A brief history of double entry book-keeping #10

Posted by Christie Malry on March 21, 2010 at 10:48 pm

Arthur Andersen advertisementThe final episode of this series looked at fraud. This recognises that accounting, as well as being a force for good can also be used in bad ways.

CM: This was, in my view, a very shoddy and badly put together episode. I will be responding to the issues raised in order to give the balance this episode failed to provide. In the meantime, I have summarised the episode verbatim below.

We have had in the last decade or so some spectacular and notorious frauds. In some cases, there were complex and exotic accounting devices used to mask the scale of the fraud. Only this last week, we have seen reference to Lehmans and their "accounting gimmicks" and questions have been raised of their auditors, Ernst & Young, who may have failed to question their disclosures.

Jenkins interviewed Steve Priddy, Technical Director at the ACCA [CM: I wonder where Helen Brand was, eh]. Were the auditors to blame? Unsurprisingly, Priddy didn't want to comment on the detail. There might be some culpability, but he wouldn't know one way or the other. Jenkins had another go - company auditors are paid millions to do their job, but what did they do in this case? Priddy explained about the audit process. Auditors do some tests to allow them to form a view on truth and fairness, but we must remember that banks are complicated. Even directors don't always understand all transactions, which makes it hard for auditors to stay one step ahead. Meantime, the Lehmans investigations will surely continue.

This is not the first time auditors have got the blame. Enron is the recent case we all remember best. Anne Loft (Lund University, Sweden) said that their auditors, Arthur Andersen, had gotten too close to the company. It was advising companies like Enron how to set up connected companies in which they could hide liabilities while also doing the audit. There were also many former Andersen employees working at Enron.

Prem Sikka is a long-standing critic of the profession. He sees auditors as a weak link in corporate governance. A major flaw is that these big firms both do audits and also advise companies on how to bypass rules and regs and how to flatter their financial statements. They could check these things but have incentives not to do it properly. It's like a game of russian roulette. In his opinion, the recent banking crisis "vindicates" his point of view. He gave a further example: even after Northern Rock had been nationalised, audit firms were still giving clean audit reports to banks. This ought to have been a wake-up call to them.

David Cooper (University of Alberta) suggested that the profession has a short-sighted view of the public interest. Auditors really do try to be independent. But auditors and accountants are brought up with a view that what's good for business is good for society.

After Enron, Andersen collapsed, leaving just the Big 4. Sikka provided some statistics to explain the size of the Big 4. Overall combined turnover is $90bn a year, which would make them a very significant country. They operate all over the world, selling lots of other services.

Cooper also bemoaned how little we know about how they operate. They portray themselves as uber-rational and efficient but they can't live up to this. They sell the model to clients but don't live it themselves. And they promote transparency/accountability but don't disclose much themselves - they don't themselves provide audited financial statements.

Sikka added that even where they do publish accounts (e.g. because they operate through a limited liability partnership) they're very unhelpful. Also, at a company's AGM you are given the chance to appoint the auditor, but are never given any information to help you decide. For example - have they been sued? Have their partners gone to jail? etc... The Big 4 sell the idea of league tables, but there aren't any for performance of accountancy firms.

By contrast, Anne Loft thought it was more or less moving in the right direction. The International Federation of Accountants, which represents most of the major bodies and which sets international auditing standards has a public interest oversight board to watch over it and maintain the public interest.

Prem Sikka thinks more radical action is needed. He advocates a properly designated independent regulator to deliver what the public expects - to open audit firms up to scrutiny. With there now being more liability concessions for firms, it makes it more difficult to sue them. He believes we will see more and more scandals.

Priddy disagrees. The global consensus is that it's not a good idea to have a central regulator; self-regulation is the perceived wisdom. Jenkins asked him if firms are transparent enough. Priddy replied that it's a road we're all on. Firms are evolving. In the UK there are now regular inspections from the national regulator and its inspections are placed in the public domain.

David Cooper said that the information that other users need are still a work in progress. What is the sort of information that corporations might be providing to the general public to help them to hold organisations to account? These are ethical issues. Whose side is the accountant on? We must remain optimistic that we can get beyond obscure information and see what's really there.

A brief history of double entry book-keeping #9

Posted by Christie Malry on March 19, 2010 at 12:04 am

Plane and soldiersEpisode 9 was on the subject of accountants and the military. It started with the Light Brigade. Yet for many that died, it wasn't guns that killed so many of them, it was accountancy. Warwick Funnell described the neglect and exposure so many suffered. They simply weren't prepared for war. This was a consequence of the prevailing wisdom at the start of the 19th century that professional standing armies were inefficient and dangerous. Post-Cromwell, Parliament had introduced a load of extra controls, including putting their budget under the Treasury.

