Double-Entry Accounting in Modern Times
How Double-Entry Parted Ways with Economics
In 1494, the Gutenberg printing press made it possible for Luca Pacioli, an Italian monk, to publish an exposition of double-entry accounting as practiced during his lifetime. Pacioli showed that the claims on the assets of an enterprise can be no more, or no less, than the assets themselves. Accounting’s fundamental attribute, as he described it, is the adherence to this immutable law of economics.
Pacioli also described the prevailing view that claims on assets were dichotomous. In his 15th century world, a claim could be either a liability or the owners’ equity — not both. Accordingly, the income of the owners through the operations of the enterprise could be derived from the change during the period in net assets (provided that the assets and the liabilities were measured correctly).
Over the centuries since Pacioli published his textbook, a chasm between double-entry accounting and the actual economic events affecting an enterprise has emerged:
1- A great many assets are absent from balance sheets, and measurement can be arbitrary.
2- The notion of a self-evident dichotomy of claims has been rendered simplistic and useless by advances in financial management and other business developments.
Less obvious, but just as important, is the absence of correspondence between claims and assets. The FASB and every other extant standard-setter have adopted non-corresponding criteria for asset and liability recognition (and measurement). Setting aside the additional problem that some assets/liabilities recognized are not actually assets/liabilities (e.g., deferred gains and losses), the effect of two recognition criteria is to produce balance sheets for which the left-hand side displays a particular subset of economic assets; and the right-hand side displays a different subset of economic claims.
Double-entry accounting still ensures that the balance sheet balances, but that fact doesn’t tell you much of anything anymore. In spite of the lack of correspondence and the absence of many assets from the balance sheet, we still persist in deriving accounting earnings from changes in net assets. But the bottom line is that, in modern double-entry accounting, there is no bottom line.
As I contemplate how all of this will affect my shareholder-oriented financial accounting system, I see three paths:
1- Continue to defend double-entry as an economic model: that changes in net assets are a reasonable representation of economic earnings — I don’t believe this for a second.
2- Invent a new definition of earnings that does not logically depend on changes in assets and liabilities — Even if a possibility, it won’t happen anytime soon.
3- Acknowledge that double-entry accounting is no longer anything other than a device for discouraging financial statement manipulation.
Author: Tom Selling