Double Entry

Key Takeaways

Under Consideration — to be added.

Interconnections

Under Consideration — to be added.

Highlights

• Kennedy said: Too much and for too long, we seemed to have surrendered personal excellence and community values in the mere accumulation of material things. Our Gross National Product, now, is over $800 billion a year, but that Gross National Product—if we judge the United States of America by that—that Gross National Product counts air pollution and cigarette advertising, and ambulances to clear our highways of carnage. It counts special locks for our doors and the jails for the people who break them. It counts the destruction of the redwood and the loss of our natural wonder in chaotic sprawl. It counts napalm and counts nuclear warheads and armored cars for the police to fight the riots in our cities. It counts Whitman’s rifle and Speck’s knife, and the television programs which glorify violence in order to sell toys to our children. Yet the Gross National Product does not allow for the health of our children, the quality of their education or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials. It measures neither our wit nor our courage, neither our wisdom nor our learning, neither our compassion nor our devotion to our country, it measures everything, in short, except that which makes life worthwhile.
• Accounting generates annually published financial statements that are meant to guarantee corporate transparency, thereby checking corporate behaviour and ensuring that markets function efficiently. These statements are the balance sheet, income statement, cash-flow statement and statement of retained earnings. But it turns out that these tools cannot be trusted to convey the true state of a business at all. And yet governments, managers, policymakers and shareholders alike depend upon this information when making decisions that affect the lives of everyone.
• The Dark Ages turned out to be not so dark after all, or at least not in the emerging city-states of northern Italy. These cities—Pisa, Genoa, Florence and Venice—were swept up in a commercial explosion sparked at the end of the eleventh century by Pope Urban II’s call in 1095 for Christian Europe to liberate Jerusalem from Islam, which prompted unprecedented numbers of people to march across Europe to the Holy Land and back again. Northern Italy became a major thoroughfare for these Christian warriors and business boomed. As trade flourished on ever greater scales, the northern Italians developed a new kind of record-keeping to cope with the growing complexity of their business dealings. It was perfected by the merchants of Venice and became known as bookkeeping alla viniziana: the Venetian method. We know it today as double-entry bookkeeping.
• The rise and metamorphosis of double-entry bookkeeping is one of history’s best-kept secrets and most important untold tales. Why? First, because it arguably made possible the wealth and cultural efflorescence that was the Renaissance. Second, because it enabled capitalism to flourish, so changing the economies of the world forever. Third, because over several centuries it grew into a sophisticated system of numbers which in the twenty-first century governs the global economy. This medieval artefact is still in daily use around the world.
• Accountability and freedom of financial information were considered essential for running the world’s first democracy.
• The Farolfi ledger displays the six essential features of double-entry bookkeeping as outlined by accounting historian G.A. Lee: first, the idea of a proprietor or business partnership as an accounting entity whose books record its financial relationships with others. Second, its entries are made in a single monetary unit so they can be added together. Third, it relates the following oppositions: increases and decreases in physical holdings of cash or goods; increases and decreases in debts by or to other individuals or entities; and increases and decreases in the business’s own assets and liabilities. Fourth, owner’s equity is shown as the sum of assets and liabilities. Fifth, profit is understood to be the net increase in the owner’s equity (and loss the net decrease). Sixth, the profit or loss is measured over a clearly defined accounting period.
• As early as the ninth century a Muslim merchant could cash a cheque in China drawn on his bank in Baghdad.
• LUCA PACIOLI’S DOUBLE-ENTRY BOOKKEEPING TREATISE Particularis de computis et scripturis (‘Particulars of Reckonings and Writings’) was published in his mathematical encyclopaedia in Venice in 1494, forty years after the invention of movable type in Europe and the fall of Constantinople to the Ottoman Turks. It appeared in the same decade that Columbus sighted America and Vasco da Gama discovered a sea route to India, at a time when mathematics was taught as astrology in the universities of Europe and witches were burnt at the stake. And yet five hundred years later his bookkeeping treatise remains the foundation of modern accounting and its system is still in use throughout the world. This is extraordinary.
• The title of one of the first known works on mathematics—the Egyptian papyrus Directions for Knowing All Dark Things (c. 2000 BC)—clearly conveys its connection to esoteric knowledge and its perceived access to the powers of darkness.
• Pythagoras and his followers boasted that in mathematics they sought pure knowledge and not the wealth its application might bring. And so from Pythagoras onwards mathematics was split into two broad streams: the calculations used by merchants in their daily business transactions, and the numbers used by philosophers to express the secret harmonies of the universe.
• Euclid’s Elements was the most successful textbook ever written and, until it fell out of use in the 1900s, the second best-selling book of all time after the Bible.
