Accounting History and the Rise of Civilization, Volume I [1] 9781631574238, 9781631574245, 163157423X

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Accounting History and the Rise of Civilization

EBOOKS FOR BUSINESS STUDENTS

Gary Giroux

Volume I

Curriculum-oriented, borndigital books for advanced business students, written by academic thought leaders who translate realworld business experience into course readings and reference materials for students expecting to tackle management and leadership challenges during their professional careers.

Volume I of Accounting History covers the first 10,000 plus years of

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was part of the developing culture from the start. With ­fortified villages, accumulating wealth meant inventory accounting, first using tokens (clay balls) and eventually writing plus the ­abstract concepts of numbers. Cultures evolved in Mesopotamia and ­elsewhere. After the Crusades, Italian city-states created ­merchant wealth based on the creation of double-entry. Luca Pacioli’s S ­ umma described the Venetian system which traveled north thanks to Gutenberg’s printing press. Enhanced forms of manufacturing, banking, and merchant trade continued. England proved to be a special place, where the Industrial Revolution was born. Along the way, a ­ ccounting ­complex ­information to survive. Accounting became a ­profession as ­ business became big and important enough to employ ­professionals. The United States went from an agrarian backwater to an ­industrial power in 100 years. Accounting sophistication matched business complexity, as manufacturing accounting and control techniques developed capable of providing information needed to run giant firms. Railroads became big, requiring complex accounting system. Andrew Carnegie used his railroad experience to adapt the railroad accounting systems to steel manufacturing. Industries consolidated and the need for effective accounting control b ­ ecame imperative. Du Pont proved to be the most effective ­ innovator and this knowledge expanded at General Motors, systems that ­dominated beyond the mid-20th century. Accounting History is written for accounting and business ­students plus business professionals. It’s not written for a ­ ccounting historians, although they may find this book useful. The writing is basic without much jargon, so the general public will also find this book insightful. Gary Giroux, PhD, CPA, professor emeritus at Texas A&M

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the rise of accounting and civilization. Conveniently, a ­ ccounting

­University, is the author of eight previous books, including ­Executive ­Compensation and Accounting Fraud (both published by Business ­Expert Press). His webpage can be viewed at www.garygiroux.net, including his Accounting History page.

Financial Accounting and Auditing Collection Scott Showalter and Jan Williams, Editors ISBN: 978-1-63157-423-8

ACCOUNTING HISTORY AND THE RISE OF CIVILIZATION, VOLUME I

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Accounting History and the Rise of Civilization Volume I

Gary Giroux

Accounting History and the Rise of Civilization

Accounting History and the Rise of Civilization Volume I Gary Giroux

Accounting History and the Rise of Civilization, Volume I Copyright © Business Expert Press, LLC, 2017. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means—electronic, mechanical, photocopy, recording, or any other except for brief quotations, not to exceed 400 words, without the prior permission of the publisher. First published in 2017 by Business Expert Press, LLC 222 East 46th Street, New York, NY 10017 www.businessexpertpress.com ISBN-13: 978-1-63157-423-8 (paperback) ISBN-13: 978-1-63157-424-5 (e-book) Business Expert Press Financial Accounting and Auditing Collection Collection ISSN: 2151-2795 (print) Collection ISSN: 2151-2817 (electronic) Cover and interior design by Exeter Premedia Services Private Ltd., Chennai, India First edition: 2017 10 9 8 7 6 5 4 3 2 1 Printed in the United States of America.

Abstract Volume I of Accounting History covers the first 10,000 or so years of the rise of accounting and civilization. Conveniently, accounting was part of the developing culture from the start. Before civilization, big-brained humans still developed language, stone tools, started trade, and made both bread and beer from wild wheat. The beer and bread combo may have been the big push to settled agriculture, villages, and the start of civilization. With fortified villages and towns, accumulating wealth meant inventory accounting, first using tokens (clay balls). Increased technology, population, and power followed, as did the need for better bookkeeping. Accountants turned inventory control into symbols and eventually writing, plus developed the abstract concepts of numbers. Cultures evolved in Mesopotamia, Egypt, Persia, China, and India, then shifted west to the Greeks and Romans. Romans mastered engineering, were professional conquerors and accomplished accountants. The fall of Rome turned Europe dark for a thousand years. After the Crusades, Italian city states created merchant wealth based on the creation of double-entry bookkeeping and the valuable information created—the Renaissance was born. Mercantile success traveled north. Luca Pacioli’s Summa described the Venetian system of double-entry bookkeeping; Summa traveled north thanks to Gutenberg’s printing press then in operation in Venice and across Europe. Development in science, technology, and intellectual societies brought the Enlightenment, systematic thinking, and the importance of evidence and experimentation. Enhanced forms of manufacturing, banking, and merchant trade continued. England proved to be a special place, thanks in part to the evolving Common Law, which viewed contracts and property rights as sacrosanct. Here was born the Industrial Revolution with all its promise of exploding productivity and economic growth as well as growing income inequality and poverty, depressions, and pollution. “Creative destruction” of textile handcrafts meant previously well-off occupations such as spinners and weavers became obsolete—a never ending process in budding industrial capitalism. Along the way, accounting sophistication rose as entrepreneurs discovered the need for enhanced information to survive, especially because of fairly regular economic downturns.

