Knowledge@Australian School of Business Finance and Investment Research Article

Knowledge@Australian School of Business

Trying to work out whether double-entry bookkeeping created capitalism in its own image, or whether capitalism's needs have shaped double-entry bookkeeping, is a classic chicken-and-egg conundrum.

Accounting specialists became embroiled in discussing it with the publication of Double Entry, a popular history of double-entry bookkeeping by Australian author Jane Gleeson-White, a postdoctoral student at the University of New South Wales (UNSW). The book was aimed at a non-specialist audience, yet Gleeson-White optimistically laid out her case for an accounting revolution. Perhaps, she mused hopefully in a public forum held at the UNSW in April, this was a subject whose time had come.

Still a standard accounting technique, double-entry bookkeeping records each transaction twice, once as a credit and once as a debit. The name of the column under which these amounts are entered depends on the nature of the transaction. Typically, columns have names such as cash, accounts receivable, interest expenses and costs. The method allows the record keeper to efficiently keep track of the overall balance, or capital.

Double entry has been at the heart of business transactions for at least 500 years and economists have taken an interest in the relationship between double-entry bookkeeping and modern capitalism for at least a century.

German economist Werner Sombart, writing at the start of the 20th century, theorised that each depended on the other for its existence; he stopped just short of saying the technique created capitalism. A little later, Austrian-American Joseph Schumpeter was less inhibited. He wrote: "[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."

The subject is not new, but Double Entry has given a dry old debate a green shake. Since double-entry bookkeeping has done so much to advance the wealth of developed nations, Gleeson-White argues it's time to utilise it to advance the health of the planet.

She notes that while double-entry bookkeeping has long been a recorder of business growth, it has been oblivious to many of the intangibles people value most, such as good human relationships and a clean environment. She suggests it should now be turned to measuring the ecological impact of our business culture in the hope that those neglected essentials can be better managed. However, her book does not deal with recent moves towards corporate integrated reporting, which is designed to factor in sustainability.

Gleeson-White sympathises with those wishing to join the dots and show that double-entry bookkeeping built a royal road from the merchant-dominated society of Renaissance Venice through the age of industrialisation up to today's market-driven mass consumption. But how meaningful is Gleeson-White's call to reconfigure the global economy via a reworked approach to double entry?

A Historical Dynamic

From about the 13th century, the merchants of north-east Italy began recording transactions in a way that provided a check against errors. This reflected their function as agents and financiers of the trade in goods between Asia and northern Europe. But their invention went further than bookkeeping. Their giant leap was to keep the focus on changes to a merchant's overall wealth, also called equity or capital: assets minus liabilities. The technique described the flow of transactions; its value lay in the dynamism of the picture it drew, not just in the knowledge of who to chase for monies owed.

Gleeson-White begins her book by tracing the life of quintessential Renaissance man Luca Pacioli – a monk, scholar and mercantilist, who in 1494 published a concise guide to double-entry bookkeeping. It synthesised what had become known as Venetian practices into one identifiable system.

Pacioli would recognise the way we use double-entry bookkeeping even today, says Leon Olsen, director of sustainability and climate change at Deloitte Touche Tohmatsu. But Olsen insists it's wrong to characterise double-entry bookkeeping as the villain in market economies' lack of care for people and environment.

"It's just a tool. For accounting as we know it, double-entry bookkeeping is a fundamental technology. Financial accounting still uses it," he says.

Bookkeeping and financial accounting are two different things. The information a proprietor receives about the past via bookkeeping is vital intelligence that assists in running the business. Financial reporting is another matter. It involves how the proprietor chooses to present the data to outsiders and is aimed primarily at investors.

Peter Roebuck, head of the school of accounting at the Australian School of Business, agrees that financial reporting could be characterised as sophisticated marketing – albeit, marketing that is regulated and audited, he stresses.

A four-year run of News Corporation's financial reports provides an example of the bravura of modern-day financial accounting. In the late 1980s, then finance director Richard Sarazen made profit after tax on operating earnings (also referred to as profit before extraordinary earnings) appear as A$364.364 million in 1987, A$464.464 million in 1988, A$496.496 million in 1989 and A$282.282 million in 1990.

Such figures are either beating odds of one in one trillion against such a run of coincidences, or making financial accounting into a sport, wrote investigative journalist Neil Chenoweth in Virtual Murdoch: Reality Wars on the Information Superhighway, his 2001 biography of News Corporation founder Rupert Murdoch.

