Why The World Should Learn To Love Good Accountants
July 18, 2013
Compared to the drama of interest rates and fiscal cliffs, accounting and auditing are often overlooked, seen as mundane and boring. But, warns a historian of the subject, they have been crucial to the smooth operation of world trade since before the time of Columbus. In an era of financial crises, our ignorance is perilous. Written by Jacob Soll
From the G20, to Davos and Doha, political leaders and pundits both defend and decry globalization, often in the same speech. Globalization offers the prospect of both riches and the faceless menace of unaccountable power. The new world that accompanies it is at once unavoidable, remarkable (from iPhone production and strawberries in winter), yet also fear-inducing (unsafe Bangladeshi textiles factories, pollution, human trafficking and off-shore finance). Even the most informed citizens and investors who benefit from global trade have only a hazy view of how companies and banks operate in an age where the laws of nations can be skirted by porous borders, mismatched and unenforceable regulations, and mysterious banking havens.
But this is not entirely new. From its inception, global trade has been attended by anxiety and mistrust. Then as now, the payoffs and the risks have always been potentially enormous. For medieval Italian traders, such as the Genoese, setting up a business venture was not so different from today. It meant finding investors, outfitting a ship, purchasing a product – like pepper or redcurrants – and bringing it back to Italy from China or India, via Persia, Arabia and the Ottoman Empire, exchanging currencies, paying duties, marketing and selling the goods, and dividing profits. Investors faced piracy, thievery, pests, the plague, counterfeiting, bad weather, hostile foreign powers and the problems of banking. Communication was slow and some trade expeditions took years.
Along with the real risks, there were also those of the imagination. In Western lands there were rumors that in Asian countries were to be found giant ants, cannibals, men with feet for heads, and Cyclops. Yet tales of monsters were paired with Marco Polo’s promises of riches. Once eastern spices worth their weight in gold started pouring into Italian ports, the ambition of international traders and bankers became limitless, as fears were overcome by the desire for wealth and precious goods.
Profit and loss
To manage multi-partner sea-trading companies and international banking houses, medieval Italians developed double-entry bookkeeping at the end of the 1200s. The separate columns of debit and credit controlled accuracy. If one column was different, an error had been made. By tallying income and loss in separate columns and then balancing the two, double-entry bookkeeping provided detailed statements of income: how much profit came from serving customers rather than shrewd investing, and how much loss sprang from the burdens of operation, rather than unexpected accidents and unwise speculation.
Once a boat returned its cargo safely to port, its accounts and logbooks were integrated into the firm’s central ledger so that each partner’s equity could be calculated. Thus began the practice of modern accounting – a profession often regarded as “boring”, which may explain the lack of attention paid to it. But in fact, as we shall see, it plays an essential role in the smooth functioning of world trade; and our lack of focus on the subject is a particularly dangerous lacuna in our financial and economic understanding at a time when little-anticipated crises have laid waste to the treasuries of states across the continents.
Genoa ran itself as a city of global commerce. The government contracted boats to bring pepper back to its port and then to appear in an authenticated municipal record. By the mid-1300s, the massari, or stewards, of the city legislated: “And [we decree] that the ledgers be kept in the office of the Two Accountants, so that they may better control the accounts of the Commune of Genoa.” Through this state account book, the government and citizens could verify investments, taxes paid, and the profitability of ventures. Transparency and balanced books provided the confidence which fed credit and investment in Genoese trade. Chinese pepper seemed less foreign and less risky when it was accounted for in clear numbers and neat columns.
As world trade expanded with Columbus’s first voyage in 1492, so did the possibility for profit, but also for mistrust and confusion. The profession of navigator, the fabled seaman enticingly claimed, “created a curiosity about the secrets of the world”. He promised Queen Isabella of Castile and King Ferdinand of Aragon “miraculously” rich lands and submissive subjects. Columbus did not, in fact, find the route to the Indies, or indeed to India, but his “discoveries” transformed navigation, expanded trade routes and created the potential for a network of world markets, which led to globalized new products, like sugar, tobacco, potatoes and chocolate, and set the foundation for new cultures at once terrifying and grandiose, from Peru, Mexico, and Goa to the Philippines.
However, in 1499, when profits ran scarce and famine set in, and the indigenous peoples of Hispaniola – the Caribbean island now divided between Haiti and the Dominican Republic – rebelled, and were subsequently enslaved, tortured and even dismembered under Columbus’s orders, the Spanish monarchs were shocked and their confidence in Columbus and his reports shaken. In 1500, they sent Francisco de Bobadilla, a royal juez pesquisidor, or examining justice, to arrest him and put him in chains. Back in Spain, humiliated, Columbus wrote a book, El Libro de los Privilegios (1502), outlining all the duties he believed were owed to him and his family. “I beg your graces, with the zeal of faithful Christians in whom their Highnesses have confidence, to read all my papers, and to consider how I, who came from so far to serve these princes… now at the end of my days have been despoiled of my honor and my property without cause, wherein is neither justice nor mercy.”