vi Abstract

Accounting became a profession as business became big and important enough to employ professionals for bankruptcy proceedings, audits, and tax calculations and issues. The story shifts to America as 13 diverse colonies joined to fight what they considered a common enemy, Britain (or, more specifically, George III). The American Revolution was won, a new Constitution established republican principles, and a government framework created to provide revenue, representation, and institutions flexible enough to last for centuries. The United States went from an agrarian backwater to a competitive industrial power in 100 years. Accountants played a growing part, as accounting, auditing, and financial reporting sophistication had to match business growth and complexity. In about 150 years American manufacturing cost accounting went from the equivalent of the Medieval Italian merchant system to sophisticated accounting and control techniques capable of providing the necessary information to run giant diversified manufacturing firms effectively. Manufacturing started as local handcrafts. As in England, the factory system using machines began in New England textile mills, then spread into other industries. Improved transportation, including canals and railroads expanded distribution systems allowing for broader markets and greater industrialization. Accounting systems, primarily focusing on basic material and labor costs, provided rudimentary information for control and planning. Railroads became really big businesses, financed by Wall Street and other capital markets, as well as governments. These ran complex system requiring substantial control by headquarters as railroad systems expanded. Professional management at major railroads created innovative accounting and control systems to keep the trains running on time and profitably. As telegraph lines expanded next to railroad tracks, information became available in real time and incorporated into management structure. Improvements continued and many of the fundamental accounting and control systems were perfected here. Andrew Carnegie used his railroad experience to adapt the railroad accounting systems to steel manufacturing to control costs and ensure that operations ran efficiently. Thanks to powerful capital markets, industries were consolidating around the turn of the 20th century, ­including

Abstract

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the billion-dollar U.S. Steel, and the need for effective accounting control became imperative. Du Pont proved to be the most effective innovator during the early 20th century and this knowledge was absorbed and expanded at General Motors. Engineer and Treasurer Donaldson Brown can be given credit for consolidating available insights and adding his own innovations to create the accounting and control system that dominated the middle of the 20th century when America was at its height of manufacturing dominance. Accounting History is written for accounting and business students plus accounting and business professionals in mind. It is not specifically written for accounting historians, although they may find this book useful (or perhaps aggravating). The book is written at a fairly basic level without a lot of jargon, so members of the general public with an interest may find this book useful.

Keywords accounting, auditing, capitalism, civilization, cost accounting, doubleentry bookkeeping, financial accounting, industrial revolution, information technology

Contents Acknowledgments�����������������������������������������������������������������������������������xi Introduction����������������������������������������������������������������������������������������xiii Supplement A: Ride Through Accounting History�������������������������� 1 Chapter 1 Accounting and the Ancient World������������������������������������9 Chapter 2 The Dark Ages to the Enlightenment�������������������������������21 Supplement B: Double Entry: A Brief Primer�������������������������������� 39 Chapter 3 Britain and the Industrial Revolution�������������������������������43 Supplement C: What Is Capitalism and Why Is It Important to Civilization?������������������������������������������������������������������������������� 61 Chapter 4 The Early American Experience���������������������������������������67 Chapter 5 The Railroads�������������������������������������������������������������������83 Chapter 6 Industrialization and Professional Management���������������93 Supplement D: Panic Attack: All Those Pesky Bubbles and Crashes��������������������������������������������������������������������������������� 105 Conclusions��������������������������������������������������������������������������������������109 Notes�������������������������������������������������������������������������������������������������111 Bibliography���������������������������������������������������������������������������������������119 Index�������������������������������������������������������������������������������������������������129

Acknowledgments Thanks to Scott Isenberg, Managing Executive Editor at Business Expert Press, who has been there from the beginning and encouraged the writing of this book. I appreciate the review of the manuscript by Mark Bettner, especially on important formatting issues. Special thanks to Gary Previts (Case Western) who read the manuscript and provided valuable insights and expertise to improve the manuscript. I would also like to thank Harold Livesay (Texas A&M University) and Thomas Omer (University of Nebraska) for valuable insights, suggestions, and comments. Thanks to my wife Naomi who took my struggles with the writing with good cheer and encouragement.

Introduction Accountancy has gone hand in hand with the march of civilization. —Arthur Woolf (1912) Human history is the history of civilization. It is impossible to think of the development of humanity in any other terms. —Samuel Huntington Accounting is data gathering and analysis, usually financial-related information to analyze complex relationships for analysis, planning, and decision making. Accountants, for example, keep track of business transactions for individuals and organization, summarized in financial reports to provide information to plan, analyze and control operations, explain finances, and provide extensive information to investors and any number of interested users. The story runs from the dawn of history before money, credit, or writing to electronic blips moving billions of dollars in complex transactions instantly around the world. This seemingly narrow focus covers a whole spectrum of civilization. Like engineers, accountants have been pragmatists of progress. The purpose of this analysis is to understand the modern world of accounting, but the starting point is the birth of civilization in Mesopotamia some 10,000 to 12,000 years ago. Civilization is the culmination of technology, information and culture, allowing communal actions, cities, trade, and economic growth. According to Samuel Huntington: The idea of civilization was developed by eighteenth-century French thinkers as the opposite of the concept of “barbarism.” … German thinkers drew a sharp distinction between civilization, which involved mechanics, technology, and material factors, and culture, which involved values, ideals, and the higher intellectual artistic, moral qualities of a society. … Civilization and culture both refer to the overall way of life of a people, and

xiv Introduction

a civilization is a culture writ large. They both involve the values, norms, institutions, and modes of thinking to which successive generations in a given society have attached primary importance.1 The concepts of civilization became associated with “Western civilization” during the Middle Ages. Huntington identified important characteristics associated with this Western perspective, particularly the following: The “classic legacy,” included Greek philosophy, Roman law and engineering; Christianity, both Catholic and later Protestant; rule of law, based both on law codes and the evolving British common law; social pluralism in the sense of groups with distinct characteristics; representative bodies leading to traditions later associated with democracy; and individualism with distinctive freedoms and a tradition of personal rights. The focus of individualism became especially strong in America.2,3