• Inscrutable to most Europeans only five hundred years ago, Hindu–Arabic mathematics seems so ‘normal’ to us today—our civilisation depends upon it—that we forget the enormity of the revolution required to establish it as the norm and thereby to produce our mathematical, quantitative approach to reality.
• According to Taylor, it was Piero ‘who awakened in Pacioli a desire to put mathematics to work by taking it out of libraries, where it had slumbered so long, and to use it in everyday life’.
• So successful did the merchants of Venice become that by the fourteenth century, traders were travelling across Europe to the Rialto—and sending their sons—to learn from their expertise in the commercial arts, especially abbaco arithmetic, currency exchange and their famous bookkeeping system.
• Departing radically from medieval thought, Alberti also valued material wealth. He expressed a respect for money that was new in Europe and would characterise his century, distinguishing it from the Middle Ages, an era when money was scarce, peasants were the majority, barter was the primary mode of exchange, people lived largely on what they or their village could produce, and wealth was seen as an obstacle to salvation. Money, wrote Alberti in the 1430s, is ‘the root of all things’: ‘with money one can have a town house or a villa; and all the trades and craftsmen will toil like servants for the man who has money. He who has none goes without everything, and money is required for every purpose.’ As historian Fernand Braudel argues, something new enters European consciousness in Alberti’s writing—along with his celebration of money went thriftiness and a concern with the value of time, ‘all good bourgeois principles in the first flush of their youth’. This radically new attitude towards wealth in the Renaissance is rarely remembered today, when we celebrate almost exclusively its artistic flowering.
• In 1486, Pacioli was appointed professor of mathematics in Perugia. Like any twenty-first-century academic, he writes of these years as burdened with the demands of teaching while he attempted to write: ‘If I do not seem to have treated these questions properly, I pray that they may correct my way of speaking and have pity on one who feels other worries, as I feel the burden of daily reading, lecturing and teaching, here in this beloved august City of Perugia.’
• He was lucky to have one of the best libraries in Europe nearby, over the hills to the east in Urbino. The library had been built up by the bookish Duke of Urbino,
• As we have seen, Pacioli had by now achieved a distinction that was almost unique in fifteenth-century Italy: he was an experienced teacher in both commercial (abbaco) and speculative (university) mathematics. He had also spent six years as a merchant’s assistant in the busiest trading centre in Europe, and he had for almost twenty years been studying the entire body of mathematics known to the Mediterranean of his day: the rediscovered work of the ancient Greeks, the Latin mathematics of the medieval schoolmen and the advances of the Arabs. The hefty manuscript he brought with him to Venice contained this collected mathematical knowledge, based largely on Euclid’s Elements and the work of Fibonacci. His manuscript would become the first printed book to deal with Hindu–Arabic arithmetic and its offshoot, algebra, and contain the first printed treatise on Venetian bookkeeping. These two great contributions to the scientific and commercial life of Europe—its transmission of algebra and of double-entry bookkeeping—make the Summa the work for which Pacioli is now remembered.
• Alberti gives a sense of the quantum leap in communications that printing provided: ‘we greatly approved the German inventor who in these times has made it possible, by certain pressings down of characters, to have more than two hundred volumes written out in a hundred days from an original, with the labour of no more than three men; for with only one downwards pressure a large sheet is written out.’
• Mathematics, says Pacioli, applies to almost every human activity, from astrology, cosmography and theology, architecture, painting, sculpture and music, to business, law and military strategy. ‘Why, the citadels of states, the walls of cities, the towers, trenches, ramparts, mounds, and all of the other defensive and offensive weapons of war are nothing else but geometry and proportion,’ says Pacioli, giving the example of Archimedes’ famous defence of Syracuse from the Romans with his mathematical knowledge, which he used to build weapons including a huge crane. Known as the ‘Claw of Archimedes’, it allegedly lifted enemy boats out of the harbour and upturned them, drowning all their warriors. Pacioli concludes by saying that ‘if you examine carefully each one of the other sciences and liberal arts there is not one which does not use in some way harmony, measure, and proportion’. According to him, without these three mathematical properties ‘everything ceases to exist’.
• Most importantly, the Summa was the first vernacular book printed in Europe to contain algebra—and it marks a dramatic departure from the algebra of the abbaco tradition. The Summa moves from using algebra as a means of solving specific problems to algebra as a language for making abstract arguments; Pacioli generalises algebraic derivations and formulates them as universally valid theorems.