What this meant was a lot of the cost control stuff that industry was perfecting at the time never made its way into the military. What mattered to the Commissariat, the military leaders making the decision, was that they could account to the Treasury for all money spent. This meant they didn't give soldiers the things they needed, e.g. coats, even though there were plenty in stores.

The Crimean war was a massive disaster. But many of the errors made in that war were then repeated in the Boer war, 50 years later. It was only much later that Richard Haldane, Secretary of State for War, tried to bring some of the industrial methods into the military. Introduced a new course for officers at the London School of Economics, which ran until the 1930s.

Michele Chwastiak from the University of New Mexico provides another angle. In the Vietnam era, Robert McNamara used accounting to shift control away from generals and towards civilians via a programme called Planning, Programming and Budgeting (PPB). This stopped generals from expressing needs in terms of warfare, and forced them to express their needs in economic terms. This meant war was explained in terms of inputs (e.g. money) and outputs (e.g. enemy deaths). This had the effect of making deaths the main yardstick of progress in the Vietnam war... a bad idea. Unfortunately, the statistics were inflated, meaningless. In any case, the Vietcong not that interested in deaths, just wanted to win. Soldiers eventually began to realise that they were being used as 'cannon fodder', which led to combat refusals and soldiers threatening to kill their commanding officers. There was a fundamental mismatch between the soldiers' reality and the commanders' management of the war. The army was falling to bits, and ultimately the war was unsustainable.

The U.S. Department of Defense has shown itself to be equally inept in financial matters. The Coalition Provisional Authority, established to run Iraq post-Saddam is a prime example, according to Christine Cooper (University of Strathclyde). The UN wanted their accounts audited. But they initially appointed a consulting firm, not a firm of auditors. When eventually KPMG was appointed to replace them, they found a complete shambles. There was no double entry book-keeping, incomplete records and oil revenues, which formed a significant part of the budget, was not reconciled to metered data, so there was no way of knowing how much was stolen. Basic controls simply weren't there.

A big advantage of double entry book-keeping is that it makes fraud more difficult. But the CPA seemed to not have heard of the concept. They expressed a complete disregard for proper administration. It is now estimated that up to $20bn of Iraq's oil revenue was never accounted for properly.

Jolyon Jenkins concludes that what happened in Iraq is a warning of what happens when you try to do without accountants.

A brief history of double entry book-keeping #8

Posted by Christie Malry on March 18, 2010 at 12:25 am

Concentration campThis episode, an uncomfortable one for our profession, looked at how accountants have been involved in genocide.

In 1938, the Secretary of Institute of Accountants and Actuaries in Glasgow (predecessor body to ICAS) wrote to the Secretary of the ICAEW. A party of Britain's top accountants was about to travel to Berlin for the 5th International Congress and some of his members were nervous. They went to the Foreign Office for advice. However, the Secretary of ICAEW was very keen to go to the Congress. Why?

Stephen Walker (Cardiff University) explains. Britain's big accounting firms were opening offices in Europe. There was lots of capital going into Germany following WW1, esp into Berlin. Firms wanted to follow the money, especially given the political uncertainty.

At the time, the German accounting profession had already been taken over by the Nazis. The Jews had been banished from the profession. But the British accountants were not concerned with the fate of the Jews, but were worried that their firms might be expelled from Germany or taken over. In the end, the attendees were looked after embarrassingly well. They were wined, dined, and even entertained by a band from a labour camp.

Lots of the top Nazis were interested in the Congress. Their view was that an organised and competent accountancy profession would be the vehicle for the implementation of national socialist policies. The British representatives enjoyed the hospitality. Even the president of the Society of Accountants in Edinburgh was won over, and the contingent left Germany much relieved.

However, within a few weeks all the British firms were expelled. Within a year, Britain and Germany were at war.

Warwick Funnell (University of Kent) has researched the involvement of accountants in the implementation of the Holocaust. Historically, accounting has tended to avoid the criticism levelled at other professions, which were perhaps more obvious. However accounting was important by supporting the civil bureaucracy, such as the train system. And accountants also assisted in costings, which helped lead to the ultimate commoditisation of people. The Germans calculated a profit per concentration camp member, based on an average lifespan of nine months and the residual value of their hair, fat and ashes on death.

Accounting was also being used to square their consciences. Himmler wanted to create a sense of moral behaviour for people who were responsible and he used accounting to 'sanctify' what they were doing. Property was recorded with painstaking accuracy. In his words, "Anyone who takes a single mark will be a dead man."