The Role of Accounting and Business Accounting was there from the start, part of the rise of agricultural surpluses and growing wealth. Number crunching sophistication grew as civilizations prospered, while wealth and cultural complexity increased. Bookkeepers were equally essential to the birth of the Italian Renaissance, the continued success of the Industrial Revolution, and the creation of giant industries in America and across the developed world. Computers became the domain of corporations and their accountants. Financial information permeates many aspects of civilization and especially important to business and finance, economics, government, and public policy. Accounting was present at the creation of ancient civilizations and continues its integral roles in the expanding global civilization. Ancient accountants gave the world inventory control and early bookkeeping, the abstract concept of numbers, and eventually writing. With these vital inventions, civilization took root and grew, with increasing trade, coins recognized as money, and early forms of credit. Writing expanded from inventory counts to contracts, written laws, and literature. Accounting sophistication led to double-entry bookkeeping and the wealth of Italian city-states and, ultimately, the R ­ enaissance— funded by merchant plutocrats. Merchants mastering accounting

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became ­sophisticated traders and bankers throughout Europe and the Mediterranean; better information meant improved decision making. As Italian success waned, merchant-bankers in Northern Europe created capital markets and corporations with their own unique accounting needs. External ownership required more extensive financial information and eventually annual reports and financial statements, audited by professional third parties. British technology to solve problems in mining and the textile industry led to the Industrial Revolution. These inventors, innovators, and entrepreneurs focused on operations and usually had little interest in accounting. That is, until depressions hit, sales fell and cash ran out. Innovative entrepreneurs like master potter Josiah Wedgewood succeeded after turning to accounting to figure out manufacturing costs and business, how to price products to effectively manage high fixed costs and multiple markets, and how to manage cash. Without becoming a gifted accountant, Wedgewood would have been just another 18th-century failure, as were many of his business contemporaries. The story crosses the Atlantic to America, where budding entrepreneurs “borrowed” British industrial techniques and founding fathers created a legal system based on democracy and property rights that worked well for business and finance—the beginning of unfettered capitalism. During the 19th century America grew from an agrarian backwater to the industrial giant of the world. Accounting proved central to this rise. Textile manufacturers and other early businesses thrived with primitive accounting, but growth involved complexity requiring increasingly sophisticated use of data. Those that mastered accounting control were more successful. Really big business like railroads required cash from Wall Street and investors wanted accurate financial information to monitor their holdings. Investing in J. Edgar Thomson’s Pennsylvania Railroad was different from speculating in Jay Gould’s Erie. Thus began decades of experimentation with annual reports and financial statements. Professional management flourished in the railroad industry, where consolidation and extremely complex operations required the fast analysis of vast troves of operating and financial data. The invention of the telegraph allowed information to be transmitted instantaneously, allowing managers to master their

xvi Introduction

o­ perations in real time, relying on technical analysis, and the creation of summary statistics and tables. Accountants became central to railroading as were engineers (and engineers often were accounting innovators). Big manufacturing in the post-Civil War era relied on accounting and control analysis created within railroads. Andrew Carnegie was typical, receiving his training on railroads and transferring that knowledge to equally big industrial enterprises. In Carnegie’s case, it was training at the highly sophisticated Pennsylvania Railroad and using that knowledge to create the biggest, most modern, and lowest cost steel company, relying on innovative accounting and the latest technology. Dozens of corporations used similar techniques (although each company had a unique story) to create modern, efficient industrial America. Post-Civil War America was the most corrupt period in American history. Seemingly everyone was one the take, with bribery the most basic form of corruption. Virtually every city and town in the United States was run by one of more political machine, as were many counties and states— with additional corruption at the federal level. Somehow, growth and innovation went hand in hand with fraud and manipulation—perhaps the rise of big-ego entrepreneurs, politicians, and speculators achieving ethics-challenged success and believing they were above the law. Despite the high costs of bribes, extortion, manipulation and the periodic panics, the economy grew rapidly and many, often the most ruthless, succeeded. That continued success required thousands of professional managers and competent support by laborers, engineers, and accountants. Big industrial corporations controlled at a central office, say in New York City, received sophisticated cost and financial accounting data continually by Telegram. With the supporting information, a manager in New York could determine which plants were efficient, which showed increasing costs indicating operation problems, and the ability to forecast sales and determine the most appropriate sales prices. Accounting innovators at Du Pont and General Motors provided particularly useful tools in the field of managerial accounting, creating the basic techniques used through much of the 20th century. Alfred Sloan at General Motors used his superior accounting to run the most efficient, profitable and biggest automobile company in America in the mid-20th century, indeed the biggest and most successful industrial firm in the world.

