Episode 7 looked at the issue of railways and scandal. It starts at Bishopsgate station, which has now been demolished. All that's left is a viaduct and some weeds. Yet 170 years ago this was a terminus of the Eastern Counties Railway, a company in which lots of investors lost their money. And this episode is about how much of our modern railway system is based on dodgy accounting and fraud.

The first commercial railway opened in 1830. Sean McCartney (Queen Mary's College, London) explained that the scale was enormous, with huge numbers of people employed. Additionally, as Dick Edwards continued, the railways raised huge issues. Britain at this time was coming to the end of its industrial revolution. The stalwarts - coal, iron, etc. - had become big slowly. By contrast, the railways grew very fast, and required massive capital expenditure at the outset. Companies turned to private investors for the money, who in turn hoped for big returns. The holy grail was the 10% dividend.

The villain of the piece was George Hudson, the self styled 'Railway King'. The system was fragmented between different companies, and the geographical location of Hudson's York line meant it made lots of money. Yet the quest for the 10% dividend didn't leave lots for replacing track or other capital items. Also, by 1840s most of the really profitable lines had already been built. The companies kept building, even as they ended up building lines that were less profitable. This led to reduced dividends, down to 2-3%. Because the shareholders were getting restless, Hudson started cooking the books, by charging items to capital that really ought to be revenue.

Dick Edwards explained how this works. It's because a debit is either an asset or expense. Hudson was putting income statement debits on the balance sheet and leaving them there. For example, the cost of replacing rails really ought to be an expense, not capital expenditure, otherwise you are overstating profits. [CM: This is more or less what Worldcom was doing]

Even as Hudson cooked profit, this only led to calls for higher dividends, for which he needed cash to cover them. He raised this from fresh investment - robbing Peter to pay Paul. At this time, there were no auditors; how a private company was run was a matter for shareholders.

Hudson couldn't get away with it forever. When he was found out, enquiries held by investors. He had to live out the rest of his life in exile. But led to further scrutiny of the other rail companies and calls for an enquiry into how to get a more effective audit of railway companies. Depreciation accounting was not common at the time, despite it being a really good idea for railway engines or tracks. Additionally, companies tended to abandon depreciation instead of cutting their dividends.

Worst of all, so many MPs had shares in the railways that attempts to change the accounting standards were very slow. Had they had our accounting standards, would the railways ever have been built?

We can think forward to the Hatfield rail accident in 2000. After the crash, it transpired that Railtrack had no comprehensive asset register, and the company had to absorb £57m in extra depreciation to cover emergency repairs. How did Railtrack respond? It raised its dividend, to show it was confident in its long-term prospects.

People who read this post also read:

• A brief history of double entry book-keeping #10
• A brief history of double entry book-keeping #5
• A brief history of double entry book-keeping #4
• A brief history of double entry book-keeping #1
• A brief history of double entry book-keeping #9

Filed under: Entertainment with tags a brief history of double entry book-keeping, bbc, depreciation, dick edwards, dividends, fraud, george hudson, jolyon jenkins, railtrack, railways, sean mccartney, worldcom