part 1 a dream of future wealth

Part 1A dream of futurewealth

The aim of ‘A dream of future wealth’ is to provide the readerwith an intuitive understanding of the rules of business financialmanagement. ‘Do you know how to play chess?’ is the questionthat mirrors our subject, whereas the rather more demandingchallenge ‘Do you know how to play chess well?’ is tackled inPart 2, ‘The hidden art of management’.

But before you skip directly to Part 2, let us remember that wecannot play chess well until we know how to play chess.

www.cambridge.org© in this web service Cambridge University Press

Cambridge University Press978-0-521-76290-8 - Financial Management for Business: Cracking the Hidden CodeRobert BittlestoneExcerptMore information

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 hasDante, or Michelangelo.

Herbert Muller1

13 March 1500. Two men are walking across the great square of SanMarco in Venice. The monk is from Borgo San Sepulcro: he is amathematician, 53 years old, and he has been travelling for the lastfew weeks with a 47-year-old artist from Anchiano.2 They haverecently left Milan where they were the guests of Ludovico il Moroat his colossal Castello Sforzesco, but on 6 October 1499 the Frencharmy invaded Milan and Ludovico was forced to flee.

Almost a century will pass before Shakespeare writes The Merchantof Venice, but the monk’s mathematical skills turn out to be of greatpractical assistance to merchants: initially in Italy, but later world-wide. The artist is also destined for immortality: a few years later hewill create the most famous painting in the world.

So what did Leonardo da Vinci, artist and designer of flyingmachines, find so compelling about the mind of Luca Pacioli, math-ematician and ambassador of accountancy?3 And what made the

1 Muller 1952, p. 257.2 Luca Pacioli met Leonardo da Vinci in Milan after arriving there in 1497. Theycollaborated on various projects and Pacioli also taught da Vinci mathematics. Theylived in the city until 1499 and moved to Venice in March 1500. A letter from aVenetian friend of Pacioli’s dated 13 March 1500 refers to da Vinci’s visit to hismusical instrument works some days earlier and to seeing his charcoal portrait ofIsabelle d’Este. These and further details of Pacioli’s work and his relationship with daVinci can be found in Michael White’s Leonardo: The First Scientist (2000), in PeterBernstein’s Against the Gods: The Remarkable Story of Risk (1996) and in Alfred Crosby’sThe Measure of Reality: Quantification and Western Society, 1250–1600 (1997).

3 Pacioli (sometimes written Paccioli) was the ambassador rather than the inventor ofaccountancy in the Summa (Pacioli 1494). As Bernstein points out: ‘this was notPaccioli’s invention, though his treatment of it was the most extensive to date.The notion of double-entry book-keeping was apparent in Fibonacci’s Liber Abaciand had shown up in a book published about 1305 by the London branch of anItalian firm’ (Bernstein 1996, p. 42). There is also clear evidence that the Dubrovnikwriter Benedikt Kotruljevic (Benedetto Cotrugli) described double-entry accounting



author of the critically acclaimed 1494 opus Summa de Arithmetica,Geometria, Proportioni et Proportionalita so interested in the relationshipbetween mathematics and art? Was this the first and last time thatthe words ‘creative’ and ‘accountancy’ were combined in a contextuntarnished by suspicion? Can we put ourselves in their shoes andpinpoint the problem they were trying to solve and the nature of thesolution that emerged?

Luca Pacioli clearly understood the hidden code of accountancy.He taught Leonardo da Vinci mathematics and da Vinci illustratedPacioli’s Summa, so the great artist had many opportunities to deci-pher the code himself. But what is the Pacioli financial code about,and why is it hidden?

Few of the tourists who visit the Castello Sforzesco enter itsTrivulziana Library, but if you do so, you will find on its shelves oneof the original printed copies of Pacioli’s book. Turn to page 201 andyou will see something quite remarkable (Figure 1.2).