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Accounting support became increasingly important in the c­ omplex, industrial world. Financial statements might require an annual audit, resulting in the development of a major profession. The birth of f­ederal income tax created the need for legal and accounting tax specialists. Accounting fraud and scandals demonstrated the need for regulation and formal accounting and auditing standards. Both regulation and ­standard-setting proved to be difficult and subject to controversy. Internal auditors and accounting specialists of all types became more important to business, plus all the nonprofit and governmental organizations springing up. Technology specialists invaded virtually all fields. The computer age hit the United States and the world in the mid20th century and became central to accounting and business, as well as our entire culture. The technical age of accounting began with computerizing payroll processing at General Electric in the early 1950s—put in place with the help of accounting firm Arthur Andersen, the same firm that crashed during the Enron scandal. International Business Machines (IBM) became a mega-corporation using mainframe computers to drive business in the United States and around the world. IBM would later stumble (and recover with a new business model), but progress continued with new mega-companies (possibly started in garages or dorm rooms) fueling the high-tech revolution. Computers and information technologies continue to affect accounting, auditing, and just about everything else. Fraud and scandals are part of the history of modern accounting. This proved especially true in the 21st century, which included Enron as the greatest accounting scandal in American history, a host of other big corporate accounting frauds, plus the massive manipulation of the subprime meltdown of 2008 and the Great Recession. No history of accounting can be complete without a description of what went wrong at Enron and the rest and what the implications are to accounting and civilization.

Why Study Accounting History? There are thousands of books on accounting and at least a few that focus exclusively on history. It’s the broad scope of this book that’s different. The story of accounting and how information is collected, analyzed, and

xviii Introduction

disclosed is as old as civilization. Many key factors needed for modern business were invented in the ancient world—money, record keeping, abstract concepts of numbers, writing, property rights, trade, banking, regulation, and the corporation. Many of the factors that are part of today’s rocket science on Wall Street date back to earlier centuries, including the use of credit, derivatives, and stock markets—plus manipulation and fraud. The information revolution started with Gutenberg’s printing press, mass transit with the railroad, and instantaneous communications with Samuel Morse’s telegraph. The Internet represents important extensions of earlier innovations, part of the latest phase of the information revolution. Historical perspective is the context of this book. “High tech” and “innovation” mean winners and losers. Bankruptcy is more common than spectacular success over long-time horizons. The business cycle is alive and well. Long-term benefits exist in downturns (Economist Joseph Schumpeter famously referred to “creative destruction”), although being in one is not enjoyable. And there are crooks and scoundrels. Institutions and technology have changed, but individual behavior seems much the same. Also, it can be hard to tell the heroes from the villains—consider John D. Rockefeller or Bill Gates: the richest men of their periods, both were vilified by the press and failed competitors before becoming philanthropists. Were they brilliant entrepreneurs, unethical tyrants, or both? An analysis of the 1870s or 1920s may be useful to interpret what’s happening this century. There may be interesting comparisons between J.P. Morgan and Ben Bernanke or Lloyd Blankfein, Andrew Carnegie and Bill Gates, Jay Gould and Michael Milken. The Revenue Act of 1862 may be instructive to modern Congressional debate on tax changes. The Securities Acts of 1933 and 1934, which introduced federal regulations to financial markets and financial accounting as part of the New Deal legislation, may be useful to evaluate the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Act of 2010.

What Follows This two-volume set has 12 chapters (plus 8 “supplements”), roughly in chronological order, but presented by topic from the ancient world to now. Volume I has six of these chapters and four supplements. The beginning

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three chapters provide historical background from M ­ esopotamia to Europe, roughly to the end of the 18th century. The first chapter focuses on the ancient world, with particular emphasis on the first accountants using “tokens” to create inventory, leading to the concept of numbers, sophisticated record-keeping, and writing. Chapter 2, from the Dark Ages to the Enlightenment, mainly covers the Italian merchant invention of double-entry bookkeeping. The Italians dominated much of the Old World trade and depended on their advanced accounting system. Double entry is still around, little changed for the most part, and just as relevant—with the same advantages, but a growing set of defects as operations get more complicated. Chapter 3 deals with the Industrial Revolution and the importance of accounting (and continuing accounting improvements) to understand costs and the relationship of revenue pricing and costs of production and distribution. This proved particularly important because of the growing problem of recurring depressions. A word on the supplements, which are short essays on related topics in a reasonably entertaining, or perhaps controversial, way. Supplement A is the history of accounting presented as a virtual reality show—something of a cliff notes version of accounting history. Supplement B provides a perspective on double entry as the underlying “program” of accounting, what it is, how it differs from single entry, and why it is still around after more than seven centuries. The third (Supplement C) attempts to explain capitalism, a system essential to Western civilization and spread to much of the world. “Panic Attack” (Supplement D) covers the miserable bubbles, panics and depressions common in the 19th century and still around; that is, the business cycle is alive and well, but downturns are less frequent and usually less severe than in the past. The 2008 Great Recession was an exception. This is a recurring hex on capitalism and unique accounting rules apply. Chapters 4 to 6 represent the story of American business from the founding of the country through the early 20th century, by which time America was the world’s dominant industrial power with exceptional prowess in sophisticated accounting. Chapter 4 is the start of American industrialism, mainly in textiles. Chapter 5 is devoted mainly to railroads, the dominant industry of the 19th century, the engine of the country’s growth, and the development of professional management and

xx Introduction

accounting. Gigantic businesses (and railroads became gigantic) could not be run without specialized and sophisticated accounting (aided by almost instant transmission of data using the telegraph). Chapter 6 covers industrialization mainly in the second half of the 19th century and early 20th century. Particular attention is paid to specific corporations where accounting leadership and innovation proved important: Carnegie Steel Company, Du Pont, and General Motors. The cost accounting techniques needed for all American business for much of the 20th century were completed by General Motors accountants in the mid-1920s.