• Pacioli became famous in his day for his knowledge of mathematics, his gift for systemising, formulating and updating it, and his passion for disseminating its secrets via the printing press to the widest possible audience in their own tongue. But his lasting fame would rest on his 27-page bookkeeping treatise, Particularis de computis et scripturis—
• Right is the proverb which says, More skills are required to make a successful businessman than are required to make a good lawyer. LUCA PACIOLI, 1494
• Pacioli defines double-entry bookkeeping broadly, as ‘nothing else than the expression in writing of the arrangement of [a merchant’s] affairs’. If a merchant follows the system Pacioli sets out, then he will always know ‘all about his business and will know exactly whether his business goes well or not. Therefore the proverb: If you are in business and do not know all about it, your money will go like flies—That is, you will lose it.’
• In today’s profit-driven commercial world we are more than familiar with the idea that the purpose of every business is to make a profit. But Pacioli was writing in an era when this was not so self-evident and the tools for calculating profit—especially the Venetian bookkeeping system—were not widely used. And so he makes it clear that the purpose of every merchant is ‘to make a lawful and reasonable profit so as to keep up his business’.
• Pacioli then describes how a merchant should enter his holdings of cash in the journal, using the expressions ‘cash’ and ‘capital’. He says that cash is your ‘pocket book’ and capital is the entire amount of what you possess. Then, as now, capital was always creditor in all the principal journals and ledgers, and cash was always the debtor.
• It is very important to keep track of these accounts, because, as Pacioli explains, in these offices they often change their clerks, and as each one of these clerks likes to keep the books in his own way, he is always blaming the previous clerks, saying that they did not keep the books in good order, and they are always trying to make you believe that their way is better than all the others, so that at times they mix up the accounts in the books of these offices in such way that they do not correspond with anything. Woe to you if you have anything to do with these people … Maybe they mean well, nevertheless they may show ignorance.
• If there is a loss—‘from which state of affairs may God keep everyone who really lives as a good Christian’—it must be closed to the debit side of the capital account. If there is a profit, it is closed to the credit side of the capital account.
• In closing, Pacioli reminds his readers how important it is to keep accounts, ‘for, if you are not a good bookkeeper in your business, you will go on groping like a blind man and meet great losses’. He concludes his treatise by saying: ‘Therefore, take good care and make all efforts to be a good bookkeeper, such as I have shown you fully in this sublime work how to become one.’
• [Printing] brought about the most radical transformation in the conditions of intellectual life in the history of western civilization … its effects were sooner or later felt in every department of human life. ELIZABETH EISENSTEIN, 1979
• THE PRINTING PRESS AND THOSE WHO USED IT USHERED in a revolution in the presentation and distribution of knowledge on a scale not seen again until the invention of the computer in the twentieth century. The printing press not only reduced reliance on oral transmission and transformed written culture, but its ability to produce multiple copies of identical texts served to advertise widely the power of printing itself. It was its own best advertisement.
• As historian Elizabeth Eisenstein argues, the changes printing brought ‘provide the most plausible point of departure for explaining how confidence shifted from divine revelation to mathematical reasoning and man-made maps’.
• As a printed treatise for merchants, Luca Pacioli’s Particularis de computis et scripturis was caught up in the tide of this printing revolution. Via its pages, Venetian bookkeeping spread across Europe—and businessmen no longer had to travel to the Rialto to learn the secrets of Venetian commerce.
• the idea of ‘good’ bookkeeping was later extended to the idea that double-entry bookkeeping was an excellent method for improving the minds of young men, a sort of mental gymnastics, because of the focus and methodical thought it demanded.
• This equation of moral rectitude and good accounting was first seen almost two millennia earlier in Cicero and is echoed in Leon Battista Alberti’s 1440 observation: ‘We shall ever give ground to honour. It will stand to us like a public accountant, just, practical, and prudent in measuring, weighing, considering, evaluating, and assessing everything we do, achieve, think and desire.’
• By the eighteenth century, double entry had become so pervasive that it had spread beyond the realm of business and into European culture more generally. Daniel Defoe famously applied double-entry bookkeeping in his novel Robinson Crusoe, published in 1719. Shipwrecked and alone on the island, Crusoe uses double entry to assess his life, drawing up his ‘State of Affairs’ and stating ‘very impartially, like Debtor and Creditor, the Comforts I’d enjoyed, against the Miseries I suffered’, the left-hand side headed ‘Evil’ and the right-hand side ‘Good’. Like the best English shopkeeper, Crusoe keeps account of himself in two columns and ‘by this experiment I was made master of my business’.
• Double entry proved remarkably adaptable to each new demand made upon it by the burgeoning and increasingly complex commercial world. While most medieval practices—such as medicine based on astrological analysis—were found wanting in this industrial age, Venetian bookkeeping came into its own. By 1900, most businesses across the planet, even late adopters like the Rothschild banks, were keeping their books in Pacioli’s double entry.
