VOLUME 1

Chapter 1 - Income and outcome

"Few have heard of Father Luca Pacioli, the inventor of double-entry book-keeping; but he has probably had much more influence on human life than has Dante or Michelangelo."

Herbert Muller

 

13th March 1500. Two men are walking across the great square of San Marco in Venice. The monk is from Borgo San Sepulcro: he is a mathematician, 55 years old, and he has been travelling for the last few weeks with a 48-year old artist from Anchiano.

Almost a century will pass before Shakespeare writes "The Merchant of Venice" but the monk's mathematical skills turn out to be of great practical assistance to merchants: initially in his own town, Florence, but later worldwide. The artist is also destined for immortality: a few years later he will create the most famous painting in the world.

 

Figure 1.1: Leonardo da Vinci and Luca Pacioli
 http://www.artchive.com/artchive/l/leonardo/leonardo_self-portrait.jpg
http://www.col-camus-soufflenheim.ac-strasbourg.fr/telech/Portrait%20of%20Luca%20Pacioli.jpg

 

So what did Leonardo da Vinci, artist and inventor of flying machines, find so compelling about the mind of Luca Pacioli, mathematician and inventor of accountancy? 1 And what made the author of the critically acclaimed 1494 opus Summa de arithmetic, geometria et proportionalita so interested in the relationship between mathematics and art?  Was this the first and last time that the words "creative" and "accountancy" were combined in a context untarnished by suspicion?  Can we put ourselves into their shoes and pinpoint the problems they were trying to solve and the nature of the solutions that emerged?

Fast forward 473 years and two men are walking across the rather more modest square of the Whitgift Centre in Croydon. One is a 37-year old accountant and the other is a 21-year old economics graduate. The young economist is baffled by the rules of business finance and seeks help from his experienced colleague. The accountant is amused by his facile questions and provides answers as best he can.

When I started my business career in 1973 I was unaware of this historical context. I found myself working for a company called Roneo Vickers as a trainee in a department called Financial Evaluation and Planning, since this was felt to be the closest match for the skills of a recently graduated economist.  The fact that I had no knowledge of the techniques that the department was supposed to apply was not seen as any specific disadvantage: ignorance was indeed bliss in those days.

In fact it took me an unconscionably long time to figure out what was going on. But it is now 35 years later and large volumes of water have passed beneath the bridge. Some of my children have embarked upon their own business careers and it seems wasteful for them and for others to have to reinvent this particular wheel. So let me share with you this story.

At that time Roneo was part of the Vickers engineering group but it operated semi-autonomously, with its own international subsidiaries across Europe manufacturing and selling office equipment products such as furniture, machinery and supplies.  Annual sales were in the region of £100 million, which obviously corresponds to a much greater figure at today's prices.   Furniture manufacture took place at Dartford in Kent and office machinery was produced at Romford in Essex; there was a paper production facility in Yorkshire and some overseas production as well.  These products were sold throughout the UK via a direct sales force and also exported to the European subsidiaries.

The Vickers Group was at that time a classically unfocussed conglomerate, with business activities such as shipbuilding, baby incubators and military tanks (perhaps unwitting originators of the phrase "from cradle to grave").  The general scheme is summarised in Figure 1.2 below, which shows just a few of the business operations at each reporting level, the rest being implied by the extra lines.

 

Figure 1.2: Vickers Group Structure in 1973

 

One of my first tasks there was to accompany the Chief Financial Officer on a visit to the major subsidiaries in an attempt to win support for the new management reporting schedules  that had recently been designed by Vickers.  As I look back on those career experiences that I count as formative, I can recall as if yesterday the words of the seasoned Finance Director of the Swiss subsidiary, who had just heard my confident proclamation "I'm from Head Office and I'm here to help you".

"Mr Bittlestone" he said, pronouncing my surname in a way that identified with uncanny precision the level of his respect for my accumulated business experience: "I see that on these schedules the Profit and Loss Account starts with Sales, then it jumps to Operating Profit, then it says 'Shipbuilding Relief Grant', then we have the Profit before Tax".

I concurred enthusiastically and he continued relentlessly, warming to his theme "And these schedules have been designed to help us?"  I mumbled assent and he replied "Mr Bittlestone, let me tell you something.  First of all, we do not in fact receive a 'Shipbuilding Relief Grant' from the Swiss Government.  Secondly, this is probably because we do not make ships at this location: instead, as you may perhaps not know, we sell office equipment.  Thirdly, even if we did make ships, I don't think there would be a grant available, because unfortunately here in Switzerland there would be nowhere we could launch them."