SUPPLEMENT A

Ride Through Accounting History The time has come the Walrus said To think of many things: Of shoes and ships and sealing was, Of cabbages and kings. —Lewis Carroll Turn on the Awesome Accounting Ride—the virtual reality trip. See the dawn of civilization in Mesopotamia. The villagers, living in mud and wood huts, are scattering wild emmer wheat on the damp plain. A thousand years later, it’s the late Stone Age and real progress is occurring. Primitive irrigation from the local river waters the crops. Wandering traders barter with the village weaver, the beginning of commerce. By following the traders’ caravan of 10,000 years ago, we discover the village of Jericho and go for a Dead Sea stroll. A scribe takes inventory of the village grain and livestock using clay balls as a counting device of the herd size and wheat harvest—the beginning of record keeping. The abstract concept of numbers will follow; writing will eventually develop. The Stone Age is over. Copper tools are widespread by 3000 BC, used in the construction of stone temples and palaces, plus weapons. Towns grow to form city-states-ruling regions based on military might. Pottery, textiles, and other crafts expand, while trading routes are ever-expanding to far-off lands. A scribe is diligently working: the concentrated gaze, the penetrating eyes, the pot belly, and love handles—is this the first accountant? Using a stylus on a wet clay tablet, he’s developing a better system to record the village wealth, the tribute of gold, wheat, and sheep. Food stocks enter and leave the stores, gold is delivered to the artisans to craft

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cultural and religious relics. The record-keeping is sophisticated using the abstract symbols. The writing on clay will be called cuneiform and will spread rapidly across the booming city-states. The sophisticated bookkeeping will expand to theology, a literature based on Gods and heroes. The Egyptians develop hieroglyphics and build magnificent tombs and temples, including the pyramids—one of the seven wonders of the ancient world. Meanwhile, record-keeping expands with economic growth. The Iron Age replaces the Bronze Age about 1200 BC, just in time for the Trojan War. By the 7th century BC, the Lydians invent the first stamped coins, standardizing the use of gold and silver as money. The Phoenicians improve the alphabet and, perhaps more important, invent soap. Mediterranean city states use silver and gold coins to expand trade—soon joined by the first counterfeiters and money changers. The Greeks simplify banking using bills of exchange, basically credit instruments (IOUs) accepted by authorities. Democracy comes to Athens in the Age of Pericles and philosophers flourish. After the war with Sparta, the fragile city-states are crushed by Alexander the Great. Greek states power is destroyed but Greek civilization spreads. Rome becomes the new Western leader with military might: prosperous and rich, developing engineering marvels—relying on improvements in cement and slaves. Roman citizens keep their own diary of financial transactions. Roman emperors debase coins to pay the legions and discover inflation. Rome rules much of the “known world” and trades with most of the rest of it. German barbarians invade and Rome falls; the west drops into darkness. A candle is burning, as a Florentine merchant keeps financial records in diary-like form for his cloth trade. Using Roman numerals, an abacus, and dealing in multiple currencies, he’s inventing double-entry bookkeeping. The Italian merchants and bankers are becoming rich, meeting European demands for exotic silks and spices in exchange for woolen goods, wine, grain, and leather. The Medici family of Florence becomes international bankers, using their sophisticated bookkeeping. Luca Pacioli, a mathematician, monk, and Renaissance man is the first to describe the Italian bookkeeping method. Pacioli’s Summa is published and spreads the “Venetian system” across Europe. The Renaissance spurs culture, economic growth, and expanding trade. Columbus, trying to

Ride Through Accounting History 3

find Asia by sailing West, bumps into the New World instead. Gold and silver make Spain and Portugal the superpowers of Europe. Without the gold, Northern Europe relies on manufacturing and trade to fuel growth. The Dutch become merchant masters, inventing the joint stock company (the first corporations), central banking, and the stock exchange. Further innovations include forward and option derivatives and market manipulation. Pacioli’s double entry is adopted and expanded to track merchant and stock transactions. European monarchs begin to form countries, each with unique ideas of governance and power. Tudor England prospers as a rising sea power under a developing laissez faire economic system, as well as property rights protections under Common Law. Wool is a major export and a domestic textile industry expands. Colonies are founded, providing raw materials and finished goods markets, while mercantilism matures. England establishes the Bank of England as a central bank, creating a sophisticated financial system allowing the Crown to borrow vast sums of money. When wood becomes scarce in England, Abraham Darby invents the reverberating furnace for iron making using coke. James Watt invents a practical steam engine for production, another Industrial Revolution milestone. The spinning jenny and water frame transform textile manufacturing. The factory system puts thousands of handcraft textile workers out of business, but productivity and factory employment explodes. England becomes the manufacturing powerhouse of the world. The railroad age begins when the steam engine is turned on its side to power locomotives. Accounting and banking lag industrial innovation. Companies learn to calculate costs for the various products and operations, beginning with labor and materials. Determining overhead proves much harder. Banks seldom lend entrepreneurs money and issuing stock is even more doubtful. They must either find their own cash or a willing merchant partner. The famous potter Josiah Wedgwood uses craftspeople, but production is massive with a steam engine running many of Wedgwood’s machines. He relies on rich partners and returning profits back to the company. Trying to survive a depression, Wedgwood becomes a cost-accounting expert and innovator. He figures out costs by both product and production stage to determine which operations are profitable. Knowing costs