Accountants have been implicated in other tragedies too. Philip O'Regan (Limerick University) has looked at the British reliefs provided after the Irish potato famine. There was a view that if relief was to be given then it should be earned. There was a prevailing view of the 'deserving' poor. The Irish population was viewed as a population that could be improved. Accordingly, nearly a million people were set on schemes that were futile, such as 'roads to nowhere'. To make it all work, lots of accountants needed. In time, this led to the development of a fairly significant accounting infrastructure.

Another rural tragedy - the Highland clearances - provides a further example. When estates went bankrupt, they fell into the hands of professional accountants. A particularly notorious one was James Brown, of mid 19th century Edinburgh. He had a strong reputation for taking estates over and evicting any sitting tenants from it, leaving them to die. His decision making wasn't entirely rational/economic. He and others tended to jump to conclusions over the tenants' morals and personal habits.

In conclusion, Jenkins asked whether dullness can be a mask Funnell disagrees. Accounting is not a neutral activity. The very act of accounting means you have to decide what to measure and how to present it.

A brief history of double entry book-keeping #7

Posted by Christie Malry on March 17, 2010 at 12:11 am

Stephenson's RocketEpisode 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.

A brief history of double entry book-keeping #6

Posted by Christie Malry on March 16, 2010 at 12:06 am

Josiah WedgwoodEpisode 6 starts with the issue of employee costs, which Jolyon Jenkins portrays as "a headache for any manager." However, it's all in a day's work for a management accountant, and this episode focuses on the development of the discipline.

David Oldroyd (Newcastle University) says that the idea of holding agents accountable is old. For example, when managing medieval estates, the manager would have to account for the costs he had incurred. However by the 18th Century, more modern forms of cost accounting were starting to be developed.

There are two main sources. The first is the books of Wedgwood Pottery, run by the imposing figure of Josiah Wedgwood, who could be considered the "grandfather" of cost accounting. Trevor Boyns (Cardiff University) describes Wedgwood's 1772 crisis. Wedgwood couldn't sell all their stocks, which were starting to back up in the warehouse. What should they do - cut back production and lay off workers? Reduce price? But if so, by how much? Josiah Wedgwood analysed the costs of his production and found that there were indeed some areas where they could reduce the price yet still be profitable. Having got the 'bug' for cost analysis, he then went on to use this sort of information again.

The second company is Boulton & Watt. Steven Toms (University of York) explains. Boulton & Watt was a factory-based manufacturing company, and found it needed better accounting methods. It also needed to deal with the cultural shift of managing the workforce. There were lots of people who were working in factories for the first time, and many family units working in factories. Boulton & Watt developed a form of cost accounting to manage them, so it could determine (1) how long it should take to complete a particular task, (2) how to price that task fairly in order to work out a profit margin, and (3) the level of bonuses to pay to staff for beating targets. Trevor Boyns sees this as evidence of using cost information to make management decisions.

However, Keith Hoskin (University of Warwick) isn't sure. It's not clear to him that the industrial revolution is a managerial revolution. There is cost control for product & labour. And there are cost-based contracts to ensure you make a profit. Although businesses are managing profitability better, they're not actually doing management with accounting.

Hoskin cites the example of the Springfield Armory in the US. Hoskin subscribes to Michel Foucault's view of management being power exercised through surveillance. Management isn't just cost control, it's perpetual surveillance and appraisal. Under this measure you don't see proper use of management acctg in Britain in the 18th century; it began in the US. Indeed, Hoskin goes further to suggest that the US's strength is derived from its development of management accounting practices, which took it from a sleepy micro-industrial state to global superpower in less than a century.

A brief history of double entry book-keeping #5

Posted by Christie Malry on March 14, 2010 at 9:50 pm

Medieval buildingThe fifth episode of this fascinating series focused on mid 14th century England. England at this time was under the scourge of the black death. And, indeed, the plague led to one of the first accounting frauds.

Evan Jones, University of Bristol, explains. Landowners at the time were upset by the lack of labour. So the Statute of Labourers Act was passed, which set the maximum rate people could be paid. However the rate simply wasn't enough, so employers have to hide pay in the accounts. So that they don't get caught, they grouped people together, gave benefits in kind, etc. This emphasises that written accounts can't always be trusted.

Michael Jones (also University of Bristol) then explained where the title "Chancellor of the Exchequer" comes from. Nobles had to account for the money they should have raised so they could pay up to the government. On the 'exchequer' board there were stones, these were moved about/removed as the negotiations continued.

Accounting at the time was concerned with social obligations, and there were few written records. In this feudal society, you were not trying to determine profit, but instead account for your obligations to others.

