- Christopher Nobes
What are the purposes of accounting? How do these purposes affect how accounting works? What is double-entry bookkeeping? ‘The international evolution of accounting’ considers these questions and outlines some examples of how different countries have contributed to the development of accounting. Double-entry bookkeeping, conceived in thirteenth-century Italy, balances the debits and credits. It enables the calculation of profit and the presentation of a business's financial position. Publication of accounting information is required to protect shareholders and creditors from potential malpractice by company directors. The globalization of world business has resulted in International Financial Reporting Standards, now used by around 90 countries. The US use their Financial Accounting Standards Board's ‘generally accepted accounting principles’.
International contributions to accounting
Among other things, this chapter addresses the following questions: How have different countries contributed to the development of accounting over the millennia? What are the purposes of accounting? How do the different purposes affect how accounting works? What are the key features of double-entry bookkeeping?
This section outlines some major examples of how different countries have contributed to the development of accounting over the centuries, in approximately chronological order. The key points will be explained and expanded upon later in the chapter.
When archaeologists uncover ancient remains in the Middle East, almost anything with writing or numbers on it is a form of accounting: expenses of wars, feasts or construction projects; or lists of taxes due or paid. It is now well documented that the origins of written numbers and written words are closely associated with the need to keep account. One major reason for needing to keep account is so that the stewards of resources can later give an account to the owner of what they did with the resources. Originally, this was the high officials giving account to p. 14↵temple complexes or kings. Now, it is the directors of a company giving account to its shareholders.
The Romans developed forms of accounting from which, for example, farm profits could be calculated. Later, India and the Arab world had sophisticated numbering systems and accounting records. However, it is probably in northern Italy in the thirteenth century that the ultimate system was invented: double-entry bookkeeping. This was driven by the increasing complexity of business, such as the setting up of partnerships and foreign branches. Later still, France led in the development of legal control over accounting in the seventeenth century.
The existence of a wealthy merchant class and the need for large investment for major projects led to public subscription of share capital in seventeenth-century Amsterdam. This creates the need to report to large numbers of shareholders who are not the managers. Then, the industrial revolution caused the need to get even bigger and to raise massive funds. This meant a growing separation of ownership from management, which led to the requirement for auditors to check on the management in nineteenth-century Britain. Scotland pioneered the accountancy profession.
Germany gave us standardized formats for financial statements at the beginning of the twentieth century. Then, the United States contributed consolidation of financial statements for groups, management accounting, and complex financial reporting such as the capitalization of leases (to be explained later). The United Kingdom invented the ‘true and fair view’ requirement for financial reporting, which is now the top principle of accounting in many countries. In the late twentieth century, Japan contributed greatly to managerial accounting and control.
p. 15↵The common feature of all these international influences on accounting is that commercial developments have brought accounting advances. Not surprisingly, leading commercial nations in any period are the leading innovators in accounting.
Debits and credits
The nuts and bolts of accounting are debits and credits. As we will see, the debits and credits fit together in an algebraic way (the totals are equal). Since they are recorded numerically, they can be manipulated arithmetically (for example, a profit can be calculated). Debits and credits are the positive and negative elements of the double-entry system but they pre-date it.
Let us go back to northern Italy before double-entry was invented; for example, to Florence in 1250 AD. The city then, as now, specialized in small-scale businesses which produced high value products, such as fashion goods. Suppose that we are looking at a business which is the equivalent of Prada, Gucci, Versace, or Dolce & Gabbana. The business can be described with a few basic facts as seen in Box 1.
The business is owned and managed by a single man (e.g. Signor Marco Pazzi) or his family.
Raw materials (e.g. wool) come from far away (e.g. England) and are not paid for in cash when they arrive. Signor Pazzi would be mad to send florins on the long journey back to England. He might send a letter of credit to his supplier, King Henry, which can be used in a branch of the Medici bank in London.
The customers are mostly Florentine nobles, merchants and clerics, plus a few from Pisa, Milan and Venice. They seldom pay cash immediately; it would be rude to ask them.
p. 16↵Under these circumstances, what sort of accounting records are needed? Remember that accounting takes time and valuable paper, so Pazzi will only want to record what is really necessary. We can start by working out what is not necessary, as in Box 2.