• We must endeavour to gratify this universal passion.’ But the mania for Wedgwood vases brought the firm such sudden success that it could not meet demand. By late 1769, Wedgwood and his partner Thomas Bentley had serious cash-flow problems and an accumulation of stock, ‘classic symptoms of uncontrolled expansion with insufficient capital resources’.
• The results of his endeavours proved to be enlightening. He found the firm’s pricing was haphazard, its production runs too short to be economical, and it was spending unexpectedly large amounts on raw materials, labour and other costs, without collecting its bills fast enough to finance expanding production. 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.
• He told Bentley that their greatest costs—modelling and molds, rent, fuel, wages—were fixed: ‘Consider that these expences move like clockwork, & are much the same whether the quantity of goods made be large or small.’ And because of these fixed costs which remained the same regardless of how much was produced, the more their factory produced, the cheaper these fixed costs would be per unit of production. As Wedgwood pointed out: ‘you will see the vast consequence in most manufactures of making the greatest quantity possible in a given time.’ In other words, by scrutinising his books using double entry in the new industrial world, Wedgwood had uncovered the commercial benefits of mass production. This is one of the earliest instances of the use of double-entry bookkeeping to analyse business accounts and apply the financial information thus extracted to guide business strategy and decision-making in the new industrial world.
• Hudson’s and other, similar cases of fraud and corporate failure led to growing pressure on the British government to regulate industry to protect creditors and investors on the new stock markets. Investors called for companies to keep publicly available financial statements based on reliable accounting records. But the existing laissez-faire system suited most British parliamentarians, many of whom had vested corporate interests, including shares in the very railway companies in question. A comment made in 1837 by the president of the Board of Trade, Charles Poulett Thomson, sums up their attitude: ‘It is by the Government not meddling with capital that this country has been able to obtain a superiority over every other country.’
• In response, seven bankruptcy statutes were passed from 1825 to 1883, all of which specified that only those experienced in accounts could handle a bankrupt’s affairs. Some of the twentieth century’s biggest accounting firms were established in London during this period: William Deloitte opened his practice in 1845; Samuel Price and Edwin Waterhouse in 1849; and William Cooper in 1854.
• With the ongoing life of a corporation, there is no ‘natural’ business period, as there was in the Middle Ages; for example, the length of a ship’s voyage. Artificial and arbitrary accounting periods had to be created—such as our accounting period of a year—so managers could allocate expenses and revenues consistently to work out how much each item had cost to produce and how much it had earned (which was essential if profit was to be calculated and dividends determined).
• Through Levin, Tolstoy expresses his general unease with the encroaching ‘rationalisation’ of life—the measurement of time and space of which double entry was a part—brought by science, accounting and the new forms of production that spread across Europe in the nineteenth century. He was just one of many writers and artists who were deeply suspicious of such modernisation.
• With its vast resources, entrepreneurial spirit and large domestic market, and a commercial culture characterised by incorporation, continual measurement and managerial accounting, over the course of the nineteenth century the United States overtook Europe to become by 1900 the world’s largest economy.
• Rockefeller started out as a bookkeeper and attributed his vast wealth and the success of his company, Standard Oil, to his mastery of double-entry bookkeeping, especially cost accounting.
• It is simply impossible to imagine capitalism without double-entry bookkeeping; they are like form and content. WERNER SOMBART, DER MODERNE KAPITALISMUS, 1902
• In Sombart’s view, capitalism and double entry are so intimately connected it is difficult to tell which was cause and which effect: ‘one may indeed doubt whether capitalism has procured in double-entry book-keeping a tool which activates its forces, or whether double-entry book-keeping has first given rise to capitalism out of its own spirit.’
• It is likely that the concept of capitalism also came from double-entry bookkeeping. French sociologist Eve Chiapello argues that social scientists must have consulted nineteenth-century account books when conceiving the idea of capitalism, because its definition is so intimately tied to the categories and practices of double entry.
• In fact, British factories guided by Venetian double-entry bookkeeping directly funded two of the great revolutionary thinkers of the nineteenth century: Charles Darwin (through his grandfather Josiah Wedgwood’s Etruria pottery works), and Karl Marx through the Engels’ cotton mills of Manchester.
• If Sombart’s analysis is right and double-entry bookkeeping made possible the explicit pursuit of profit and the accumulation of wealth by merchants, then this would help to explain why the cities of northern Italy, where double-entry bookkeeping first appeared in Europe, amassed such stupendous riches in the fourteenth and fifteenth centuries. The fact that their rulers—the Medici of Florence, Ludovico Sforza of Milan, the doges of Venice, the dukes of Urbino, the governors of Sansepolcro—expended vast sums of this wealth to finance the splendour of their courts, civic buildings and cathedrals makes it possible to argue, as some have, that this Italian accounting innovation produced the Renaissance.