Columbus demanded 10 percent of all the wealth of the New World, but would receive nothing in his lifetime. Others enriched themselves from Columbus’s brilliant but morally compromised enterprise and, for a time, Spain reaped massive wealth from the gold, silver, forced labor and natural resources of its new colonies. The monarchy’s financial management, however, was poorly staffed and disorganized, with no central bookkeeping office. Accounting was often unclear and many who kept financial records, like Columbus himself, rightly feared their accounts would not make it back to Spain, or if they did, that they would be ignored or misunderstood.
The demands of maintaining a planetary empire, overreliance on natural resources for industry and war, and poor state accounting undermined the Spanish economy, which collapsed as all talent and resources went into extracting wealth rather than industry. By 1575, after finally employing professional accountants, the crown established that it had only an estimated income of 5,642,304 ducats and debt of over 73,908,171 ducats.
Without any expenditure at all (an impossible state of affairs), it would have taken the crown 15 years of high income to pay off its debts, and yet Philip II was only beginning to fight his wars against the Protestants in Holland and the Turks in the Mediterranean, all on credit. Finally, with the disastrous Armada against the English in 1588, he lost his fleet, his fortune and even shook his own faith; he had overstretched the state into unmanageable debt. He could no longer effectively protect his gold and silver convoys that now were being pirated by the boats of the tiny, breakaway Dutch Republic. For all of its mighty dominions and Philip’s reforms in financial administration, Spain had few highly trained accountants, and, in comparison with Holland, no schools to train managers in both the techniques of accounting and the ethos of accountability. Those who did write rudimentary accounts for the state or Church could not be sure their superiors would put them to good use.
By the time Philip died in 1598, his heirs, unable to face the debts and challenges of such a massive, crumbling empire, began to undo his accounting reforms, only making matters worse. Global trade without the capacity or, indeed, will for clear financial communication or accountability promised the world, but, as Columbus – and the Spanish monarch – found, could end in financial ruin.
Spain provided the great exemplary warning that as commercial empires grew, long-distance trade was much more risky without accounting being central to the enterprise. Financial numbers were one way to shrink distance and inspire confidence. Britain’s North American colonies began as joint-partner companies, mixing business with religion as Puritan pilgrims searched for a promised land of religious freedom through colonial business ventures. Faith was made stronger in both through clear accounting. Established in 1624, the Massachusetts Bay Company relied on good account books and audits so that investors back in England felt in control of their investment: “But for that there is a great debt owing by the joint stock, it was moved tha some course might be taken for the cleering thereof, before the gouvmt bee transferred; and to this purpose it was first though fit that the accompts should bee audited, to see what the debt is.” When the company struggled, therefore, audits were made and new accountants shipped to America.
On the railroad
So it was widely recognized that international trade needed strong audits and vigilance by all for it to flourish. In 1850, Parliament passed the English Companies Act and related laws, which required an independent examination of a company’s accounts in order to make a certified financial statement. British companies did systematic audits of their accounts, as outside inspectors would “examine the books of the treasurer” to ascertain “that the amount of moneys received and paid out, were correctly entered upon his books”, based on an examination of vouchers and receipts. But British accountants had a hard time imposing their standards overseas.
This was a problem for global trade. British investors, flush with cash from the Industrial Revolution, saw America as a primary point for their money; US railroads promised wealth on a scale previously unknown. The problem was, how could an investor keep track of equity in companies with complex expenses and depreciation? Many investors in Europe did not have a firm grasp on the enormous complexity of overseas holdings. Everything from steam engines, ticket sales and track wear all had to be accounted for in one way or another, and fraud could take place on a massive scale, from ports in Scotland, India and the Philippines, to obscure railroad stations in Utah and depots in Pennsylvania. Books could be falsified at all levels, from cost accounts to the improper valuing of stocks. Indeed, Jay Gould (1836-92) – the vastly rich and corrupt railroad speculator – paid off legislatures, made Boss Tweed (head of the equally infamous New York State “Tammany Hall” political machine) the director of the Erie Railroad, and simply burned the stocks of his inquisitive British railroad investors, instantly wiping out their stakes.
Such scandals created the market for ratings firms. While today the Big Three ratings firms are under fire for conflicts of interest, companies like Moody’s and Poor’s were both founded to create verified financial statements for railroads so British speculators could invest overseas with relative confidence. Poor’s Manual from the 1880s published verified financial statements on the Pacific Railroad. In 1912, John Moody followed suit with his How to Analyze Railroad Reports. Even the financial press developed in part to publish these statements, so that investors in Bombay could read about profits and fraud in Montana. The better and more trustworthy the statements were, the more were willing to invest in global trade. By 1897, American accountants moved to create the regulated profession of Certified Public Accountants.
