But what is the “capital” of Apple or Facebook or Coca-Cola? Clearly, intellectual property has taken on a greater role in economic activity over the centuries. What else, though? Should more attention be put on valuing and including “environmental capital” or “social capital” for purposes of assessing the success of a modern business enterprise?
Many intuitively recognize that the value of a business that generates a 6 percent return on capital, but ends up destroying significant natural resources that cost eye-wateringly high sums to replace, is in some real and tangible way less than the value of a business that generates a 6 percent return on capital and does not cause such damage. Unless that replacement value can be quantified and integrated into the company’s financial statements, however, its impact on the narrative of the company’s performance will be lost, unaccounted for, at least for a while.
Similar arguments can be made in regards to the talisman of macroeconomic league tables, Gross Domestic Product (GDP). No less a bastion of conservative, free-market inclinations than the frenetic former French president, Nicolas Sarkozy, realized that GDP was a frustratingly crude measure for how well a country was actually doing at any given time. He went so far as to launch a commission to consider alternatives to GDP as a measurement tool for countries in the 21st century.
According to Sarkozy, “[T]he global economic crisis and fluctuating commodity prices of recent years have laid bare both the deficiencies of our accounting structures and our dependence on finite and fragile natural systems.” For answers to this dilemma, Sarkozy turned to Nobel laureate Joseph Stiglitz.
Stiglitz and the French commission issued their report in September 2009, and the criticisms they made against GDP are the same that have followed accounting over the centuries. What gets measured and included in the records and any subsequent calculations provides an incomplete picture, while what is left unmeasured gets temporarily lost from the storyline.
The ambitions of accounting are not modest. Telling a fair and accurate story about complex commercial and financial relationships, in a systematic and readable manner that can be understood by a wide range of interested persons, is no simple task. This difficulty is obviously compounded when businesses, banks, and countries use the available gaps and leeway in the system to hide their weaknesses and fragility from the world, knowingly creating fictions in their financial statements.
The gap between the complexity and ambiguities of the real world and the representation of that world on the page through words and figures will never close completely. However, understanding the nature and extent of that gap can and has been refined and increased over time, and this should remain a high priority for both reformers and champions of the current free market system.
Gleeson-White’s historical approach to these questions gives the reader a broader context in which to consider the temptation of dishonesty that resides within this gap between the real world and its written representation. To the extent that financial statements are created to obscure a story rather than clarify it, all who read and rely on these accounts will be at risk of drawing false conclusions. Understanding how these challenges have been a recurring feature of accounting since its earliest days will help users of financial statements to continue to update and revise the rules of accounting to ensure that they can be as effective in their contemporary use as possible.