• In the end, the Renaissance still shapes up as the product of immense genius, but genius animated by money and the skills essential to commerce.
• For Schumpeter, capitalism ‘generates a formal spirit of critique where the good, the true and the beautiful no longer are honoured; only the useful remains—and that is determined solely by the critical spirit of the accountant’s cost-benefit calculation’.
• In an essay published in 1985, the historian James Aho linked double-entry bookkeeping to the ancient art of rhetoric, the rules used to make persuasive arguments perfected by the Roman lawyer and orator Cicero (an art, incidentally, which Aristotle says sprang from a property dispute). According to this argument, medieval merchants used double-entry bookkeeping as a rhetorical tool of capitalist propaganda, to persuade their ‘audience’ that their business was honest, morally sound and its profit-making ethically justified.
• They argue that a double-entry account is not just a piece of neutral information, but also an ‘account’ or story; that accounting is not merely a technical practice, but also a means of framing a set of business transactions with a rhetorical purpose. Bookkeeping is a way of making sense of business for an ‘audience’ that has grown and changed from Pacioli’s day to our own.
• 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.
• 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.
• As his biographer Robert Skidelsky says: ‘Keynes was the first economist to visualize the economy as an aggregate quantity of output resulting from an aggregate stream of expenditure. This new way of seeing the architecture of an economy is the General Theory’s most enduring legacy.’
• Much as the crisis in the Etruria pottery works had led Josiah Wedgwood to examine his books and make the first experiments in cost accounting and account-determined intervention in the workings of a firm, so the economic crisis of the 1930s led Roosevelt and Keynes to devise account books for their nations in order to formulate policies for government intervention in the workings of their economies.
• The first official measure of the overall US economy—measures of national savings, consumption and investment—was devised by Simon Kuznets and his colleagues in the 1930s to provide policymakers with a comprehensive picture of what was going on. No comprehensive measures of national income and output had existed before then. It was the Depression that raised the need for national accounts such as the Gross Domestic Product (GDP)—or, as economist William D. Nordhaus said in 2010: ‘If you want to know why GDP matters, you can just put yourself back in the 1930s period, where we had no idea what was happening to our economy.’
• This was an historic moment: it was the first practical application of Keynes’s new analytic technique, which conceived the whole economy as a balance between total current resources (including real gross national product) on the supply side and total consumption, investment and expenditure for the war effort on the demand side. This was a radical shift because although earlier attempts had been made to measure national income, they had been mere guesses. Keynes devised a conceptual apparatus for understanding the working of an entire economy. Before this, governments did not systematically intervene to direct the economic affairs of nations (with notable exceptions such as the economic experiment being conducted contemporaneously in the Soviet Union).
• According to Hagen, ‘national income measurement is best thought of as double-entry bookkeeping, involving the consolidation of the operating accounts of all productive enterprises in the economic system, including government’.
• the Bank for Reconstruction and Development (which became the World Bank) and the International Monetary Fund (IMF). It was the creation of these and other international organisations after the Second World War that made the gathering of national income statistics an essential task for every nation involved and prompted an era of national income accounting. Accounting became an essential component of national and international government.
• 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.
• US Senator Paul Sarbanes describes the central place national accounting has in the government of the United States: ‘The GDP accounts provide Congress and the rest of government with vital signs on our economy’s health. We are making better economic policy today because the GDP accounts give us a better understanding of what policies work.’
• 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. As he explained in 1971, many costs of economic development—such as those related to migration and the retraining required by technological advances— are not now included in economic measurement, and some … may never be susceptible to measurement. Internal migration, from the countryside to the cities (within a country, and often international) represented substantial costs in the pulling up of roots and the adjustment to the anonymity and higher costs of urban living. The learning of new skills and the declining value of previously acquired skills was clearly a costly process—to both the individuals and to society.
• It would be interesting to know how many of those whose hearts leap up at the announcement of an increase in earnings per share have any idea of the estimates, judgments, and conventions that must go into all such calculations. HOWARD ROSS
• As John Lanchester says: ‘The experience of reading a publicly held company’s accounts is not supposed to resemble a first encounter with the late Mallarmé’, the notoriously difficult French symbolist poet.
• As American industrialist and investor Warren Buffett wrote in 2004: ‘No matter how financially sophisticated you are, you can’t possibly learn from reading the disclosure documents of a derivatives-intensive company what risks lurk in its positions. Indeed, the more you know about derivatives, the less you will feel you can learn from the disclosures normally proffered you.’