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ACCOUNTING HISTORY AND THE RISE OF CIVILIZATION

helps decisions on dealing with high fixed costs, how to exploit segmented markets, and what to charge customers to improve profit. He flourishes as accounting-illiterate competitors face bankruptcy. Manufacturing firms discover depressions and business failures. But this leads British accountants to a profession—bankruptcy proceedings. Price Waterhouse, Deloitte, Peat, and Coopers Brothers are among the accounting firms starting in the mid-19th century. Professional societies are formed, creating the designation Chartered Accountants in Britain. Similar societies form in the United States and Canada. Continued self-­regulation under government oversight promotes the accounting profession. London’s financial district develops into the biggest and most important capital market in the world. Joint stock companies form based on royal decrees. The Bank of England, initially specializing in lending to the government, becomes the central bank of Britain. Investors buy government bonds and corporate stocks, but often based on little financial information. Caveat emptor rules as brokers sell virtually any securities at inflated prices—the South Sea Bubble explodes amid evidence of vast corruption. Speculation driving up asset prices leads to inevitable collapse. Reforms are demanded and the British Companies Acts regulate securities issued. Regulations, including accounting and auditing rules, change often. Accounting (especially bankruptcy services) and finance specialization grow. The American colonies rebel in the late-18th century. Independence is declared and won. A constitution passed and the United States is born as a republic. George Washington is sworn in as the first president in New York in 1789. Alexander Hamilton serves ably as the first secretary of the treasury. Hamilton defends strong finances for the new government, including the full repayment of all government debt issued during the revolution. The Bank of the United States becomes the first experiment with American central banking. The first panic (Panic of 1792) happens soon, as former Treasury official and speculator William Duer borrows heavily attempting to take over a New York bank and fails. An embarrassed Hamilton takes action to prevent a depression by flooding the financial system with cash buying government securities. American industry starts with handlooms for textiles, lumber and grist mills using water power, soon joined by New England textile mills.

Ride Through Accounting History 5

Machine power expands to all phases of textiles and recordkeeping improves to increase the information flow of the operating complexity. Eli Whitney uses interchangeable parts for rifle manufacturing and the Springfield Armory creates the most innovative bookkeeping in the first half of the 19th century. John Jacob Astor, Commodore Vanderbilt, and Andrew Carnegie become folk heroes and villains. The biggest and most important industry is railroading, becoming bigger through consolidation. Professional management, engineering, and accounting develop here. President Lincoln recites the Gettysburg Address, formulating fundamental principles of American government. The Union wins the Civil War; Northern businesses boom and economic innovation and growth explode—so does corruption. John D. Rockefeller trains as an accountant and starts a high-risk oil-refining business that comes to dominate the industry. His Standard Oil creates the trust company to grow corporations across state lines. He avoids banks and stays out of the stock market. Although a brilliant entrepreneur, Rockefeller is labeled one of the Robber Barons of the age. He ruthlessly destroys competitors, accusing them of producing inferior products and undercutting his prices. After a building binge relying on capital markets, railroads cross the country. Speculators and brokers manipulate stock prices, frustrating both professional managers and investors who often have little financial information to go on. Commodore Vanderbilt fights manipulators ­Daniel Drew, Jay Gould and Jim Fisk for dominance of New York railroading— the Erie Railroad is in play! Vanderbilt loses, but remains America’s richest man. Professional management developed at the major railroads, including minute-to-minute masses of operating and financial data using the telegraph to control the minutia of these gigantic operations. Railroad treasurers and controllers calculate what to charge for services. The infrastructure is expensive and costly to repair. How does depreciation work? How are costs charged to individual customers? Answers develop, initially quite different from one railroad to another. Governments do not like the answers; Congress begins federal regulation with the Interstate Commerce Commission Act of 1887. Court cases are won and lost, new legislation passed and procedures eventually standardized. The Baltimore

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and Ohio Railroad presents considerable financial and operating information to investors. Other railroads present various types and amounts of data, some almost nothing. New York City in 1900: Frank Broaker, New York’s first Certified Public Accountant (CPA), audits a client, checking every transaction, every voucher, every receipt. Accounting is professional and booming. The mechanical office age is here, with the noisy adding machines and typewriters and the occasional tabulating machine. British firm Price Waterhouse has a thriving Manhattan practice and the Chicago firm of Haskins and Sells opens a New York office. Investment bankers serve big business—mainly the result of mergers. J.P. Morgan, the most powerful banker in America, combines businesses into monopolies and provides financing on a major scale. He charges large fees and demands control—placing Morgan partners on boards of directors. U.S. Steel, formed by Morgan, becomes the first billion-dollar corporation. At Morgan’s insistence U.S. Steel hires Price Waterhouse, producing their first audited consolidated financial statements in 1902. The Wright Brothers fly at Kitty Hawk. Soon Henry Ford invents the moving auto production line and turns out the low-priced Model T’s by the millions. Big business needs sophisticated cost accounting. Frederick Taylor, an engineer and innovator of scientific management, conducting time and motion studies. Engineers invent standard costing. Du Pont develops the bonus plan and return on investment criteria. Alfred Sloan becomes president of General Motors and creates a complex decentralized management style based on complex accounting information. General Motors under Treasurer Donaldson Brown develops the first modern cost accounting system by 1925. The Roaring Twenties has arrived, with its new industries, optimism, speculation, and margin trading. Suddenly the stock market crashes in 1929, the start of the Great Depression; the result: soup kitchens, bank failures, massive unemployment. Franklin D. Roosevelt wins the 1932 presidential election and begins the New Deal: bank reform, the Securities and Exchange Commission, social programs, Social Security and the payroll tax, and persistent budget deficits. The Glass-Steagall Act created the Federal Deposit Insurance Corporation to provide bank deposit insurance, but also separates