Figure 1.1 Leonardo da Vinci andLuca Pacioli

Figure 1.2 Pacioli’s Summa in theCastello SforzescoPhotographed by the author withthe kind permission of the BibliotecaTrivulziana. Copyright Comune diMilano. All rights reserved.

in his 1458 Libro de l’Arte de la Mercatura. See Yamey 1994, pp. 43–50; and also Stipetic2000, p. 32.

4 F INANCIAL MANAGEMENT FOR BUSINESS : CRACKING THE HIDDEN CODE



Pacioli’s code is concealed within this extract from his book atFigure 1.3. Althoughhewas not thefirst to invent it, he deserves greatcredit for explaining it and his publication has been of incalculableinfluence ever since. It contains the circuit diagram of capitalism: itsets out the financial plumbing that makes it possible for a businessto attract investors, to borrow money from banks, to conduct trade,to pay its workforce and its suppliers, to collect money from itscustomers, to remit taxes and to reward its shareholders. Withoutit, business as we know it would simply not exist.

But it is not at all straightforward for today’s students of financialmanagement to glance at this extract and to understand immediatelywhy it is of such fundamental importance. In fact the effort involvedhas made the subject so unpopular that Pacioli’s hidden code is nowfelt by some practitioners and academics to be a purely mechanicalprocedure that no longerwarrants a place on the business curriculum.4

Figure 1.3 Luca Pacioli’s hidden codeL. Pacioli, ‘Summa de Arithmetica, Geometria, Proportioni et Proportionalita’, Pt 1,Section 9, Treatise 11: Particularis de Computis et Scripturis in J. B. Geijsbeek, AncientDouble-Entry Bookkeeping (Denver, CO: J. B. Geijsbeek, 1914), pp. 44–45.

4 See, for example, this comment from a Professor of Accounting: ‘To the casualobserver, accounting would appear to be being taught in a vacuum, with littlereference to either its past or to its future. It appears to lag behind the real worldand to focus upon teaching students about accounting as it was practised in the pre-computer age of the 1970s, with the sole acknowledgement of progress being anemphasis on accounting standards in all accounting degrees, presumably on the basisthat knowledge of the latest pronouncements of the IASB and FASB are all the up-to-date information that is needed for a graduate to enter the profession. In addition,anecdotal evidence suggests that double entry – the first real development of

INCOME AND OUTCOME 5



When I started my career in 1973 I was unaware of this historicalcontext. I foundmyself working for a company called RoneoVickers asa trainee in a department called Financial Evaluation and Planning,since this was felt to be the closest match for the skills of a recentlygraduated economist. The fact that I had no knowledge of thefinancialtechniques that the departmentwas supposed to applywas not seen asany specific disadvantage: ignorance was indeed bliss in those days.

In fact it took me an embarrassingly long time to work out whatwas going on. But it is nowmore than thirty-five years later and largevolumes of water have passed beneath the bridge. Some of my chil-dren have embarked upon their own business careers and it seemswasteful for them and others to reinvent this particular wheel. So letme share with you this story.

The Vickers Group was at that time a classically unfocused con-glomerate, with business activities such as shipbuilding, office equip-ment, baby incubators and military tanks (perhaps unwittingoriginators of the phrase ‘from cradle to grave’). Roneo Vickers wasthe office equipment subsidiary, with annual sales in the region of£100 million, a substantial business in those days. Furniture manu-facture took place at Dartford in Kent and office machinery wasproduced at Romford in Essex; there was a paper production facilityin Yorkshire and some overseas production as well. These productswere sold throughout the UK via a direct sales force and also exportedto the European subsidiaries.

One of my first tasks there was to design and implement a user-friendly management reporting system. The goal of our project wassimple: to create a set of paper forms which would identify clearlythe performance of each subsidiary. Every month about thirty ofthese subsidiaries would be required to fill in these forms with keynumbers reflecting the month’s results and to send them in to thecentre. Our project design therefore had to adhere to establishedfinancial rules and I was trying to find out about these laws ofaccountancy from the Group Chief Accountant, because I didn’tunderstand them at all.

