How to Understand Accounting: Translating Geek to English

Topics: Accounting
Accounting Pic

Photo by Timm Suess

Accounting is needlessly complicated.  And there is often a huge communication barrier between the Accounting department and the rest of an organization.  Maybe that Intro to Accounting class was supposed to help you understand the difference between Debits and Credits, but in my experience, very few (if any) people actually retain this concept.

Debits and credits are part of Double-Entry Bookkeeping, which can trace its roots back to the ancient Greek mathematicians – it’s just a simple Algebraic equation.  But the concept was first codified and published by an Italian Friar named Luca Pacioli in 1494.  It seems pretty clear that Pacioli was using this system as a tool concerned mainly with who owed what to whom.  And there was clear benefit to this system.  Each transaction had to balance out (the debit side equaled the credit side); double-entry bookkeeping is one of those closed systems that must always be in balance.  It forced discipline, it forced transparency, and it forced honesty.  And while this system originally created great virtue effects, those effects are not quite so clear today.

So in order to understand Accounting, we first have to overcome the following aspects of it: 

  • Terminology:  Accounting has its own language, and most people don’t speak that language.  The terms debit and credit are particularly confusing for most people.  Thanks to banking, most people associate the word debit with decrease and credit with increase.  Uhhh…that’s not exactly how it works in Accounting, and that can be confusing.  So use terms that ordinary humans understand.  Eliminate debit and credit; use Shall Give or Shall Receive, Increase or Decrease, Put In or Take Out, etc.  Bookkeeping will become more understandable to everyone.  Translating accounting language to normal language is one of the most challenging things I deal with in getting everyone on the same page in an organization.  I used to use the words ‘debit’ and ‘credit’ and it only confused people.  I finally learned that I was the one who needed to change.
  • Communication:  Accounting is simply a means of communication.  Everyone has to be involved in determining exactly what is being communicated.  Primarily, Accounting should be a tool for decision-makers.  It has to help them run the business, and it has to establish responsibility for doing so. And it must do so in language that is clearly understandable.  By the way, a good accountant is incredibly observant.  Simply walking around the office (listening to people, watching them work), and then thinking through observed, but unmentioned needs can be a huge help.  This is the process of Natural Inference.
  • Purpose:  At the time Pacioli was codifying Double-Entry Bookkeeping, the words “asset” and “liability” didn’t exist in bookkeeping.  It would probably be better if they weren’t used now either, but that’s not likely to happen.  Just remember that a liability is not always a liability, and an asset is rarely an asset.  What does that mean?  The word asset comes from the French word “assez,” meaning “enough.”  The word developed simply to determine whether someone had “enough” to cover his or her liabilities.  And a person wasn’t “liable” to creditors; he or she was simply “trusted by” them.  In other words, the original purpose of double-entry bookkeeping is not the same as its current purpose.  It has gone through an aggressive evolution since its inception.  Just remember that classifying something as an “asset” or “liability” may not mean very much.
  • Higher Order Effects:  Because of the narrow arithmetical nature of accounting, accountants are often bound by fairly rigid thought.  Economic reality is far more dynamic that Accounting can capture, so understand this when reviewing accounting statements.
  • Time Periods:  An Oscillation is a repetitive variation between two or more different states.  In business, the business cycle serves as an oscillation covering the entire spectrum of an economic environment.  If you want to understand a business, you have to look at it over a full business cycle.  The fiscal quarter and the calendar year have little to do with economic performance or reality.  Don’t feel comfortable with 10-Q’s or 10-K’s – they have little communication value.  The year and quarter are just two more accounting hurdles to clear.

A certain amount of reasonableness is all that’s needed to understand Accounting.  The ability to ask questions in a common language is probably the most critical aspect.  But understanding what Accounting is really communicating is also vital: estimates of value over arbitrary reporting periods.