Ride Through Accounting History 7

commercial from investment banking. J.P. Morgan becomes a commercial bank, while Morgan Wall Street partners form Morgan Stanley as a separate investment bank. The SEC’s mandate is to regulate securities markets including accounting and financial reporting. Financial disclosures are required by corporations trading on stock exchanges. Accounting committees form and generally accepted accounting principles (GAAP) are created and used for the first time. Accounting pronouncements standardize accounting procedures and financial statements. Standard setters include the SEC (issuing Accounting Series Releases), the Committee on Accounting Procedures (issuing Accounting Research Bulletins), Accounting Principles Board (issuing Opinions), and Financial Accounting Standards Board (FASB; issuing Statements)—all eventually codified by the FASB. Accountants continue to have problems. The Price Waterhouse audit failure in the McKesson & Robbins scandal demonstrates major problems in auditing. Auditing starts to standardize with “generally accepted auditing standards.” World War II brings big tax increases and payroll deductions. Post-World War II America is the most powerful country on Earth and becomes a global superpower. U.S. multinationals and the Big 8 flourish internationally. In the lobby of IBM Headquarters in the late-1950s is an IBM 702, the first practical IBM computer for business use. IBM dominates information technology and the computer becomes essential for business and financial information. Progress in hardware innovations and continuing software applications—killer apps—continue. IBM, Apple, Microsoft, and others create the personal computer. IBM falls behind as other companies to dominate this new industry. Enron Headquarters in downtown Houston seems to represent a new business model, expanding from gas trading to high-tech operations across the world. It turns out this represents Enron overconfidence and sophisticated fraud. Are they overaggressive geniuses? Are they crooks (crooks according to the courts)? Accounting manipulation and fraud are central components to their crimes. Following new federal regulation, the SEC and accounting profession reorganize. Within a few years Lehman Brothers implodes, the biggest bankruptcy in history. Federal regulators rush to keep the world financial economy from collapsing. Despite a

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multitrillion-dollar bailout the Great Recession begins. New regulations make the financial world more complex and possibly safer. However, not many changes occur in financial accounting: corporate executives continue to have incentives to cheat and accounting techniques to do exactly that. Twenty-first century accounting looks more like rocket science, with vast information systems and the ability to move trillions of dollars instantly. Financial records of public firm are available on the Internet. Auditors make great strides to review inventory, purchases and sales transactions, and any level of summary information. Payables and receivables can be reviewed directly on the information superhighway. Users can access more levels of aggregate information and details notes. The adventure is just beginning. See how accounting and the birth of civilization go hand in hand, how accounting helped create the Renaissance, the relationship of accounting to the Industrial Revolution, the rise of the United States as an industrial giant, and how accounting became intertwined with computer and information technology.

CHAPTER 1

Accounting and the Ancient World We can begin with the key discoveries of green history: Civilization was purchased by the betrayal of nature. The Neolithic revolution, compromising the invention of agriculture and villages, fed on nature’s bounty. —Edward O. Wilson [From 3200 BC–2700 BC], that’s 500 years, writing is only a­ ccounting. —Denise Schmandt-Besserat The two ancient inventions of agriculture and the walled city led to civilization, the transition from hunter-gatherer to farmer. Farming required a single location, relative stability, seed crops, calculating the seasons, plowing and harvesting, and the development of settlements—perhaps with a big assist from the discovery of beer. Crop surpluses led to accumulated wealth which had to be organized and accounted for, leading to a multitude of inventions from recordkeeping to numbers and writing that proved necessary to the continued rise and prosperity of future great empires and culture. The recordkeeping part—accounting—is the essential element of this story, one just as important today as to the ancients, medieval merchants, inventors, bankers, and entrepreneurs creating the industrial and then information age.1 Initially, the barter system meant wealth was determined by possessions—mainly livestock and grain stocks, which served as mediums of exchange. This interrelated parade of progress started at least 12,000 years ago, based on the archaeological record and corroborating evidence in the particular place called Mesopotamia or the Fertile Crescent (a somewhat broader term than can stretch out south to Egypt and east to Persia

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and beyond). It all required a series of convenient accidents (or perhaps fate): a receding ice age, intrepid Homo sapiens migrating north, and a developing environment seemingly perfect for settlement—somewhere representing the proverbial Garden of Eden. Global warming ended the last major ice age 13,000 years ago, bad news for the woolly mammoth, good news for humans moving north. Plants evolved and prospered in certain, now warmer, places—one ideal spot, the Fertile Crescent, came to be called the cradle of civilization. Jared Diamond identified 31 large-seed grasses (potentially cereals) in the “Mediterranean zone,” which includes the Fertile Crescent (roughly centered on modern Iraq).2 Wild wheat and barley seem to have been first discovered here.3 The ancestors of domesticated sheep, goats, cattle, and pigs also existed in the Mediterranean zone. Geography is key to this story. The Fertile Crescent is in the middle of the huge temperate Eurasian land mass, the Mediterranean zone, which stretches thousands of miles from the Atlantic to Pacific at about the same latitude. This meant discoveries in one area could move rapidly (at the time generally meaning over decades or hundreds of years) and successfully across this vast area. Primitive Europe with its mild and wetter climate would ultimately benefit from the developments in southwest Asia and beyond. The wild-to-domestic relationships, locations and dating are fairly well established—so claim the experts. Scientists studied Mesopotamia in detail and understand the ancestors to the useful crops and animals based on genetic analysis, geographic range, and climate conditions over the last 10,000 plus years. Wild emmer wheat likely was the first domesticated cereal. The processes for making grain edible (reaping, grinding, cooking) were probably worked out thousands of years before domestication. With climate change, wild wheat and barley became available in large enough quantities for proto-farmers to settle down and discover cultivation. These now-sedentary farmers could experiment with new plants, new farming technologies, new cooking strategies, homes, and all the conveniences of village life. Critical to civilization was food storage. A specific harvesting season meant keeping food edible, unspoiled, and safe from vermin for the rest of the year. Stockpiling required storage jars or baskets, cover and