Our Chief Financial Officer fumed all the way back to Heathrow and my next assignment was to join a team charged with designing and implementing a user-friendly management reporting system specifically for the Roneo Vickers businesses.  It was via this and other character-building experiences that I gradually became convinced that there were some subtle and challenging issues to be addressed in the area of multinational business control.

The goal of our project was to create a set of paper forms which would clearly identify the performance of each subsidiary.  Every month about 30 of these subsidiaries would be required to fill in these forms with key numbers reflecting the month's results.  These reports would first be transmitted to the appropriate operating division where they would be summarised into a single document so that the divisional management teams could monitor what was happening.  These three or four divisional reports would then in turn be summarised into a further single document for the Roneo Vickers executive board.  This total would then be transcribed onto the Vickers schedules where the absence of a shipbuilding relief grant could be explained without embarrassment.

This meant that the data that Roneo collected should be consistent with that elsewhere within Vickers so that the results of the overall Vickers group could be aggregated.  Our project design therefore had to adhere to certain rules and I was trying to find out about these laws of accountancy from the Group Chief Accountant, because I didn't understand them at all.

I was staring at two numeric schedules, one of which was called 'Profit and Loss Account' and the other 'Balance Sheet'.  The original documents had various additional rows and columns but I have reproduced at Figure 1.3 the essence of the Profit and Loss Account. My main problems were with the Balance Sheet, but I did have a few questions to ask about the first schedule, so I went to find my senior colleague, hoping he was in a supportive frame of mind, and we had a conversation along the following lines.

"David, do you have a moment to help me with some of these schedules from the management reporting project?"

"Yes, but what's the problem -- they look pretty straightforward to me?"

"Well I'd first like to make sure that I've understood the Profit and Loss account properly, so let me explain what I think it means and please correct me if I'm wrong.  Let's start with the top line.  Sales presumably means the amount that we have sold to our customers, the things that they have bought from us and paid us for?"

"Not at all.  The Sales line does correspond to what we have sold to our customers, but they won't have paid for their purchases yet.  We give them trade credit so that they can buy from us on account and settle their bill later."

I wasn't entirely confident about the implications of what he had just said but it didn't seem to matter very much, so I moved on to the next line.

 

Figure 1.3: An indicative Profit & Loss Account

 

"The Cost of Sales is presumably what it costs us to sell the things that the customers have bought?"

"No, in our accounts the Cost of Sales does not include the cost of selling, only the costs of manufacturing."

"Really?  Why don't we call it the Cost of Manufacturing then?"

"We just don't.  I'm sure everybody knows that the cost of sales refers only to the costs of the things that we sell, not the costs of selling them."

"What happens to the selling costs then?"

"They get included further down the schedule, in the Expenses line."

"Oh I see.  So this Cost of Sales line then refers just to the raw materials we bought this month to make the products, and to the cost of shop floor wages, electricity and so on?"

"Absolutely not.  The raw materials we bought this month don't have anything to do with the cost of what we sold this month, because it takes us several months to make a batch of duplicators.  So the cost of the components we buy in the factory in January is destined to be included in future production; it won't be the same as the cost of the components contained within the completed products shipped from the factory in January.  Likewise, the cost of our labour force and electricity in the factory in January goes towards the cost of products we sell later this year, not the costs of products we actually sell in January."

"I think I get it… but then how do we calculate the cost of sales in January?"

"Well, the factory keeps a detailed note of the cost of the parts and labour and overhead that goes into making each of our products.  They add this up to form what we call the Unit Cost of Production – the total cost of producing a single duplicator.  Then if the sales team sells 100 duplicators in January, they multiply this Unit Cost of Production by 100 so that they know the total cost of sales for that product.  Repeat the process for all the other parts sold, add up the individual totals and there's your overall Cost of Sales."

This conversation was starting to worry me for two reasons.  First, I had imagined that I understood most of the Profit and Loss account already, but David's explanation was already opening up a whole raft of broader issues.  Second, at this rate it was going to take a solid month before I had the answers to all my questions, and we were supposed to have a draft design for the new management reporting system ready in two weeks.  I pressed on.

"David, I'll have to come back to you later for some help on the factory points, but let's stick to the schedule for now.  The next line is Gross Profit and this looks to me to be simply the difference between Sales and Cost of Sales – am I right?"

"Yes" said David, with just a hint of irritation.

"So now we come onto Expenses, which I presume include the selling costs you spoke about earlier and also the costs of developing the products in the first place and managing the company generally?"

"Not at all. Our research and development costs are capitalised and end up in the balance sheet as fixed assets, so they are not included in Expenses. You are right about the management costs, but don't forget to include the depreciation."

"I'm a bit confused here.  How can our R&D costs become an asset?"