Pazzi employs a few staff. However, it is not necessary to record wages. If it is Friday, he pays; if it is not Friday, he does not.
If Pazzi wants to know how much inventory there is, he looks in the store cupboard.
If Pazzi wants to know how much money there is, he looks in the chest (cassa is the word for chest; hence the English word ‘cash’).
There are no taxes on profit, and there is no-one to share profit with, so profit does not need to be calculated. Pazzi is an experienced businessman; he can ‘feel’ how well he is doing.
However, what is absolutely necessary in order to avoid commercial chaos is a record of how much the customers owe Pazzi and how much Pazzi owes them. Without such records, Pazzi will forget to demand payments from customers and he will not know whether demands on him from suppliers are justified. Pazzi must keep the records in detail (dates, times, amounts, currencies, etc.). Good records will be persuasive when talking to customers and suppliers, or if it is ever necessary to go to court.
So, Pazzi keeps one piece of paper for each customer and each supplier. Naturally, he begins with the sign of the cross. He uses Roman numerals because foreign Arabic/Indian numerals have not arrived in general use yet. An abacus is used for adding and subtracting. It works with multiples of five and ten, which suits Roman numerals (and fingers) perfectly.
p. 17↵Suppose that, so far, King Henry has sent 300 florins of wool on January 5th; and Signor Bardi has bought 21 florins worth of garments on January 10th and another 12 florins worth on February 3rd. No cash has changed hands. The records will then show:
Of course, Pazzi writes in medieval Tuscan, so instead of ‘he owes’, Pazzi writes ‘debit’; and for ‘he trusts’, Pazzi writes ‘credit’. So Bardi is a debitor (a debtor; he must pay Pazzi) and King Henry is a creditor (he trusts Pazzi to pay him later).
p. 18↵You might be wondering why the debits (such as Bardi's) are on the left of accounts and the credits are on the right. Some bad aspects of ‘left’ can be seen in Box 3.
the Latin word is ‘sinister’; the French word is ‘gauche’—both with negative connotations in English
the bad thief was on Christ's left at the crucifixion
at the last judgement, when we are all called to account, the sheep (the good) go up on Christ's right, and the bad (the goats) go down to the left (as can be seen in Michelangelo's ‘last judgement’ in the Sistine chapel)
at the last supper, Judas was on Christ's left (see Figure 3, where Judas is not only on Christ's left but on the other side of the table).
So, whose balance shall we put on the left: that of the wretched customer who has not yet paid us, or that of the kind supplier who has trusted us to pay later? Hence, the debtors’ balances are entered on the left.
Pazzi never crosses any numbers out; that would lead to confusion and allegations of fraud. Pazzi never uses minuses, since minuses do not exist yet. When Bardi pays Pazzi (perhaps 50 florins), the amount is recorded on the right of Bardi's account. It is to Bardi's credit that he has paid. When Pazzi pays the King (perhaps 120 florins), the amount is recorded on the left of the King's account. At any moment, Pazzi can balance each account to work out how much is due to or from any party. In summary, including the cash transfers just mentioned, the result is:p. 19↵
From single to double
You will have noticed that the earlier accounting system records each transaction once. Furthermore, the debits do not equal the credits. There is no reason why they should. However, during the thirteenth century, business became more complex as seen in Box 4.
Co-owners (partners) and employees, who were not members of the immediate family, were brought in. This increased the chance of dishonesty, which meant that fuller records were useful.
The arrival of the partners meant that it became necessary to calculate profit, so that it could be shared.
Some branches of the business were set up far away (in Venice, Rome, Paris, Bruges, and even London). This increased the need for records. There were multiple currencies, and sometimes goods or credit notes were in transit between branches for weeks.
The cash and the inventory were now large. Particular employees looked after them. It became important to have a record of how much cash and inventory there should be so that this could be compared to how much there actually was. The cashier and the stock man could be regarded as debtors of the business. For example, when cash is received by the business, the cashier takes it and then ‘owes’ it to the business.
p. 21↵Some transactions can now easily be seen as a double entry. For example, if a customer pays some money into the business to settle his account, we record: debit cashier; credit customer. Or, if the bank lends the business some money, we record: debit cashier; credit bank.
