The example Figure 2.1 has presented is a modernization, through information technology, of an existing infrastructural procedure, on which rests the whole tradition of practical accounting. It is always rewarding to look at a system’s beginnings because it allows one to learn a good deal about its foundations. In his writings, Luca Paciolo suggests that three accounting books should be kept:
● The memorial
● The journal, and
● The general ledger.
The memorialis a type of first entry and voucher on which must be transcribed all accounting operations ‘day-per-day and hour-per-hour’, that is, in a chrono- logical order. In the memorial are registered, as well, all the entries which repre- sent operations without classification into debits and credits. (Both the practice and the name memorial remain today. For instance, they are part of the law in the Grand Duchy of Luxembourg.)
In the journal, the operations described in the memorial are entered in separate credit and debit accounts with indication of foreign currency operations. The cities Paciolo had visited in his research on accounting had different currencies in which they traded with one another. In the old master’s tradition, which con- tinued till the end of the 17th century, neither balances nor reports were made in the journal. Its goal was:
● An organized, meticulous transcription of all transactions
● A chronological record showing the names of accounts to be credited or debited
CASH SECURITIES
CASH SECURITIES CLOSE POSITION
OPEN POSITION
CASH SECURITIES
CASH SECURITIES
DT CT DT CT
DT CT DT CT
CUSTOMER A
CUSTOMER B
RECEIVE OR DELIVER SECURITIES
Figure 2.1 Delivery vspayment means that we do the operation simultaneously on four books which are databased
● A register of amounts of credits and debits providing useful information about transacting business.
Postingis the process of making the changes to the balances of accounts, accord- ing to instructions contained in the journal. No account balance should ever be changed, except on the basis of a journal entry.
It is in the general ledgerthat each entry which was made in the journal will be divided with precision in credit and debit columns with balances on each page and appropriate reports to the continuation of the account. The ledger is a device for reclassifying and summarizing by accounts information originally listed in chronological order in the journal. Paciolo seems to have been the first to define that the total of creditsand of debitsshould correspond.
● The methodology he established includes the definition of the need of keeping subsidiary books, such as books for inventories.
● This methodology also specifies that all books should be validated by the merchants’ corporation, in the city where the enterprise resides.
Therefore, it seems that, among other contributions, Paciolo was among the first to recognize the importance of verification – therefore, of regulatory action – and to write about it. Both the principles characterizing accounting, and the directive concerning the need for verification, amount to a giant step towards financial reform, much bigger than what IFRS is proposing.
The fact that, since its normalization in 1494, the function of accounting includes the posting, accumulation, and communication of financial data con- cerning economic activities, is nothing less than transparency in accounts. The data are typically expressed in monetary units while, as a process, accounting is concerned with the translation of financial transactions into business records:
● Collecting information about transactional operations of different types
● Recording such data in a homogeneous and dependable manner, and
● Transmitting financial results to interested persons, in a comprehensive way.
In terms of their dynamics, accounting reports aim to meet the need for objective reporting. This involves different presentation services which may serve a great number of purposes, but each one rests on a mathematical infrastructure. The genius behind Paciolo’s work is that the underlying concept is so flexiblethat it
can be used in many other applications than general accounting, for instance in contracting a bill of materials (BOM) which must be updated by:
● Product
● Due date, and
● Manufacturer.
Whether we talk of money, financial instruments, engineering products or any other goods, proper accounting procedures permit us to tally valuables entrusted to custodians, and also to compare results against the stewardship expected of them. The reader should never forget that financial accountinghas the function, indeed the primary objective, of providing information to parties outside the company: investors, creditors, regulators, the taxman. Hence,
● To show the disposition of properties given over for prudential but pro- ductive management, and
● To permit to measure value, worth, and ownership – with argument giving way to evidence provided by reliably accounting for something (see section 5).
Words like ‘reliable’ and ‘useful’ always connote some purpose for which the figures are to be used. Many of the problems accountants face in this regard are textbook type, but others are not. In the latter case the whole profession of accounting is concerned with the recognition of a new problem, and its impact, as well as with finding ways towards its solution – a job increasingly falling upon the shoulders of standards boards.
A practical example of a notion that does not seem to have existed in Paciolo’s time, but today confronts IASB, is contractual rightsand contractual obligations to receive, deliver or exchange financial instruments. These are themselves financial instruments meeting the corresponding definition (see also Chapter 3) because they ultimately lead to:
● Receipt or payment of cash, or
● Acquisition or issue of an equity.
A novelty of our time, promoted through derivatives, is that the exercise of con- tractual right or satisfaction of contractual obligation may be absolute, or contin- gent on the occurrence of a future event.
Assets or liabilities that are not contractual, like income taxes, are created in the wake of statutory requirements imposed by governments. These are notfinancial assets or liabilities. By consequence, deferred tax allowances (DTAs) are not
financial assets, even if they are reported as such by some banks while supervi- sory authorities look the other way – and they are written in the entity’s books in violation of accounting principles.8
Neither are prepaid expenses and other items for which the future economic ben- efit is the receipt of goods or services, rather than the right to receive cash or another financial asset. Also, items like deferred revenue and (most) warranty obligations are notfinancial liabilities because the outflow of economic benefits associated with them:
● Is not a contractual obligation to pay cash or another financial asset.
● Rather, it is some sort of delivery of goods and services.
Post-mortem additions to a carefully crafted system are tricky things, particularly so when conflicts of interest try to accommodate the unaccommodatable (an example being the DTAs). System design does not work that way, and this is another reason why AISB’s redesign of accounting should be most welcome.
In conclusion, as a mathematician Luca Paciolo essentially did far more than normalize the journal and the general ledger. Neither notion was totally new.
Available evidence indicates that a sort of general ledger was kept in Sienna as far back as in 1255, and by the mid-15th century a similar concept seems to have been used by merchants and credit institutions all over North Italy, in Genoa, Milan and Venice. But,
● Neither of these followed standard layouts, and
● Neither was based on firm principles with rules that can have universal impact.
Able solutions to both problems have been Luca Paciolo’s contribution. Finally, it is interesting to note that the first systematic approach to mercantile accounting is to be found in a book on practical mathematics. Paciolo also seems to have structured teller procedures, but his most important legacy still is the mathemat- ical theory which explains the mechanism of double entry and its importance in keeping under control both transactions and the economic results of management.