 

Figure 1.4: A Roneo Duplicator
http://content.answers.com/main/content/wp/en-commons/thumb/0/0c/250px-1906_Roneo_Copier.jpg

 

David looked at me as if I were completely mad. "All sorts of costs end up as assets in the balance sheet" he said.  "The cost of motor vehicles, the cost of building the factory in the first place, the cost of buying the land, the cost of installing a telephone system - they're all in the balance sheet as assets."

"What about the cost of selling?  Is that in the balance sheet too?"

"No, because the criterion that we generally use for categorising a cost as an asset is that the item concerned should have a productive life of longer than a year, which is true for motor cars but not for selling costs."

"But what happens if our selling costs include advertising to build up the Roneo Vickers brand in the long-term, over a period much longer than a year - shouldn't this advertising then be classed as an asset as well?"

"Maybe from a theoretical perspective, but in practice if companies were allowed to do this then the framework would be wide open to abuse, with any kind of miscellaneous publicity costs being treated as an asset.  We have a clear set of rules about things like this -- in England we call them Statements of Standard Accounting Practice (SSAPs) and in America they are referred to as Generally Accepted Accounting Practice (GAAP) -- and part of my job is to ensure that we comply with these rules." 2

"But coming back to the research and development expenditure for a moment, doesn't this mean that if for example we happened to have an R&D team that was half as effective as that of a competitor such as Gestetner, so that it took us twice as long and cost us twice as much to develop the same sort of duplicator, then your accounting rules would mean that our balance sheet would list an asset of twice the value of theirs?"

 

Figure 1.5: A Gestetner Duplicator
http://www.patriotgroup.com/gestetner/duplicator/6244_200.jpg

 

"Yes"

"But that means that anyone reading our balance sheet would get a completely distorted view of the worth of our company?"

"Yes"

"David, why are you grinning?"

"Well, that's their problem really, isn't it?  As long as we comply with the SSAPs and the auditors approve our annual statements, we can't be held responsible for how people interpret the results."

With the benefit of hindsight I can attest that even in 1973 this conspiratorial attitude was unusual, but I didn't know that at the time and the project deadline was looming, so I continued with my naïve questions.

"You also told me not to forget the depreciation -- what is that exactly?"

"Well, most of our assets wear out over time, except for land of course, so if we are to form a realistic view of our overall costs, we need to include some allowance for our use of these assets.  In most cases we calculate the monthly charge by dividing the original cost of the asset by its expected lifetime, although for factory machinery we usually divide it by the expected production hours rather than the calendar lifetime.  But then again you need to remember that the factory depreciation becomes part of the cost of sales rather than the expenses."

"I get the general idea but it does sound somewhat arbitrary to me.  Supposing you make a mistake when you estimate the productive lifetime of the asset – doesn't that mean that all of your historic depreciation charges were wrong?"

"Yes, but in practice we stick to the same depreciation period for the same type of asset, so at least we're consistent."

"You mean at least we're consistently wrong?"

David looked piqued. "There are always judgments involved in accountancy - it's rarely black and white.  My task is to ensure that the accounting rules are correctly applied and to stop our managers from trying to influence these judgments purely to present an over-optimistic outcome."

"Let's move on to the operating profit.  These numbers suggest that this is simply the gross profit minus the expenses - is that right?"

"Yes"

"Then we have to subtract the interest paid to the bank?"

"No, this isn't the interest actually paid to the bank, since most of our subsidiaries pay that only once a quarter, or sometimes just annually.  This is the interest that we would pay to the bank each month if they asked us to do so - we need to keep a record of that in order to have a true and fair view of the month's total costs."

"But how do we know what the month's interest charge is if we don't get an interest statement from the bank until the end of the quarter or the year?"

"We know how much we borrowed from them and we know what the interest rate is, so it's not hard to calculate an approximate figure, which we correct from time to time when the bank's interest statements arrive."

"So this means that the Profit before Tax is the Operating Profit less this interest charged?"

"Yes, although you need to bear in mind that this happens to be the way that Vickers define these things.  Other companies' management accounts would probably show considerable variation".

"But I thought you said that the SSAPs set out the rules?"

"Yes, but the rules are just a framework - in practice we still have substantial discretion on what costs to include in our P&L headings".

"Let's come to the Tax Charged - presumably this gets filled in once a year when we pay the taxman?"

"No, it's like the interest - each month we calculate the tax that we think will be due on the profit we have made, using an estimated tax rate, and then we correct it once the annual tax bill is actually determined."

"What are the Extraordinary Items?"

