DOUBLE ENTRY SYSTEM
When you think of Leonardo da Vinci, I’m sure the Mona Lisa, The Last Supper and the Vitruvian Man jump to mind. If you have visited Paris it is likely that you sought out the Mona Lisa, you might even have skipped everything else in the Louvre just to tick the box. I lived for a few years in Paris and as a result I had the opportunity to take my time in the Louvre. We could go on a Sunday for free and it was possible to get lost in a small section for hours. I am sure I only visited the Mona Lisa once and in fact it is behind glass and usually thronged with people, so it is difficult to appreciate.
When I visit a city and take in a museum or gallery, I am usually pressed for time and the temptation is to run around trying to catch everything. Now I prefer to pick a few pieces and spend some time with them. Imagining how they were conceived, what life was like for the artist at the time, wondering about all the people who have sat down in front of the same piece and I wonder what they thought about. For me art is a wonderful form of meditation, unfortunately it was twenty years ago when I lived in Paris and dare I say it, if I knew then what I know now. Youth is wasted on the young.
Leonardo da Vinci was a polymath (a person of wide knowledge or learning) and he was good friends with Luca Pacioli an Italian mathematician & Franciscan friar. He is referred to as “The Father of Accounting” in Europe and he documented the accounting system we use today in a book called the Summa de arithmetica, geometria. Proportioni et proportionalita (Venice 1494), a textbook for use in the schools of Northern Italy. The accounting system he described was in use at the time by Venetian merchants.
At the route of this system is the principle of double entry accounting. This is the system that invented the balance sheet, debits and credits, reconciliations, ledgers and the rest. There are a few key elements that you should be aware of and they will help in the understanding of accounts in your business. What are the ledgers, why do we reconcile and do journals and why have a Profit & Loss and Balance sheet?
In the simplest form the ledgers are a list of items. It is likely that the first accounting systems used by the Sumerians, Babylonians, and the ancient Egyptians 7,000 years ago was just this, a count of items. The most important ledgers in your business are your list of sales, list of purchases. These are known as your sales ledger and purchases ledger and when they are combined with who owes you money and who you owe, they make up the Debtors and Creditors ledgers.
If you run technology in your business the sales ledger is most likely in your CRM package or other front-end technology that you use. This is where you access information on your customers and record what you sold them and what they owe.
It’s likely that your purchases ledger sits in your accounting package and if you are smart you are using some of the really efficient applications for streamlining this process. When I started out in accounting, a lot of effort went into raising purchase orders, getting approvals, matching to receipt of product/service, matching to invoices, approving, and paying. All this was paper based. Now the technology does most of this.
The other ledger we use is the nominal ledger or general ledger which holds all the individual accounts for tracing income and costs. For example, your wages account or rent account.
Pacioli’s innovation was to create two entry’s every time we accounted for a transaction (sale or purchase). We call this the double entry system, and each entry has a debit and a credit side. The innovation was the check to make sure both sides balanced, detecting errors as you go.
In simple terms, we debit the bank with a sale (cash in) and we credit the sales ledger with the sale and at the end of the day the debits (in) in the bank should add to the same as the sales we make in the sales ledger. If we don’t receive cash but instead, we give credit, then the debit side is not the bank account but the debtors account with our customer. When we get the funds in from the customer, we credit their account and we debit the bank. At the end of the day both sides of all accounts should add up to the same. If for some reason the salesperson processed a credit note and only put it against the sale ledger and not the customer account then the accounts wouldn’t balance.
Before IT systems this was all done on paper but now this happens in your IT system automatically, but you should understand what is happening.
Reconciliations and Journals
These two words have the ability to send most sales professionals over the edge and most other departments in the business shudder when they hear that the accountant has ‘been doing a reconciliation’ or that she needs to ‘put through a journal’ – it usually means bad news.
A reconciliation is a tot between the sales ledger or purchase ledger and the corresponding debtors and creditors ledger. Sometimes we call these the control accounts. In simple terms, all the sales, less the cash in and credit notes should add up to what is owed.