• Given that modern corporations are now so complex that even gurus like Warren Buffett warn that some of their practices, such as derivatives, are inscrutable, should we not be asking whether it is actually possible to construct a set of financial statements that summarise in a few numbers the vast range and complexity of a corporation’s annual activity? And whether this can be done just weeks after the financial year ends, and to such high standards that they are taken seriously by the market and those who need to assess the progress of the corporation? The miracles abound.
• With computerisation, the internet and the deregulated international economy, the demand for financial information has exploded—and the accounting profession has expanded accordingly.
• The ‘audit expectations gap’ refers to the discrepancy between the common but wrong public belief that auditors guarantee the rectitude of accounts, that they thoroughly check every detail of corporate accounts and certify them, and the reality, that in fact auditors are required merely to check the accounts enough to assure themselves they are okay. Auditors express an opinion only; they guarantee nothing.
• Former US president George W. Bush’s post-Enron resolve to clean up corporate America was remarkably similar to Roosevelt’s ‘truth in securities’ vow following the Great Crash of 1929.
• But as former chairman of the US Federal Reserve Paul Volcker observed before Obama signed the legislation on 21 July 2010: ‘There is a certain circularity in all this business. You have a crisis, followed by some kind of reform, for better or worse, and things go well for a while, and then you have another crisis.’
• Accounting’s use of numbers gives it an air of scientific rectitude and certitude, and yet fundamental uncertainties lurk at its heart. Indeed, accounting is as subjective and partial as the art of storytelling, the other meaning contained in the word ‘account’.
• Even accounting’s most fundamental concepts and practices, such as income measurement and asset valuation, are based on uncertainties. Accountants still cannot agree on how to define income, the measurement of which remains one of the intractable problems in financial accounting theory and practice. The valuation of assets only becomes more complex and more fiercely debated as modern global corporate structures and financial instruments become increasingly labyrinthine, and income measurement, the key to determining profits and therefore dividends, is inextricably linked to this contentious, chimerical practice of asset valuation.
• The importance of numbers such as EPS (earnings per share) reflects the increasing domination of capital markets and the globalisation of finance, and shifts focus from the balance sheet (and the ability to pay) to the income statement (and earnings capacity).
• Economist Raj Patel points out that while every civilisation has had traders and markets, only modern market society has spawned the corporation, ‘a novel human creation moved by the search for profit’, which now dominates the planet. Patel tells the story of a group of filmmakers (Mark Achbar, Jennifer Abbott and Joel Bakan) who decided to treat the corporation like the person it legally is and test its psychological profile. Using the American Psychiatric Association’s Diagnostic and Statistical Manual of Mental Disorders (DSM-IV), they found that the corporation shares many of the characteristics that define psychopaths. That is, corporations break the law if they can, they hide their behaviour, sacrifice long-term welfare for short-term profit, are aggressively litigious, ignore health and safety codes, and cheat their suppliers and workers without remorse.
• But even when they go about their lawful business, corporations cause harm simply because of the way they—and profit-driven markets—value the world. In order for profits to be as high as possible, corporations keep costs as low as possible. The real costs of their business are higher than their stated costs—but they remain hidden. For example, Patel has estimated the real cost of a Big Mac to be US$200. The reason Big Macs sell for almost one-hundredth of this figure is that their drive-through price does not account for their real costs. These include their carbon footprint, their impact on the environment in terms of water use and soil degradation, and the enormous health costs of diet-related illnesses such as diabetes and heart disease. Traditional accounting models do not take these costs into account, but they still have to be paid. It is just that the McDonald’s Corporation does not pay them. So, who does pay? We do. Society as a whole pays, in the form of environmental disasters, climate-change-related migration and higher health costs.
• ‘You’d be forgiven for thinking that this ongoing bailout from nature and society to private enterprise is what puts the “free” in free markets—despite its protests, corporate capitalism has yet to prove that it can operate without these kinds of subsidies.’
• According to a recent study, the bill for the earth’s degraded ecosystems could amount to US$47 trillion. While the fruits of this debt are mostly enjoyed by those of us who can afford to buy the goods produced by corporations—computers, t-shirts, toilet paper—the cost of the debt is unevenly spread across the world, mostly paid by the nations who can least afford it (such as in the desertification of Bolivia, the mudslides of Pakistan, the deforestation of the Amazon): ‘The ecological debt of rich countries to poor ones [estimated at US$4.32 trillion] dwarfs the entire third-world debt owed by poor nations to rich ones, which is only US$1.8 trillion.’