I was staring at three financial schedules. One of them was calledthe ‘Profit and Loss Account’, another was called the ‘Balance Sheet’and the third one was called the ‘Cash Flow’. The original documentshad various additional rows and columns but I have reproduced atFigure 1.4 the essence of these three forms.

My main problems were with the Balance Sheet and Cash Flow,but I did have a few questions to ask about the Profit and LossAccount, so I went to find my accounting colleague, hoping he wasin a supportive frame of mind, and we had a conversation along thefollowing lines.

‘David, do you have a moment to help me with some of these schedulesfrom the management reporting project?’

accounting into the discipline as we know it today – is no longer considered to be anecessary tool of an accounting graduate’ (Sangster 2010, pp. 23–39).




Figure 1.4 The three primaryfinancial schedules




‘Yes, butwhat’s the problem – they lookpretty straightforward tome?’‘Well I’d first like to make sure that I’ve understood the Profit and

Loss Account properly, so letme explainwhat I think itmeans and pleasecorrect me if I’m wrong. Let’s start with the top line. Sales presumablymeans the amount that we have sold to our customers, the things thatthey have bought from us and paid us for?’

‘Not at all. The Sales line does correspond to what we have sold to ourcustomers, but they don’t pay for their purchases immediately. We letthem buy from us on account and settle their bill later. The amount theyowe us is listed in the Balance Sheet under Debtors, which is calledAccounts Receivable in the USA.’

I wasn’t entirely confident about the implications of what he hadjust said, but it didn’t seem tomatter verymuch, so I moved on to thenext line.

‘The Cost of Sales is presumably what it costs us to sell the things that thecustomers have bought?’

‘Absolutely not: the Cost of Sales has nothing to do with the cost ofselling, it’s the cost of manufacturing the product or buying it in from asupplier.’

‘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 Profit and Loss Account, in the

Expenses line.’‘David, I’ll have to come back to you later for somemore advice about

the Cost of Sales, but let’s stick to the schedule for now. The next line isGross Profit and this looks to me to be simply the difference betweenSales and Cost of Sales – am I right?’

‘Yes,’ said David, with just a hint of irritation.‘So nowwe come onto Expenses, which I presume include the selling

costs you spoke about just now and also the costs of developing theproducts in the first place and managing the company generally?’

‘Not at all. Our research and development costs are capitalised and endup in theBalance Sheet asfixedassets, so they arenot included inExpenses.’

‘I’mabit confused here. How can the research and development costsfor our copiers become an asset in the Balance Sheet?’

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 costof motor vehicles, the cost of building the factory in the first place, thecost of buying the land, the cost of installing a telephone system – they’reall in the Balance Sheet as assets.’

‘What about the cost of selling then? 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 oflonger 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 uptheRoneoVickers brand in the long term, over a periodmuch longer thana year – shouldn’t this advertising then be classed as an asset as well?’

‘Maybe from a theoretical perspective, but in practice if companieswere allowed to do this then the framework would be wide open to




abuse, with any kind of miscellaneous publicity costs being treated as anasset. There is a clear set of financial rules about things like this and partof my job is to ensure that we comply with these rules.’

‘But coming back to the research and development expenditure for amoment, doesn’t this mean that if for example we happened to have anR&D team that was half as effective as that of a competitor such asGestetner, so that it took us twice as long and cost us twice as much todevelop our copiers, then your accounting rules would mean that ourBalance Sheet would list an asset of twice the value of theirs?’

‘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 rules and the auditors approve our annual statements, we can’t beheld responsible for how people interpret the results.’

With the benefit of hindsight I can attest that even in 1973 thisconspiratorial attitude was unusual, but I didn’t know that at thetime and the project deadline was looming, so I continued with mynaive questions.