"Well, from time to time we may do something like restructuring the company, or closing down a factory, or spending time and money on an acquisition deal that falls through, or developing a product prototype that we subsequently decide not to sell.  It wouldn't be fair to include these costs as part of our general expenses, because that would give the impression that our running costs were higher than they really are, so we categorise them instead as extraordinary items and show them below the profit after tax line."

"David, I realise I've only been here for a few weeks, but even I know about the Crayford Works closure, and the electronic duplicator project that never took off, and the hush-hush deal to buy a facsimile company in Israel.  Have I just arrived at an unusually extraordinary time for the company?"

"No, a company of our size usually has several projects of this nature on the go at any one time."

 

Figure 1.6: Vickers Crayford Works
http://www.ideal-homes.org.uk/bexley/crayford/vickers-1920-02.html

 

"Then why on earth are they called – oh never mind, let's move on.  The next line is called Dividends Charged and I think I know what these are. Dividends are what we pay to shareholders once a year, but we have to make an allowance for them every month, so this line is what you think you would be paying the shareholders this month if in fact you did so."

"Yes, except bear in mind that as a wholly owned subsidiary of Vickers, we have a single shareholder in the form of our parent group."

"Understood.  Presumably the next line, the Profit Retained, is then just the profit before tax less these last three charges?"

"Yes"

"But I don't understand the next line after that - 'Opening Reserves'.  What's this?"

"Our reserves are a record of all the profit we have ever made that we have not yet paid to our shareholders as a dividend.  In effect it's the surplus that the business owes to the shareholders but has not yet distributed to them."

"But if we owe it to them, why don't we pay it to them? Presumably we have to pay other people that we owe money too, such as our suppliers and the bank?"

"Yes, but the nature of the contract we have with our suppliers and the bank is rather different to our implied contract with our shareholders.  Our shareholders wish to maximise the return they make from investing in our business over a reasonable period of time.  If the management of the company decides that it would be better to retain some of the profits to help grow the company for the shareholders -- perhaps by acquisition or a major R&D programme -- then it may be appropriate to hold back from paying out a dividend today so that the company can become more valuable in the future."

"So what you are telling me is that at the beginning of January there was a reserve of profits that had not yet been distributed to shareholders, and then during January we made a further profit, so by the end of the month the balance of profits due to the shareholders - what you have called the reserves - is increased accordingly?"

"Very good Robert, we'll make an accountant out of you yet."

"So these reserves of profit are the same as the cash in our bank balance?"

"Absolutely not" said David, exhibiting signs of considerable frustration.

"David, I was going to ask you a whole lot of questions about the cash flow and the balance sheet, but that was when I thought that my questions about the profit and loss account would only take about five minutes.  I think it might be better if we catch a late lunch and pick up on the rest another day."

"Agreed."

So we had our lunch, but I didn't really enjoy it: I was already the victim of some serious intellectual indigestion. Before our conversation I had assumed that the Profit & Loss Account was simply a categorisation of money coming in and money going out, rather like my bank statement, but I was clearly quite wrong about this.  What was worrying me was that when David made statements like "The raw materials we bought this month don't have anything to do with the cost of what we sold this month" or "Our research and development costs are capitalised and end up in the balance sheet as fixed assets", he was referring to some form of interconnection between the Profit & Loss Account and the Balance Sheet that I hadn't anticipated. Instead of simply being an itemised list, these schedules evidently contained all sorts of hidden complexities and linkages to each other that I didn't understand.

Most puzzling of all, if those reserves of profit were not the same as the cash in our bank balance, what sort of meaning did they have instead?  It seemed to me that I really had no alternative but to confess my continuing ignorance to David and pester him for another humiliating briefing. 

Over the next few months he indulged me and so I was able to work out from first principles what these financial interconnections are and how they apply in practice. In the process I discovered that they are simple and quite specific but also that they are not taught from a fundamental perspective in most of the conventional accounting texts. A few years later I felt comfortable enough to turn them into a diagram that was used at Vickers for a series of senior management training courses and this is reproduced at Figure 1.7.  In the process of delivering this material it became apparent that most of the senior managers present were also entirely unclear about these fundamental rules of business engagement.

Although I have used this diagram since that time to help small groups of graduates to understand business finance, it has taken the best part of 30 years for computer technology to develop to a point that now enables us to experience this framework personally. So please don't worry if you find the diagram intimidating, because almost everyone does the first time they see it. We shall develop it gradually over the next few chapters and by the time you see it again I hope it will have become blindingly obvious. And there is a good reason why you should persist, because once you are comfortable with this diagram, you will have understood almost all you need to know about the rules of business accounting.

 

Figure 1.7: How The Accounts Work (c. 1977)
Copyright Robert Bittlestone 1977, 2008

Click on:

Next - Previous - Instructor

 

Participants