They then explained the concept of the tally stick. This kept track of how much was owed to the Exchequer by making scratches on a stick. When the marks had been made, the stick was split lengthwise, so there were two copies, which were virtually incapable of being forged. In time, tally sticks would start circulating as a sort of currency. Evan Jones explained that this early form of credit helped lubricate the wheels of commerce by allowing assets to be allocated more effectively.

Once feudalism broke down, money started moving sideways as well as just up. This made reliability very important - could you trust someone to be good on his debts? So long as you settled your debts on time you were fine. If didn't, you might find credit hard, and business could go bust.

James Bolton (Queen Mary, University of London) picks up the story. Unfortunately we do not have very many accounting records from this time - lots of them don't seem to have survived. This means we don't know whether our accounting was ahead/behind others. However, one set of accounts that have been found, of a John Smith, record a meticulous truth that the owner would probably have preferred not to be recorded. His accounts are very detailed and show that he recorded export figures higher than the customs accounts. This means he was smuggling! But smuggling prosecutions at the time were rare; they would have had to catch him with the goods, so he was pretty safe.

And that's all for episode 5. More history next week!

A brief history of double entry book-keeping #4

Posted by Christie Malry on March 11, 2010 at 11:51 pm

Luca PacioliEpisode 4 started with Luca Pacioli and how new accounting paved the way for capitalism. As we covered in an earlier post, Pacioli was a mate of Leonardo da Vinci's, and also happened to be very good at chess. But his main achievement was his book on double entry book-keeping. He didn't invent the form, but he did promote it.

Christopher Nobes, Royal Holloway: In the old days - two types of account. What you owned, what you owed. No need for cash or profit (no taxation). So we started off with "What we own" and "Who trusts us to pay them later". Hence "debit" and "credit".

Every transaction has two aspects. If I buy bread for £1, I'm up a loaf of bread and down by a pound. Cash is in the accounts as a debit, because the cashier is treated as a debtor of the business. The more you start recording, the more you spot that two things are happening. It all adds up, and all "feels good".

Was it divinely inspired? Alan Sangster of Middlesex University sees two sides in perpetual balance. He thinks Pacioli loved this: the beauty in balance.

Accounting can be seen as a form of storytelling, which means you need a listener, an auditor. The auditor was God, originally. James Aho of Idaho State University believes you can find lots of forms of accounting everywhere, including in business. There was a form of neurosis that inspires obsessive book-keeping, doing everything twice.

Jenkins observed that usury is not allowed by the Bible. But double entry book-keeping lets you fudge this. For example, you can sell an apple, and it's right that you get some money for it. But interest is like selling time, and time is God's alone to dispose of. People were using double entry book-keeping to hide things from the church, and from themselves.

But Basil Yamey disagrees with this interpretation. How can accounting - which lays things out for all to see - make things less clear?

Some people have suggested that capitalism couldn't have happened without double entry book-keeping. People don't generally agree these days, but Sangster supports it. He believes it helps build trust, and therefore trade, because you have two lists of things - your list and their list, from both sides.

Yamey pooh-poohs this idea. You had partnerships before double entry. And later, you didn't have double entry book-keeping in big companies, e.g. Rothschilds and Dutch East India Company.

Dick Edwards said that the beauty of double entry book-keeping is that it lets you produce final accounts whenever you want, based on data you already have. It lets you produce a profit figure. This is important, because although all forms of accounting give you some sense of stewardship, double entry book-keeping also lets you see profitability. So you can assess the honesty of the steward as well as his profitability.

Efficiency is the most durable legacy of the double entry approach. Things that can't be measured are simply ignored. Only financial stuff gets into the books, with other externalities being excluded. Ironically, this means that it ends up concealing as much as it reveals.

A brief history of double entry book-keeping #3

Posted by Christie Malry on March 10, 2010 at 11:50 pm

Latin inscriptionThis episode looked at Roman and Greek accounting.

There's a problem compared to the Mesopotamian stuff, in that there is very little surviving paperwork. However what remains gives us a glimpse of why the empire was strong in some places and weak in others.

The programme kicked off with the story of Gaius Verres, who had been Governor of Sicily. While Governor, he had extorted lots of money from the island. Eventually he came to trial with Cicero as his prosecutor. Unfortunately for him, he found his own accounting records being used in the trial against him. In some cases, he had destroyed records, and tried to argue that because he hadn't kept accounts he should be allowed to go free. Some other records had been deliberately manipulated and falsified. However, after Cicero's opening speech, Verres gave up his defence.