Pacioli might be amazed by the conventions of modern accounting standards, and admiring of the wizardry practised by today's financial accounting experts. But he probably would not recognise it as familiar, says Olsen, because the conventions of reporting to the market, along with the legal concept of a company, have been adopted since his time.

Obstacles to Responsibility

The push to make companies more responsible has to contend with many adversities, and to most observers double-entry bookkeeping is the least of them. Commentators generally agree that limited liability is a more important determinant of corporate behaviour. If a limited liability company is sued, its non-director shareholders cannot lose more than their investment and will incur no other losses.

Limited liability legislation in Europe and the UK during the late 19th-century solved a problem that did not exist until ownership and control began to separate in industrialising economies at the start of the Industrial Revolution. Namely, that people who stump up cash to finance large-scale operations but don't make operational decisions, also don't want to bear the consequences if operational decisions go wrong.

Today this all-care, no-responsibility model has led to shareholder pressure on companies to make big profits and make them as fast as possible. Some say the pressure on directors has become unbearable when combined with the social push to make directors personally responsible for their decisions. It's a crunch, and there's no solution in sight.

The opacity of financial reports is another obstacle along the road to better corporate behaviour. But it's not as if the international community is blind to the problems caused by headlong economic growth. Global technocrats are putting an enormous amount of effort into developing a method of integrated reporting to take corporate disclosure beyond the sustainability report.

Financial accounting is focused on financial capital, explains Roger Simnett, professor of financial accounting and auditing at the Australian School of Business, who is on the content task force of the International Integrated Reporting Committee.

"[Financial accounting] is about your ability to make money. People are looking for more than that today. We're hoping that companies with good integrated reports will eventually pay a lower cost of capital," he says.

The aim of an integrated report is to relay to the public how the board is managing risks to the sustainability of a company's operations. These risks typically include remuneration, ethics, and environmental issues. The term integrated is somewhat misleading, because the report is not an alternative to the financial report, rather, as conceived at present, it is a parallel document. A beta version of this new reporting genre already exists, and is this year being trialled by a group of about 60 multinationals.

At the corporate level, the integrated report as presently formulated will, arguably, not force shareholders and management to see the world through a radically different lens. That's good for those afraid that upsetting the status quo will result in paralysis. But some are concerned that a half-way measure will reassure without solving the problem.

John Purcell, professional accounting body CPA Australia's policy adviser on environment, social, and governance issues, concedes that integrated reporting does not require companies to measure the value of the natural resources they consume in daily operations. But he adds: "It seeks to do it."

With all the discussion about social and environmental responsibility, when double-entry bookkeeping is considered, it seems that an intriguing "what-if" question has been lost. What if Pacioli had included in his theory of costs the value of the environmental or social welfare resources depleted by business activity?

"That might have made a difference to how our financial accounting developed," agrees Purcell. So why didn't he? "He had no motivation to. You could shift that burden on to other people."

UNSW's Peter Roebuck makes an even pithier response to the question. "Maybe Venice would never have been built," he jokes.

Beyond Neutrality

Double entry is not a neutral tool. Convention dictates what is considered a cost, accounting formulas value those items, and it is easy to ignore such basics as the value of clean air and clean water. Nowadays, partly due to the paradigm-busting theories of Karl Marx and Friedrich Engels, it's harder to ignore the value of a safe and fair workplace.

But the reassessment of capitalism by Marx and Engels had shortcomings as a prescription for economic organisation. However, their theory about fair exchange of labour did not contain a complementary theory of accounting.

Which comes back to Gleeson-White's call for a fundamental reassessment of accounting. Her brief discussion in the book about including environmental factors in the national accounts (gross domestic product) is sceptical about the seriousness of governments in Australia and elsewhere to tackle the challenge.

The framers of the integrated reporting standards say it will achieve change because of the positive effect that clear disclosure will have on a company's share price. This hypothesis relies on three assumptions: that integrated reporting will become mandatory globally; that capital markets are efficient allocators of financial resources; and that large fund managers will choose sustainable practices over quick profits. None of those factors is a sure thing.

Gleeson-White does well to alert a wider circle of the population than accountants that the important decisions being made in this arena are critical to creating a more balanced world economy.