Double-Entry Accounting and Financial Literacy
The concept of developing financial literacy among a greater share of the citizenry has been gaining traction in recent years, particularly after the financial crisis left many Americans drowning in debt.
Financial literacy is traditionally associated with areas like understanding how mortgages work, the meaning of compound interest, the importance of saving enough for retirement, the advantages of diversifying investments, etc. Another important area that few people know about is double-entry accounting, and that could be hampering our economy, according to a recent opinion column in The New York Times.
“Few of us can do basic accounting and fewer still know what a balance sheet is,” wrote Jacob Soll, a professor of history and accounting at the University of Southern California. “If we are going to get to the point where we can have a serious debate about financial accountability, we first need to learn some essentials.”
In the article, Soll discusses how double-entry bookkeeping and accounting became common knowledge in European societies centuries ago, including Renaissance Italy and 17 Century Holland. The spread of accounting know-how helped enable the development of the mercantile class, the banking industry and publicly traded companies.
Double-entry accounting was originally written about by Luca Pacioli, an Italian mathematician and Franciscan friar who was a friend of Leonardo da Vinci in Renaissance Italy. Pacioli’s description of double-entry bookkeeping in his 1494 book, “Summa de arithmetica, geometria, proportioni et proportionalità,” was tremendously influential, spreading the practice among the Italian merchants of his day and their trading partners abroad.
The system basically involves creating parallel entries of debits and credits in a ledger, for example offsetting assets and liabilities, and income and expenses, to arrive at the bottom line of a profit or loss.For example, if you earn $1,000, you might debit $1,000 in an account called “Cash,” while also entering a credit in the opposite column in an account labeled “Income.” Ideally, the debits and credits would all balance, and you would be able to calculate your equity by subtracting your liabilities from your assets.
Soll points out that the balance achieved in accounting was considered to be a kind of moral reckoning as well, with some philosophers and merchants tallying their goods deeds against their sins in moral account books. While accounting led to the growth of the first publicly traded enterprises like the Dutch East India Company in the 1600s, suspicions of fraud also led to the introduction of auditing to examine the ledger books for signs of financial mismanagement.
While an understanding of double-entry accounting was widespread among many business owners and their bookkeepers a century ago, the rise of computer technology and automated bank statements has led to a decline in basic accounting knowledge to the point where few people even take the trouble to balance their checkbooks nowadays.
Stoll thinks that’s a mistake. “A population well-versed in double-entry accounting will not immediately solve our complex financial problems, but it would allow average citizens to understand the nuts and bolts of finance: balance sheets, mortgage interest, depreciation and long-term risk,” he writes. “It would also give them a clearer sense of what financial accountability really means and of how to ask for and assess audits.”
He points out that it can be helpful to journalists as well, as business reporters must often deal with complex data about the economy and the financial markets.
That is certainly a good idea. I have listened in to webinars and sat in on seminars about financial journalism, but as someone who writes about accounting on a regular basis, I must confess that I sometimes feel a bit lost when I try to assess the jargon that is frequently used in earnings reports, financial guidance, IRS regulations and accounting standards. A good many professional accountants find themselves scratching their heads too when it comes to parsing the truth behind the numbers and understanding the financial rigmarole that frequently obfuscates it. A population better educated about accounting is probably less likely to be bamboozled by financial manipulators. On the other hand, the successful swindles of someone like Bernard Madoff demonstrate that even sophisticated investors and financial analysts can be taken in by a shrewd fraudster.
Do you think more people should learn the basics of accounting and bookkeeping?
Michael Cohn is editor-in-chief of AccountingToday.com.
Image: Thinkstock
I've watched business owners and church boards glaze over during the most "fundamental" accounting presentations or explanations. I've always felt it more important to grasp reality than to grasp a depiction of that reality, which an accounting system is. And an arcane one at that. Asserting that lay people can and should be able to understand financial statements, balance sheets, etc., in accounting terms, is the same as saying that lay people should be able to understand business contracts, in legal terms. And I agree! They should be able to! But they can't! And that's the problem. It should not take an attorney to understand the work of an attorney, and it should not take an accountant to understand the work of an accountant. That it does, by design, seems to me the crux of the problem. There is a degree of obfuscation possible in the hands of an inscrutable master of the art, which would not be possible if true transparency of intent were the goal of these systems. Therefore, if these carefully crafted systems utterly fail to communicate the reality of the financial situation in these cases (such as Bernie Madoff, as mentioned in the article), I have to ask, why go through the bother at all? There simply has to be a better, simpler way.
Owner, M.R.Limaye&Co
10 年If fundamental principles of book keeping are understood properly then a person can read a balance sheet as well as profit & loss account easily. So concentrate on fundamentals..
international tax | cross-border structuring | ASC 740 tax provisions | transactional planning & compliance | M&A | lecturer | mentor | business development
10 年....the academic in me enjoys the discussion on the concept of double entry accounting. Very interesting.
Managing Partner at Primal Advisory Services
10 年Everyone should have a basic idea about bookkeeping and double entry system. This will help them to keep track of their income and where they spent it. Only then can people start budgeting. As many mentioned above, budgeting is very important. So is understanding the present economic conditions around you. Blind signing of documents, not taking efforts to understand one's portfolio will result in catastrophes. Recession is a proof of that. People should educate themselves at least about the basic things, so that when they consult with a professional, they will get a better picture and help them in making better and hopefully smarter choices. Thank you
Retired from accounting, finance, BPM, non-profit administration and lean 6 sigma,
10 年There is an immediate need for financial literacy. Rudimentary accounting methods would help if there is an understanding between the income and balance sheet, budgets and cash flow. As with business a basic understanding of cash flow would help understand concepts of sunk and opportunity costs and sources of cash flows. Use of a cash flow statement and a budget and balance sheet would help most people manage their expenditures and savings. Most people fail to appreciate the opportunity cost of immediate consumption and the sunk cost of that consumption, you can't recoup the value once expended without significant loss of salvage value. People also need to understand the true cost of borrowing either through debt of future savings. Double entry works if you are able to commit to a ledger system and most people lack the time or drive to do this. Double entry accounting basic should be part of a general financial literacy program that financial and consumer advocates should provide.