Peeling away financial reporting issues one layer at a time

Double-Entry Accounting in Modern Times

My Shareholder Oriented Financial Accounting (S-OFA) Standards will require that debits equal credits.

Duh.  But if I am truly going to start with a clean sheet of paper, then I am compelled to explain how double-entry accounting serves a purpose.  I see three possible justifications:

Error checking — But I expect we can readily agree that the days of writing down a number twice in order to verify that the two numbers match are long gone.

Deterrent to financial statement manipulation — The basic idea is that a trial balance is like a balloon filled with water:  if you squeeze in one place (e.g., revenue), some other place will bulge (e.g., accounts receivable).

Realistic economic model of a business enterprise — The informational value of double-entry accounting as economic model would be the most compelling justification. I am going to explain that this is no longer not even close to being true.

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:

  • A great many assets are absent from balance sheets, and measurement can be arbitrary.
  • The notion of a self-evident dichotomy of claims has been rendered simplistic and useless by advances in financial management and other business developments. (See my previous post for more of my take on this – and a follow-up as soon as I can find the time.)

Less obvious, but just as important, is the absence of a correspondence between claims and assets.  The FASB and every other extant standard setter has adopted non-corresponding criteria for asset and liability recognition (and measurement).  Setting aside the additional problem that not all assets/liabilities recognized are not actually assets/liabilities, 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:

  • Continue to defend double-entry as an economic model: that changes in net assets is a reasonable representation of economic earnings — I don’t believe this for a second.
  • 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.
  • Acknowledge that double-entry accounting is no longer anything other than a device for discouraging financial statement manipulation — and act accordingly.

Next Steps 

 By ‘act accordingly,’ here are some examples of my plans:

Truth in labeling —Starting with a clean sheet should also mean jettisoning such time-worn terminology as “earnings” and “financial position” that have come to promise more than they can deliver.  There might have been a time long ago when accounting came reasonably close to measuring economic earnings and financial position, but not anymore, and likely never again.

Reconcile, reconcile —  The property of double-entry accounting that comprehensively links stocks to flows (i.e., “articulation”) will be exploited to the maximum extent practicable through detailed quantitative disclosures that are linked directly and explicitly to the financial statements, and among themselves.

Corresponding recognition criteria — Although I can’t say this for sure, I wouldn’t be surprised if Pacioli had realized that a claims on one entity must also be an asset of some other entity (more on that in a follow-up post).  Therefore, a non-corresponding definition for liabilities, and other non-residual claims, is not necessary.  All that is needed is a definition of “asset” for accounting purposes.

Claims presentation — Instead of liabilities versus owners’ equity, S-OFA will refer to ‘non-residual interests’ versus ‘the residual interest’ (the latter being measured as the difference between total assets and total non-residual interests).  Thus, the question that has bedeviled the FASB of what is a liability, or what is not, will come down to a question of presentation.  For example, pure liabilities may be presented as a group, apart from the hybrid claims I mentioned earlier.

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I started this post with an obvious statement, and I’ll end it with one:  Double-entry accounting is still useful, but not in all of the ways it once was.


  1. Reply Daphne Main May 18, 2017

    Just like websites make you enter your password twice to catch errors, I still see a use for entering numbers twice in the books…

    • Reply Tom Selling May 18, 2017

      Hi, Daphne:

      My understanding is that accounting applications do not require double entry of the number. If they did, I expect that many users would just copy and paste their first entry to make the second one, which would have the effect of defeating the error-catching feature of double-entry accounting.


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