The glory of double entry bookkeeping
Here’s a stretch: double entry bookkeeping deserves to be ranked among the glories of the renaissance. Around the time Columbus discovered the Americas and Michelangelo sculpted David, an Italian monk was codifying the rules of double entry bookkeeping; rules that had been in practice among Italian merchants for some time. His effort deserves to rank among these masterpieces.
You don’t agree? Think about what double entry bookkeeping manages to achieve. It, of course, records money in, and money out. This ‘cash book’ function must have been used for millennia before, and by countless club treasurers today. Amidst all this cash flow, it also monitors how much you are owed by your customers, and how much you owe your suppliers, and can produce detailed statements for both, should there be any dispute. Important as cash is, double entry bookkeeping also keeps track of how much profit or loss all these transactions amount to; something it’s easy to lose track of if you are too focused on cash. In other words, it combines profitability analysis, with cash flow analysis in one, simple, easy to use, unified system. It’s elegant and, in its way, beautiful.
If you’re still struggling to appreciate the power of this system, imagine yourself at The Grand Bazaar in Istanbul today or perhaps Venice in the Middle Ages. Your stall is brimming with goods from all over the world and customers are standing three-deep, desperate to buy. But this being a bazaar, no one wants to pay your asking price and you have to negotiate every transaction separately. Moreover, you can’t recall the amount you paid for every item on your stall. You had to haggle out a separate deal with each merchant just as every customer wants to negotiate their own price with you. After an exhausting day’s trading, you are left with a bag of money at the end of the day. And so it goes on, every day of the week. How do you know how well you’ve done? At one level, you could say if, at the end of each week, the bag of money is heavier than it was at the beginning of the week, I must be doing well. However, maybe you need all that money to buy stock for next week. Take this example, add in the complicating factor of both buying and selling on credit, then imagine having to save up for the annual rent of your stall, and remember to put aside enough to pay your taxes, and you have a model of a modern business.
It’s easy to lose track of all these transactions. If that happens you are flying blind, trading by intuition and very vulnerable to large unforeseen cash payments such as your taxes, or an unexpected bill. Even if you manage to stay in control of the cash, you’ve still got the problem of working out how much profit you’re making.
Double entry bookkeeping brings order to this chaos. And it does it in such a marvellous way. For every accounting entry, there must be an equal and opposite entry in another account. Tot up all the accounts at the end of the week or month and you arrive at profit or loss account (an analysis of your profitability) and a balance sheet (a snapshot of your credit worthiness) at that date. So you know how much profit you made, and how much cash you’ve got left for trading in the future. In this ‘equal and opposite’ system of debits and credits everything has to balance, otherwise there’s an error somewhere. It is the accountants equivalent to e=mc2. Amid the jumble of trading transactions, double-entry book-keeping explains the relationship between profit and cash.
Accountancy is a known as a conservative discipline. Its foundations – double entry bookkeeping – haven’t changed since they were first ‘invented’ 500 years ago. What a timely invention because, after the discovery of the Americas, global trade exploded to such an extent that we would never have been able to build the world we live in today.