Double entry bookkeeping

The historian of accounting Rob Bryer argues that the real advantage of double entry bookkeeping is that it makes it easy to calculate the rate of return on capital. That became crucial when enterprises became joint investments rather than a single person or a single firm and each investor wanted to be sure they were getting the appropriate return on their investment.

Can anyone here provide a simple model of how double entry bookkeeping automatically gives investors the means to calculate the rate of return?

Thanks

Firms raise funding – financial capital – from debt and equity.

"Capital", in this financial sense, is (long-term) debt plus equity: the amount of funding originally raised from these two different sources.

This funding must be paid for. Debt holders must be paid interest, and equity holders will be paid a certain amount of dividends. Using this funding received from debt and equity holders, the firm hopes to create an income stream.

Net Income is this income stream. The firm took the funding, created a working enterprise, and created the income stream. This net income already has the interest expense deducted, so all that is left is paying the dividends. (Dividends are not, technically, an expense that would already be deducted.)

Net Income - Dividends subtracts out these dividend payments given to shareholders, who were presumably expecting those payments when they chose to make the initial stock investment. The firm might not have been able to raise its original funding without the presumption that such dividends would be paid.

And so the Return to Capital is (Net Income - Dividends)/Capital. The firm created an income stream. It then paid for the funding it used to create that income stream. What remains, as a percentage of total capital (debt + equity, the denominator of the formula), is the return to capital. This is the return that’s left after paying for the initial funding.




It is absolutely true that this is dead easy to calculate from the standard accounting statements.

Net income will be on the income statement. Dividends are generally paid in cash, so they should appear on the statement of cash flows. And the book value of equity and long-term debt will appear on the balance sheet.

Plug and play.

If you have the firm’s financial statements (created, of course, using the standard double-entry procedure), then you have all the pieces you need to make this calculation.




I am not immediately convinced that this is the “real advantage” of double-entry bookkeeping and its standard financial statements.

When Luca Pacioli wrote his mathematics treatise, and threw in a random section on the method of accounting he learned from the Venetians, the idea spread like wildfire. There were new editions printed that excised all of the more creative mathematical stuffs he was writing about, and left only the business technique. I’m not a historian, but I’d guess joint-stock enterprises were a slower, much more legally cumbersome thing.

Double-entry is used because it is easy.

It can summarize a large amount of disparate information in a way that minimizes the chance of recording error. The fact that the return on capital is simple to calculate is just part of the general pattern that practically everything is simple to calculate if you’re doing it right. I mean, there’s always plenty of work keeping the accountants busy as they draw up the financial statements period after period. But if all that work is done right, it should be possible to read off a lot of useful information all at once. Including, yes, the return to capital.

Thanks for this. I’m not a historian of accounting, like Bryer is, so I have no opinion on whether DEB was adopted because of the ease in calculating each investor’s rate of return. His argument is that the usual reasons for it: easily spotting theft, for example, are not persuasive but what is created at the same time in Italy as the take up of DEB is the pooling of capital for new ventures. So his point is that DEB becomes popular because joint ventures mean each investor is keen to see their appropriate share of returns. As I say, I’m just an interested spectator in this historical argument. Appreciate your help!