• Which brings us to the most pressing issue of the day: the health of our planet. In the words of the Economist: ‘There has been much hullabaloo about corporate accounting scams in America, yet perhaps the biggest accounting oversight of all time remains hidden in governments’ own national figures. GDP per head is the most commonly used measure of a country’s success, yet it is badly flawed as a guide to a nation’s economic well being.’ Yes, GDP is deeply flawed as a guide to a nation’s wellbeing. And it also completely fails to account for the cost to the planet of economic growth.
• These accounting systems evolved at a time when the natural world seemed endless and our focus was on managing the industrial revolution, not our natural environment. WENTWORTH GROUP OF CONCERNED SCIENTISTS, 2008
• But the GDP was not designed for this purpose. It was not conceived to be the primary gauge of the economic health of a nation, it was not created to be a key tool for policymakers and investors, it was not born to govern the global financial markets. As a measure of national wellbeing, the GDP is a deeply flawed rule. Simon Kuznets himself, one of its creators, warned of the limitations of GDP measures, especially their exclusion of household production and other non-market activity, as well as the many costs of economic development. Kuznets’ concerns have been reiterated ever since, most famously, as we have seen, by Senator Robert Kennedy in the speech he gave at the University of Kansas in 1968 just months before his assassination.
• Gross National Product counts air pollution and cigarette advertising, and ambulances to clear our highways of carnage. It counts special locks for our doors and the jails for the people who break them. It counts the destruction of the redwood and the loss of our natural wonder in chaotic sprawl … Yet the gross national product does not allow for the health of our children, the quality of their education or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials … It measures everything, in short, except that which makes life worthwhile.
• But just as the nineteenth-century railway entrepreneurs had to learn that human-made capital—rails and machinery—wears out and must be depreciated, so some economists are beginning to understand that nature’s capital is also subject to wear and tear and depletion.
• The Australian government’s official line on environmental accounting as reported by the ABS is that: The economy has a complex relationship with the environment. The environment provides the raw materials and energy for the production of goods and services that support our lifestyles, but it also sustains damage through the activities of households and businesses … While the environment clearly provides services to the economy, these are often provided at no cost or are implicit in the value of goods and services rather than in explicit transactions. Environmental assets are often not controlled by economic agents because of their physical nature, or in some cases are so plentiful that they have a zero price. For this reason, the valuation of environmental flows and stocks is fraught with conceptual and practical difficulties. And so they are not valued at all.
• The UN began to develop its environmental accounting guidelines in 1992, when it recommended that the GDP and other traditional systems of national income measurement include supplementary environmental and social information. Most countries have since attempted to expand their national accounts to include such satellite accounts. The United States published its first environmental satellite accounts in 1994, which adjusted the GDP for the depletion of oil and other non-renewable resources. But the figures with their downgraded view of US wealth proved so controversial and so politically explosive that Congress shut down the programme almost the moment the revised numbers were published. Everett Erlich highlights the Orwellian nature of this move when he says that by putting a stop to the US environmental accounts, ‘Congress made thinking about a Green GDP a thought crime’.
• Although it pays lip service to environmental accounts, in 2006 the ABS concluded that ‘work on the valuation of environmental damage (externalities associated with human and economic activity) is an undeveloped field of research and it is unlikely that the ABS will have the capacity to make advances in this area in the foreseeable future’. The key word here is ‘externalities’, which veils a multitude of sins. In economics an externality is a cost, but one not transferred through prices and therefore not accounted for. The pollution of waterways or the atmosphere by factories, for example, is an externality.
• Professor Dasgupta is a passionate advocate of the poverty-reducing potential of national environmental accounting. He argues that ‘poverty will only be made history when nature enters economic calculations in the same way as do buildings, machines, roads and for example software’.
• Nature’s services include carbon absorption by forests, the coastal defence (from erosion, storm damage and flooding) provided by coral reefs, the pollution-filtering potential of wetlands and the nutrient recycling carried out by the soil. Under current GDP measures, countries that cut down forests for timber exports, dynamite their reefs for fish, pollute and degrade their soil for intensive agriculture, and allow farms and factories to contaminate their waterways appear to be getting richer in the short term.
• Former Executive Director of the United Nations Environment Programme, Klaus Toepfer, outlines the implications of our current economic models: By continually depleting and damaging [nature] and without investment in the running, maintenance and management costs, the Earth’s life support can suddenly and abruptly fade or switch to become less productive and predictable. I believe we are slowly winning this political and economic argument but not fast enough. So we must hurry up otherwise all six billion of us will eventually be scratching around trying to survive.