It will be useful to do some introductory double entry now. Suppose that a company's very first transaction is: the owners put 40 cash into the company. So, two things have happened:
The business has 40 more cash.
The owners have an interest of 40 in the company.
The top part of Figure 4 shows the balance sheet after this transaction.
p. 22↵Now, suppose that the company needs more money to start operating, so it borrows 60 from the bank. The company now has cash of 100 and a liability of 60. Balance sheet (II) shows the result, as in the bottom part of Figure 4.
At some point in the thirteenth century, it became clear that all transactions could be seen as having two aspects. However, this involved inventing accounts for increasingly abstract things, such as sales or wages. Overall, the accounts could now be divided into three types:
Personal accounts, relating to debtors and creditors.
Real accounts, relating to such things as land and buildings; buying a building for cash can then be recorded as: debit building, credit cash.
Nominal accounts, relating to sales or wages; paying the wages in cash is recorded as: debit wages, credit cash.
An ordered, clerical mind will be attracted to the marvellous result that the total of all the debits equals the total of all the credits. The balance sheet shows the balances on the personal and real accounts: the cash, land, debtors and inventory (the assets), and the claims on those assets held by the owners and the creditors. By looking at all the nominal accounts, the excess of credits over debits is a profit. The profit belongs to the owners. When the profit is added to the owner's interest, the balance sheet will balance. This is a very satisfying result, rather like finishing a Sudoku or a crossword. A more detailed numerical example is given in Chapter 3.
The spread of double entry
Double entry imposes a discipline by requiring a high quality of recording. It enables the calculation of profit and the presentation of the financial position of a business. It provides a satisfying, p. 23↵balancing result. It also alerts the business person to errors in recording, because a lack of balance in the system must mean that an error has been made.
These advantages led to the spread of double entry—first among Italian merchants. The oldest surviving records relate to such merchants operating in Provence (1299) and London (1305–8). Double entry spread to non-commercial activities: the administrators of the city of Genoa were using it by the 1340s. There were different versions of double entry, notably a Tuscan one and a Venetian one. The latter had the clearer two-sided presentation, which is seen in the boxes above.
However, the method spread somewhat slowly round the world. For example, the administrators of the city of Bristol did not adopt a full double entry system until 1785. Bristol is a good English analogy for Genoa; they were both important trading ports. Boats were going between the cities throughout the four and a half centuries that it took for double entry to pass from Genoa town hall to Bristol town hall. Obviously, Bristol knew about double entry, but just thought it was not necessary. Incidentally, the British parliament eventually abandoned tally sticks in favour of double entry. When the old tally sticks were burnt, the fire got out of control and destroyed the Houses of Parliament in 1834, as recorded by Turner in a painting.
Even for commercial activities, double entry arrived slowly in Europe, and then spread to America, Japan, and so on, over the centuries. One aid to its transfer was textbooks. The earliest surviving textbook is a section of a massive work on everything mathematical by Luca Pacioli, a Franciscan friar and mathematics professor. The book, Summa de Arithmetica, Geometria, Proportioni et Proportionalità, was published in Venice in 1494. The book was in Italian not Latin, so it was more easily understood by merchants. And it was printed. The double entry section formed the basis of later works in Flemish, French, and English.
p. 24↵A portrait of Pacioli is shown as Figure 5. It has been much copied. For example, it forms the cover of Australia's oldest academic accounting journal, Abacus; and it has been used in several professional accounting publications. Pacioli has been called ‘the father of double entry’, but this is somewhat misleading given that double entry was conceived 200 years before his seminal work.
Publication and accountability
After the Industrial Revolution and the victories of Nelson and Wellington, Britain became the ‘top nation’, commercially and militarily. Legislation to ease the creation of limited liability companies in 1844 led to widespread ownership of many large companies. In order to protect the shareholders and creditors p. 25↵from potential malpractice by the directors of companies, publication of accounting information was required.