But in each financial crisis, from the Crédit Mobilier/Union Pacific Railroad scandal of 1872 to the crash of 1929, accounting, audits and the ratings firms failed to protect investors; either bookkeeping standards or auditing laws were too lax to provide accurate controls. After each crisis, there was accounting reform, such as the creation of the American Securities Exchange Commission (SEC) in 1934, which aimed to enforce how companies in the US reported their accounts. For a time, rigorous regulatory standards and public awareness of them restored confidence in world markets and similar institutions grew in other countries. Transparent accounting and reporting regulations accompanied the great economic boom that followed World War II. Over the past seven decades, there has been a move to standardize world accounting and auditing procedures.
But as we know, it has only partially succeeded. Accounting and auditing have not kept up with the complexities and grey zones of international trade and banking. In spite of the SEC, American corporate balance sheets are only a snapshot of their earnings and risks, and bookkeepers have many ways to cook those books. Indeed, from Enron to Lehman Brothers and Bank of America, auditors have been slower than companies at finding tricks to mask losses and risks. Since the 2008 banking crisis and the ongoing crises of accounting and accountability in Greece and other European countries, the global public has declining faith that banks, companies and governments will properly report their earnings and debts.
Paradoxically, confidence is most bullish in the most opaque of the great economies. A closed society, China, has lived up to Marco Polo’s promises of seemingly limitless wealth. Investors overlook poor accounting, auditing and, indeed, social, political and environmental standards, because profits flow so freely. But China’s balance sheets are shrouded in mystery. What if Chinese municipal debts were shown to be unsustainable and the economy slowed? Would world investors lose confidence in the country? Fitch recently downgraded China’s credit rating to AA-, based on estimates of national debt and worries about opacity in the banking sector. As Russia has learned, the divestment risk for opaque economies is real, as foreign investment has begun to flee its oil-dependent, corruption-plagued economy. The maxim is simple: foreign investors will stop investing if profits are not guaranteed and they cannot trust companies and governments to provide financial transparency.
But world trade faces challenges on the auditing side of the equation too. Confidence in the great credit rating companies – Moody’s, Standard and Poor’s, and Fitch – as well as in the Big Four Auditing Companies – PwC (formerly known as PricewaterhouseCoopers), Deloitte Touche Tohmatsu, Ernst & Young and KPMG – has been shaken. After Enron and the collapse of Arthur Andersen, the Big Four (down from Eight, then Six) have a monopoly on world corporate accounting with more than 700,000 employees. And yet these are fragile giants, caught in a paradox of their own making. Past debacles have led to regulation that ties their hands and makes it very hard for them to make aggressive audits (they can be sued into oblivion for mistakes).
At the same time, however, regulators fear not only that audit companies will work in collusion with corporations, but that exposing such scandals will bring down those companies, only further concentrating the control over auditors in the hands of a few. Their virtual monopoly on auditing makes it very hard to control their conflicts of interest or to push them to make zealous audits. In the face of big finance, they are often ineffectual, dramatically illustrated by their complete inability to predict any of the crises of 2008. And even with armies of accountants, neither the Big Four auditors nor international regulators have the time, money, will or means to make sure the financial behemoths are effectively audited.
What is most startling is that few even discuss this problem – which as history should show, is of far greater importance than the shifting of an interest rate one percent here or there, or the imposition of a new levy or tax, however dramatic the subsequent discussions may be on the floor of the US Congress or the National Assembly in Paris. It is even more important than the introduction of new regimes of protectionism or austerity.
For they involve the visible facades of world trade: but the problems of auditing and regulation are sufficient to weaken its very foundations and structure. Globalization is often discussed in moral terms: the West versus the rest; the poor and the rich; the one percent; oppressors and oppressed. Without doubt, these age-old dichotomies remain. But, just as in the time of Columbus, the global economy and the riches many dream it will bring still depend on trust and good accounting. That few recognize its crucial role and do not seek to expand and support it is reason to fear there will be more crises to come.
What can be done, then, in the face of such enormous global challenges? For transparent financial reporting, we need a return to basic regulation, outlining the clearest financial statements possible, which allow investors and governments to assess the profitability and risks of companies. At the same time, the credit ratings and auditing companies must be reformed to remove all hint of collusion and conflict of interest. This means fewer profits for such companies (who should never be able to provide consulting services for the companies they audit and rate).
More aggressive and better-funded auditing mechanisms must be developed to keep pace with the complex and purposefully confusing financial products created by investment banks. But most of all, the public needs to cry out not only for reforms and pragmatic regulations; they must demand numbers and good balance sheets. The key to the health of world trade might lie in better mathematical and financial education. Not dismissing accounting as merely “boring” would be a good start. But that, as we know, is another challenge unto itself.
Jacob Soll is Professor of History and Accounting at the University of Southern California, and author of the forthcoming book, The Reckoning: Lessons from the Perilous History of Finance, Politics and Accountability – from the Ancient World to Modern Wall Street.