A bank reconciliation which is a key accounting routine reconciles the bank account in your accounts system (on your ledger) with the bank account balance that your bank has on your bank statement. This will be different due to timing differences mostly e.g. you have recorded a cheque as received in your system, but it has not arrived in the actual bank account yet. Other differences will be down to error or fraud and for this reason it is essential to validate your accounting system with the actual bank account to detect errors and fraud. In growth businesses some of these normal controls can be neglected as the business of developing technology, winning customers, and raising finance takes over. If your business does not reconcile Debtors, Creditors and Bank every month then you are risking material errors and fraud. If you do not think it will happen to you then you are suffering from Optimism Bias. Maybe it won’t but it probably will.
I worked on a business in France and we found the Managing Director had renovated his house using business funds by doing the creditors control himself. Another business I worked on in the UK, the MD had their spouse running another business in the factory loft using ‘similar’ raw materials as the company her husband worked for. Her business was particularly profitable! There are plenty stories of accountants completing the bank account reconciliations and being given full control of bank accounts allowing them to redirect funds for personal use.
“An average organisation should expect losses owing to fraud to account for between 3%–6%, although in some cases is as high as 10%.” The Financial Cost of Fraud 2019 – Crowe / University of Portsmouth
Reconciliations are a crucial control in your business, make sure they are being completed, ask to see them every now and have the reconciling items explained to you.
A journal is just a manual double entry to adjust the accounts for something outside the normal day to day routines. We process journals to make the accounts accurate. Some journals are quite specific. E.g. an accrual (journal) to record a cost we know is coming like accountants’ fees but we haven’t received the invoice yet. A general accrual estimating bad debts we might have is also a journal.
Many businesses rely on their external accountants to process journals at the year end to get their statutory accounts correct but don’t update their own system for these adjustments. In this situation, the internal monthly management accounts remain inaccurate. It is best practice to maintain an accurate set of monthly management accounts. In the past this may have been beyond the capability of the small to medium sized business but with technology advances in the last numbers of years this is no longer the case. You should make sure your business maintains an accurate set of records with appropriate journals processed and reconciliations completed.
Profit & Loss and Balance sheet
Earlier on I mentioned the nominal ledger, this is where all the individual item accounts are grouped together. The sum of these accounts gives us the Trial Balance. The balance sheet does what it says on the tin; it balances all the nominal accounts in a summary format. The balance sheet and profit & loss account are the basis of the financial statements and it is best practice to include a Cash Flow also.
There are many formats for financial statements, and these are regulated nationally and internationally. Simply put, for the balance sheet we are interested in the adding the assets of the business and taking away the liabilities (what it owes). This gives the net asset position. Again, in simple terms this is the base value of the business and to have put these assets in place (financed them) we have either raised equity or made profits in the past. The balance sheet will balance when the net asset figure equals equity plus the past profits of the business.
The profit and loss is a summary of the revenues and costs in a period (month, quarter or year). The profit and loss is represented in the balance sheet through the profit figure that has contributed to building assets.
Many businesses survive on a limited profit and loss statement every month. In my view up to annual revenues of up to €500,000 per annum it is possible to run a business through the bank account and a simple debtors and creditors ledger. However, this is lazy, as there are many simple accounting solutions to give you good information with limited expertise required for every size business. When a business starts to grow beyond that and certainly at revenues of more than €1,000,000 per annum then robust monthly financial information including a balance sheet should be available for management. With this information you can then prepare solid cash flows, prepare good projections, and monitor business trends on a timely basis.
I am consistently surprised at the lack of quality monthly financial information in businesses up to €10,000,000 in revenues. Beyond that level it is nearly impossible to control your busines and grow without good financial control. If you have ambitions to grow your business into something of significance with value, now is the time start putting good systems in place.
If you do not have access to a set of monthly accounts, reconciled, with journals posted and summary balances included then you need to fix that. The technology and expertise are available. No excuses.
To think in 1494 in Venice they maintained reconciled accounts with a balance sheet and there was no regulator requiring it. Just best practice. Not only that, but they were also teaching it and artists were passionate about accounting! I wonder what Leonardo da Vinci would think of our progress if he looked at your average €2,000,000 business in Ireland today?
(Photo Mika Baumeister)