A Brief History of Accounting

The activity of accounting has been around for several thousand years.

Example:
Part of Confucius’ job responsibilities as a government employee was accounting (500 BC).

Much of what we know about the daily lives of ancient peoples comes from accounting records, such
as inventories and sales records, found at archeological sites.

After the Crusades:

• Trade dramatically increased between Europe and the Middle East
• Italy became the intersection for this trade

Business owners needed to know how well their “stewards” were managing. They had to rely on
written records.

Great need for better recording of transactions:

• Businesses expanded in size and distance
• Owner could no longer do everything himself

This led to:

è First major advance in accounting
Around the 13th century AD:
Modern accounting (“double-entry” accounting) was developed in Italy

Genoa: a major center of commercial activity

: Genoese system probably evolved from an ancient Roman system
Assumed the concept of a “business entity”
Used “money” to record transactions, so unlike items could be compared in common terms
Distinguished between:
Capital (owner’s investment)
Profits (earnings of the business)
Oldest known Genoese double-entry books date from 1340
However, system was already well developed

Florence: a major artistic center

: Gold florin was accepted as standard coin across Europe
Developed large associations and partnerships that pooled capital
Distinguished between individual partner’s capital accounts
Allocated profits and losses between partners

Venice: a key commercial and port city

: Perfected double-entry accounting
The “Method of Venice” is the true ancestor of modern accounting
The Franciscan Roots of Modern Accounting
First surviving accounting textbook:
“The Summa” written by Luca Pacioli in 1494
(included illustrations by L. Da Vinci)
• A best seller in its day
• Publicized the Method of Venice
• Helped to spread literacy in the middle class

Luca Pacioli—the “Father of Accounting”

L A mathematician and merchant
Became a Franciscan friar
Franciscans came out of, and ministered to, merchant class
*** Laca did not invent double-entry accounting, but spread the knowledge

Pacioli stated that a merchant’s responsibilities were:

To give glory to God in their enterprises
To be ethical in all business activities
To earn a profit

The Method of Venice (Double-entry Accounting)

Invention of the “Debit” and “Credit” concepts from the Italian terminology

Allowed for much easier addition and subtraction before calculators were invented

Debit
Comes from the Italian “debito”
which comes from the Latin “debita” and “debeo”
which means:
OWED TO the proprietor
or an asset of the proprietor

Credit
Comes from the Italian “credito”
which comes from the Latin “credo”
which means:
Trust or belief (in the proprietor)
or OWED BY the proprietor

The next important period of history:

19th century

What began in Britain in the 1830s, spurred by Eli Whitney’s invention of the cotton gin
(in the U.S.)???

The industrial revolution took hold in the U.S. after the Civil War.
T Mass production became possible

Businesses expanded in:

B Physical size,
Degree of mechanization, and
Number of employees.

Government regulation and taxation also increased.

During/after the industrial revolution--where did business owners get the funds to expand?

Businesses began operating as CORPORATIONS to bring in funds from “outsiders”

t Stocks
Bonds

How do stockholders and creditors know how well their investment is doing?

The need developed to provide information to outside investors.

èSecond major advance in Accounting (1900, 1930s):

S First—requirement of reporting
Later—standardization of reports
This brings us to the late 20th and early 21st centuries

From the 13th century to the present:

 Double-entry accounting spread throughout the world
 Accountants in each country adapted accounting practices to suit their:
A Cultures and Environments
Laws & regulations
Capital market structures

National differences in accounting rules and practices make financial statements of

companies based in different countries UNCOMPARABLE

èThird major advance in accounting:

T Development of international accounting standards
Harmonization of accounting and reporting
 +
Dr Cr Cr
A = L + OE
Cr Dr Dr
-
 Ratio Analysis - one of the tools we use to analyze
financial statements and tell us about a company’s
health.

Financial ratios
 Show relationships between financial statement amounts.

 Each ratio sheds light on a different aspect of a company’s

health.
Debt Ratio
1. Measure of leverage—extent to which a company has
borrowed money to leverage the owners’ investments.
2. Total liabilities ÷ Total assets.
3. General rule of thumb: should be around 50%, yet varies
from industry to industry.

Current (or Working Capital) Ratio

1. Measure of liquidity: a comparison of the current assets (cash
receivables, and inventory) to the current liabilities.
2. Total current assets ÷ Total current liabilities.
3. Historically, a current ratio below 2.0 suggests liquidity problems.
4. Some loans impose a minimum current ratio restriction to force the
borrower to maintain its liquidity.
Asset Turnover
1. Measure of company efficiency (asset utilization).
2. Sales ÷ Total assets.
3. Generally, the higher the asset turnover ratio, the more
efficiently the company is using its assets to generate sales.
Return on Sales
1. Measure of the amount of profit earned per dollar of sales.
2. Net income ÷ Sales.
3. Should either be compared to company's period
performance or against others within the same industry (or industry
average) since what is a "normal" ROS varies between
industries.
Return on Equity
1. Overall measure of performance—profit earned per dollar of owner
investment.
2. Net income ÷ Owners’ equity.
3. Good ROEs typically run between 15% and 25%.
Price-Earnings Ratio
1. Measures the relationship between the market value of a
company and its current earnings.
2. Market price per share ÷ Earnings per share.
 3. In the United States, PE ratios typically run between 5 and 30.
4. High PE ratios are associated with companies that investors
believe have strong potential.

DuPont Framework
1. Provides a systematic approach for identifying the three factors
contributing to return on equity (ROE).
2. Return on equity = Net income ÷ Owners’ equity
3. ROE summarizes the financial health of a
company and shows the amount of net income an investor earns in
one year per dollar of investment.
4. Equal to:
a. Profitability x Efficiency x Leverage.
b. Profit margin x Asset turnover x Assets-to-equity ratio.

(Net income ÷ Revenue) x (Revenue ÷ Assets) x (Assets ÷ Equity).

5. Profit margin = Net income ÷ Revenue. Shows the amount of profit

generated from each dollar of revenue.
6. Asset turnover = Revenues ÷ Assets. Shows
the number of dollars in revenue generated by each dollar of
assets.
7. Assets-to-equity ratio = Assets ÷ Equity. Shows
the number of dollars a company is able to acquire using each
dollar invested by stockholders.

B. Common-Size Financial Statements

1. Divide all financial statement numbers for a given year by the total
revenues for that year.
2. All numbers are then reported as a percentage of revenues
for that year.
3. By converting dollars to percentages, size is factored out.
This allows the company to compare its performance to other
companies in the same
industry in order to pinpoint problem areas.
4. For a common-size balance sheet, the asset section can be used to
determine how efficiently the company is using its assets.