Even so, some company failures involved massive losses, for example the City of Glasgow Bank in 1878. This led to the requirement for audit by outside experts, initially for banks, and then for all companies from 1900. Britain had invented the widespread publication of audited financial statements. Throughout the twentieth century, Companies Acts gradually introduced more accounting regulations. These eventually included EU attempts at harmonization.
America takes over
While Britannia had been ruling the waves, American companies had been waiving the rules. Indeed, when the Wall Street Crash overtook US commerce in 1929, there were hardly any requirements on publication or audit, even for the largest listed companies. One of the reactions to the catastrophe was the creation, in 1934, of the world's toughest and oldest stock market regulator, the Securities and Exchange Commission (SEC). The US audit profession then began to write its own reporting and auditing rules, eventually called ‘standards’, apparently following the term used in the British process which started much later, in 1969.
In 1973, the US profession handed standard-setting on financial reporting to a new independent body, the Financial Accounting Standards Board (FASB). At present, the SEC accepts the FASB's standards as part of its required rules, called ‘generally accepted accounting principles’ (US GAAP).
New York still has by far the world's largest stock exchange, in terms of the number of listed companies and their market capitalization. There are thousands of companies and millions of investors in shares and in debt securities (i.e. bonds, whereby the p. 26↵company promises to re-pay amounts to the holders). Gradually, by the 1970s, a newly clear purpose for financial reporting was identified: to give useful information to investors to help them to make economic decisions by predicting a company's cash flows.
So, during the twentieth century, the USA contributed stock market regulators, private-sector standard-setters, and a user decision-making focus for financial reporting. The FASB was also generally ahead of the rest of the world in writing rules for any particular type of transaction.
Accounting practice becomes international
As already explained, many nations have contributed to developments in accounting. However, this does not mean that financial reporting was necessarily done in the same way across the world. Until the 1970s, there seemed to be no need for this. However, as usual, commercial developments led to accounting developments.
From the 1970s onwards, ‘globalization’ gathered pace. For decades, British groups had owned American subsidiaries, but now British banks started lending to American companies, and British pension funds started buying American shares. Of course, the traffic was both ways, and it now involved Japan, Germany, France, and many other countries.
A major purpose of financial reporting is to enable investors (such as shareholders or bankers) to compare companies. However, this is frustrated if financial reporting practices differ on an international basis. Chapter 4 will give examples of the differences. By the 1970s, governments and accountants had become interested in international ‘harmonization’ of financial reporting. In the Common Market (now the European Union), proposals were drawn up to change laws to achieve harmonization. This alarmed accountants in the UK, who did not want to lose p. 27↵control of accounting, especially to French or German governments. So, in 1973, the year in which the UK joined the Common Market, the British accountancy bodies (see Table 2 in Chapter 1) led the development of an International Accounting Standards Committee (IASC); the accountancy bodies of nine nations founded the IASC.
For 20 years, the IASC produced international standards which few companies obeyed. Then, from 1994, some large German companies began to use international standards. Political developments were behind this, just as they lay behind the foundation of the IASC. When Germany re-unified in 1990, this led to international expansion of many large German companies, and to capital-raising in New York and London. Most large German companies had adopted international standards by 2000. This was a prelude to the EU adopting international standards for listed companies for 2005 onwards. The EU wanted common standards in order to integrate and boost European stock markets. The EU had tried the route of changing laws but this was slow and ineffective because of political compromises over the content of the rules.
In 2001, the IASC was replaced by an independent private-sector trust, the International Accounting Standards Board (IASB), which was modelled on the FASB. Its standards (International Financial Reporting Standards (IFRS)) are now required for the financial reporting of listed companies in about 90 countries, including the EU, Australia, Brazil, and Canada. In some other countries (e.g. Japan and Switzerland), IFRS is allowed. In yet other countries (e.g. China), national rules are now close to IFRS. However, IFRS is not accepted for US companies. The US regulator (the SEC) believes that the greater detail of US GAAP is more appropriate in the USA, where legal cases involving accounting are much more common than they are anywhere else. It seems likely that IFRS and US GAAP will remain distinct sets of requirements: a very large proportion of listed companies follows either one or the other.