• Millennium Ecosystem Assessment,
• A 2003 project in New York City called Neighborhood Tree Survey provides a telling example of the way the pricing of nature can affect our attitudes and behaviour towards it. The survey calculated the value in dollars of 322 trees in New York City based on the amount the city would have to pay to replace each tree. Their total value was US$1,038,458, with an average value of US$3225 per tree. The most expensive tree? A 214-year-old tulip tree on Staten Island, worth US$23,069. The cheapest was a six-year-old ginkgo in the South Bronx, valued at US$54. The organisers hoped that putting price tags on trees would ‘help people realize the real value of street trees’.
• The New York Parks Department’s chief of forestry and horticulture said of the experiment: ‘People always knew there was some vague benefit to trees, but you could never quantify it. But once you have the methodology to equate trees with dollars, now you’re talking. It’s no longer about hugging trees because they’re good, but because you have hard data in a language more effective in the public dialogue.’
• Recently the GDP as traditionally measured has been actively challenged by several world leaders and international bodies like the OECD. It seems that at last, after all the evidence of the shortcomings of economic growth as a measure of national prosperity and the decades-long criticisms of GDP accounting, the 2008 financial collapse and the increasingly apparent environmental crisis have together created some political momentum for the radical revision of our methods of national accounting.
• In response, Sarkozy established a commission to consider alternatives to the GDP, recruiting Stiglitz, as well as another Nobel laureate, economist Amartya Sen, and economist Jean-Paul Fitoussi to ‘tear apart the GDP’ as they saw fit. The Stiglitz-Sen-Fitoussi Commission released its report in September 2009, making suggestions for measuring the progress of nations in ways better suited to the twenty-first century. The commission endorsed both main criticisms of the GDP, arguing that ‘the economic measure itself should be fixed to better represent individuals’ circumstances today, and every country should also apply other indicators to capture what is happening economically, socially and environmentally’. It recommended using at least seven different measures to assess national quality of life: health, education, environment, employment, material wellbeing, interpersonal connectedness and political engagement. It also recommended measuring equity, and economic and environmental sustainability. Stiglitz believes that the 2008 global financial crisis requires us to rethink our social contract. As he says, ‘We should also, in the aftermath of an extraordinary economic collapse, talk about what the goals of a society really are.’
• And in March 2008, at long last—forty years after his speech questioning GDP accounting—Robert Kennedy’s questions were taken up by the US government in Washington. A United States Senate Committee discussed the GDP’s failure to measure environmental damage, poverty, income inequality, health and the quality of life, as well as the danger of using the GDP to express national wellbeing. At the time of the Senate hearing, there was no US legislation to accommodate a possible revision to US national accounting. But two years later, on 23 March 2010, President Barack Obama signed into law the Patient Protection and Affordable Care Act which contains one small section—section 5605—which requires that Congress help fund and oversee the creation of a new ‘key national indicators system’. The ‘State of the USA’, a set of measurements independently created by its president and CEO Chris Hoenig, will become that system. Founded as a tax-exempt organisation in 2007, the State of the USA contains several hundred new measures—for health, education, ageing, families and children, crime and justice, arts and culture, the environment, the economy—which will be freely accessible online. Hoenig calls the GDP ‘an artefact of a world before the Web’ and believes his online indicators are more suited in form and content to the new millennium. He hopes that with easy access to these key indicators Americans might be able to ‘shift the debate from opinions to more evidence-based discussions’ and make the United States the first country in the world whose population enjoys ‘a shared, quantitative frame of reference’.
• In February 2011, Sukhdev’s Green Economy Report, part of his work with the United Nations Environment Programme, was launched with the headline ‘How two per cent of global GDP can trigger green growth and fight poverty’. It outlines how investing 2 per cent of global GDP, or around US$1.3 trillion a year, in ten key sectors would convert the world’s ‘brown’ economy into a ‘green’ economy, and challenges the prevailing belief that there needs to be a trade-off between economic growth and environmental investments.
• Accountants, remodelled as eco-accountants, can play a central role in this conversation—and it is for this reason that Jonathan Watts wrote in 2010 that they may be the one last hope for life on earth. As he also pointed out, done badly, eco-accounting will mean the natural world is further ‘commodified, priced, sliced and sold to the highest bidder’. But done well, it could reframe our values and transform the capitalist world in ways we are yet to imagine.
• The old way of measuring value is becoming irrelevant. AL GORE, 2006
• It seems that if we want to bring our infinitely voracious consumerism into line with the resources of our finite planet, we must consider giving our planet a value that the market can recognise and account for, assign a monetary value to the oceans, air, forests, rivers, wildernesses. As the global economy continues to collapse around us, yet to remake itself, and the earth’s resources are increasingly threatened with exhaustion, this would seem to be one of our key economic and ethical challenges for the twenty-first century. In one way or another, this century will be the one in which we learn to account for our planet. Because unless we start accounting for our transactions with the earth, we will bankrupt it for all future human habitation.