‘What is this word “Depreciation”?’‘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 toinclude some allowance for our use of these assets. In most cases wecalculate the monthly depreciation by dividing the original cost of theasset by its expected lifetime, although for factory machinery we usuallydivide it by the expected production hours rather than the calendarlifetime. But then again you need to remember that the factory depreci-ation 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 life-time of the asset – doesn’t thatmean that all of your historic depreciationcharges were wrong?’

‘Yes, but in practice we stick to the same depreciation period for thesame 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 blackand white. My task is to ensure that the accounting rules are correctlyapplied and to stop our managers from trying to influence these judg-ments purely to present an over-optimistic outcome.’

‘Let’s move on to the Operating Profit. These numbers suggest thatthis is simply the Gross Profit minus the expenses – is that right?’

‘Yes.’‘Then we have to subtract the interest … then there’s the tax.

Presumably this is what we owe to the taxman?’‘Absolutely not. Each month we calculate the tax that we think will

be due on the profit we have made, using an estimated tax rate, and thenwe correct it once the annual tax bill is actually determined. The amountwe owe to the taxman appears in the Balance Sheet.’




Figure

1.5

Visualising

Pacioli’shidden

code:howthe

accountswork

Copyright

Robert

Bittlestone1977,2010.



I found myself becoming increasingly uneasy with David’s effortlesscross-references to the Balance Sheet and so I thought it might bewise to inquire about it.

‘I think I understand the Profit after Tax bottom line of the Profit and LossAccount, so shall we switch to the Balance Sheet now? There’s a linethere called Undistributed Profits – can you explain what that means?’

‘Our Undistributed Profits, also called Retained Earnings or Reserves,are recorded in the Balance Sheet as a record of all the profit we have evermade that we have not yet paid to our shareholders as a dividend. Ineffect it’s the surplus that the business owes to its shareholders, but hasnot yet distributed to them.’

‘But why does Profit appear in the Balance Sheet as well as in theProfit and Loss Account? In fact I see that it also appears in the Cash Flowstatement that we haven’t even discussed yet. Why is it in all three ofthese statements? And if we owe all this money to the shareholders, whydon’t we pay it to them? Presumably we have to pay other people that weowe money to, such as our suppliers and the bank?’

‘Yes we do, but the nature of the contract we have with our suppliersand the bank is rather different to our implied contract with our share-holders. Our shareholders wish to maximise the return they make frominvesting in our business over a reasonable period of time. If the man-agement of the company decides that it would be better to retain some ofthe profits to help grow the company for the shareholders – perhaps byacquisition or a major R&D programme – then it may be appropriate tohold back from paying out a dividend today so that the company canbecome more valuable in the future.’

‘So these reserves of profit are the same as the cash in our bankbalance?’

‘Absolutely not,’ said David, exhibiting signs of considerablefrustration.

‘David, I was going to ask you a whole lot more about the BalanceSheet and the Cash Flow statements, but that was when I thought thatmy questions about the Profit and Loss Account would only take aboutfive minutes. I think it might be better if we catch a late lunch and pickup on the rest another day.’

‘Agreed.’

So we had our lunch, but I didn’t really enjoy it: I was already thevictim of some serious intellectual indigestion. Before our conver-sation I had assumed that the Profit and Loss Account was simplya categorisation of money coming in and money going out,rather like my own bank statement, but I was clearly quite wrongabout this.

What was worrying me was that when David made statementslike ‘All sorts of costs end up as assets in the Balance Sheet’, hewas referring to some form of interconnection between the Profitand Loss Account and the Balance Sheet that I hadn’t anticipatedat all. Worse still, as I looked over these three schedules, I couldsee that the Bank Account figure appeared in both the Cash Flowand the Balance Sheet tables, while I had already observed that theProfit figure appeared in all three statements, but in curiouslydifferent ways.




part 1 a dream of future wealth

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