On to Richard Macve for some background on what accounting was like. Primarily, it was lists of things that you owned, e.g. grain or slaves. It was basically a rudimentary stock list, and no more. However, Professor Dominic Rathbone of Kings College London has found evidence of more detailed records. He talked about the records of an estate with multiple accounts, maintained by several different people. There were linked monthly accounts which, although not exactly double entry, were quite similar.

Richard Macve believes the Roman number system was a constraint on their ability to innovate, because Roman numerals don't lend kindly to arithmetic. But they did use abacuses, which are fast. (Professor Macve confessed he can't use an abacus!)

The traditional view is that the Roman/Greek economies were built on slave labour. Dominic Rathbone thinks this is unfair; he has found evidence of entrepreneurship. Others agree, and have even found what they interpret as the notion of profitability.

A brief history of double entry book-keeping #2

Posted by Christie Malry on March 9, 2010 at 11:43 pm

SumerianThis episode focused entirely on Mesopotamia.

A big part of Mesopotamian history is its antiquity. A lot of tablets have been found and they are really old. These tablets contained lists of who owned what.

In ancient Sumeria, the state was religion and religion was the state. The Sumerian state created thousands, maybe hundreds of thousands of clay tablets documenting assets. By 3000BC there were armies of accountants working for the state.

Archeologists have found cones and little tokens dating back as far as 8000BC. It is believed that these represented real life objects and were used for documenting ownership. Some believe that this led to writing, because they needed a way to record the tokens. Eventually they worked out you could drop the tokens altogether and just write down the numbers on tablets. But this theory is disputed.

What they do agree is that accountancy was a vital part of keeping track of things. Whereas literature could be memorised, accountancy needed writing to work.

A brief history of double entry book-keeping #1

Posted by Christie Malry on March 8, 2010 at 11:59 pm

Old book-keepingEpisode 1 of this BBC series broadcast today, presented by Jolyon Jenkins. Here are some notes from the episode.

The programme started by observing that there are more accountants than the whole of the rest of the EU and that accountants are involved throughout the economy.

The programme will be reviewing the modern idea of the audit culture, which I suspect will owe more than a little bit to the work of London School of Economics Professor Michael Power (e.g. his Audit Explosion). However, the examples weren't quite as good as the ones in Power's books. Jenkins used the example of measuring performance against targets. I'm not sure that that can be blamed entirely on accountants.

The programme then turned to some unlikely accountants - the Iona community. Their rules require them to account to each other - not just in money terms but also for the use of their time. This is important to them because how you spend your time and money is a significant part of how you spend your life. They're now focusing on carbon measurement too.

Jenkins observed that double-entry book-keeping started in Italy, with the original idea being the accounting of the person towards God. They identified the sense of indebtedness with the sense of 'sin'. People would seek to justify what they were doing to God and the community to make their sins good. Book-keeping was known as the "Italian" method for this reason. However, it also enabled merchants to see both what they owned and how well they were doing with their capital. There was a short comment from Dick Edwards, who has written a splendid book, A History of Financial Accounting.

The programme then had an odd segment on the link between art and accounting, involving the work of former LSE professor, Basil Yamey.

Jenkins turned to how accounting can be used to fudge the truth. For example, take carbon accounting. One of the Iona community has a son in Seattle, whom they wish to visit every second year. Yet clearly they can't deliver a 10% reduction year-on-year if they're flying every second year. Should they remove the flights and reduce the rest? Isn't that creative accounting?

There was then a segment involving Professor Richard Macve, from - you guessed it - the LSE, on accounting as an instrument of social control. Macve observed that double entry book-keeping is partly responsible for the growth of large organisations, because you can divide up the book-keeping work into different ledgers. As an added bonus, it lets the people at the top keep things secret from the people lower down!

Macve continued - in the past, you would have used torture to control people. Now, you can use performance measurement and monitoring to do the same thing.

The programme finished up with a piece featuring Lucy Kimbell of Oxford University's Said Business School (who is, according to Twitter, ridiculously pleased to hear herself on the radio... just wait until she sees this blog) - She believes that organisations aren't terribly good at getting the right data. They have lots of data, but don't really know how to use it. Her party piece appears to be asking people to "audit" her. She has a form she hands out to friends, with questions not just on money but also on social, cultural, environmental worth, even relationships. Fascinatingly, she has found that people are quite obedient in helping her, which she considers to be "horrifying".

Kimbell sees lots of measurements in the world today - cinema scores, other people's reviews on the internet, ebay ratings, etc. It gives us some power.

Jenkins concluded by saying that the programme will return to the theme of accounting as power in future episodes.