Getting to grips with Accounting 101

Luca Paciola uncovered the secrets of double-entry bookkeeping in 1495. Four centuries later, the penny finally dropped for me!

Managing for profit by Peter Hughes

At school, we were taught about the great discoveries of scientists such as Isaac Newton, Louis Pasteur, Alfred Einstein and others. Never did we hear the name ‘Luca Paciola’.

It was only when I started out on my journey to financial literacy that I learnt about this unsung hero who brought order into the chaos of commercial record-keeping in the late 15th century.

I discovered all of this while trying to understand what, for me, was one of the most confusing things about business record-keeping – the double-entry bookkeeping system.

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Paciola did not actually invent the system, but he refined and formalised it. While delving into the commercial records of rich street merchants in Venice, he saw that they separated their enterprises from themselves as individuals.

As a result, they kept records of business transactions entirely separate from their personal financial records. It was a giant mental step in a world where any business was seen as inseparable from the person who founded and ran it, and it was this revelation that triggered the practice of recognising two sides to every transaction.

Assets and liabilities: the essence of the system
For example, if Luigi, an Italian entrepreneur, decided it would be good business to buy and sell cheese, he took 1 000 lire of his own money and bought the cheese.

But – and here was the revelation that put Paciola onto the track of double-entry bookkeeping – Luigi recognised that he personally did not own the cheeses. The business, Luigi’s Supreme Cheeses (LSC), owned them and now owed him, Luigi the individual, 1 000 lire. (In today’s terms, we would say that Luigi had invested 1 000 lire in the business – an ‘equity investment’).

Hence the double entry on LSC’s balance sheet: 1 000 lire owed to Luigi (now known as a ‘liability’) and 1 000 lire of cheese held in stock (now called an ‘asset’).

Today’s world has taken the concept of separating the business from its owners even further, with the creation of separate legal entities such as the ‘company’, where the founders and owners are protected from failure of the business, even if their own bad judgement was the cause.

But that’s another story.

Being profitable, yet going bankrupt
Having gained some understanding of double-entry bookkeeping and its language of debits and credits, I went on to ponder something I had heard people speak of from time to time – the mystery of a profitable business going bankrupt.

In my attempt to get to the bottom of this conundrum, I sought the advice of a hard-bitten entrepreneur – let’s call him Ronnie – who had achieved great success in the business world.

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“Ronnie,” I said, “I’ve just read about a retail business that has been trading profitably for years going into liquidation. How is this possible?”

“It’s simple,” replied Ronnie. “Business survival depends on cash, not reported profits, which often tell a misleading story. Profit statements take account of revenue – ‘accrue’ is the word used – not yet actually received. If the cash then doesn’t materialise – poof! – there goes your profit and maybe also the business.

“Always treat profit figures with suspicion, and remember that cash is a fact – profit is an opinion!”

At last I understood why I had so often heard that the cash flow statement was the most important one prepared by the accountants.

But there was more to learn. Ronnie had talked about ‘accrue’ – cash that was accounted for but had not actually appeared. What was this?

How could sales that had not yet come in be recognised? Clearly, I would need a few more sessions with him.