Accounting and the Ancient World 11

buildings, all developed and improved with trial and error by Stone Age Edisons. The hearth was needed for cooking (and warmth); kitchens and shelter centered here. Large food stocks increased the potential population and the demand for trade. Thus, storable stocks increased food choices and, presumably, the value of cooks. As stores became larger, so did the need for recordkeeping—more on this shortly. Related to storage was spoilage—raw foods turn rancid (and worse) quickly. Out is this came opportunistic inventions such as beer, which provided nutrition, a relatively safe drink, and the proverbial (no doubt spiritual) buzz. One working theory for civilization was the importance and improvements in beer—that being the only viable reason to settle down. Assuming civilization began with the first permanent settlements, trade is likely much older than civilization. Important goods such as salt and obsidian exist naturally only in certain locations. These have been found from the oldest levels in virtually every archeological site. Trade is the only possible explanation. Traders invented distribution, marketing, exchange rules before money, perhaps primitive credit terms, inventory control, and security. Important discoveries might be adopted and spread by traders along the trade routes. These free-market merchants must have lived high-risk lives, but they left no direct evidence except the discovered trade goods. Marco Polo told his Travels as a merchant across the entire Silk Road, but this was a 13th century adventure, some ten thousand years after the earliest traders.4

Permanent Settlements Step two to civilization was village life. Small permanent settlements included round huts supported by wooden posts, with dirt floors and a hearth in the middle. A village of 30 or 40 huts might support a couple of hundred people, such as Karim Shahir in northern Iraq (probably a seasonal site beginning about 11,000 years ago). An important advancement was outer walls for defense. Success meant a growing population, specialized tools (digging stick, hoe), and cooking tech, plus more civic responsibilities. The oldest fortified city yet discovered (and most people heard of ) was ancient Jericho, a 10-acre site with perhaps 2,000 people. Part of the

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oldest walls, from 10,000 years ago (despite Joshua’s best efforts some seven millennia later) are still standing, at a height up to 12 feet and 6 feet thick at the base. The people lived in round houses made of sundried mud brick. Jericho does not meet the standard theory that cities started after sophisticated agricultural villages were established. When it began, the people had only started to domesticate grains. Instead, Jericho was a prominent stop across primitive trade routes existing from even earlier times, a trade center exchanging salt from the nearby Dead Sea for food and foreign goods. Jericho would be abandoned, reoccupied, and conquered a dozen or more times by cultures more advanced than the original Neolithic settlers.5 Catal Huyuk, founded in southern Turkey a thousand years after Jericho, was a larger trade center than the original Jericho settlement, specializing in mining nearby obsidian—one of the most valuable trade goods, because it has been found at virtually all ancient digs. Many of the buildings were ancient rectangular “condos” built of mud brick to several stories. Terraced roofs and ladders served as walkways. The people produced textiles, pottery, wooden containers, and dishes, plus art works. Mat making and baskets first date from about the time of Catal Huyuk. Simple mats from river reeds date from before 7000 BC, soon to be followed by rope, woven mats, baskets, then textiles. Fired pottery also date from the same period (unbaked pots are much earlier). The firing initially was on an open hearth, later an oven and finally a kiln. These were major inventions along with cooking pots, storage vessels, and bricks. Pots could be cleaned, storage jars could hold liquids and protect grains and other foods from rodents and insects, and fired bricks used for all kinds of building projects.

Tokens: The First Accounting Near the oldest levels of five sites in Iran and Syria were found clay balls, called plain tokens by archeologist Denise Schmandt-Besserat.6 These were made by hand and often hardened by fire (possibly because the barbarians at the gate broke through and burned the place down). The plain tokens averaged about 1 inch in diameter and had basic shapes: spheres, cones, ovals, disks, and cylinders. They were unmarked, making them easy



Accounting and the Ancient World 13

to identify and easy to make. Plain tokens appeared at the same time as the first cultivation of cereals, suggesting their relationship to agriculture. As stated by Schmandt-Besserat: The need for counting and accounting seems to be related in that part of the world to an economy based on the cultivating and hoarding of cereals, and the socioeconomic changes that followed the birth of agriculture. It seems logical that an economy involving the planning of subsistence over the seasons would both incite and require a feasible record-keeping system.7 Schmandt-Besserat hypothesized these were counters representing the oldest accounting system and a precursor to numbers, writing and measuring wealth. Thus, symbolic representation is ancient, the developing innovation using symbols for pragmatic purposes. A small round token could be used to represent a sheep; a token for each sheep owned is a complete inventory. Difference sizes and shapes (Schmandt-Besserat identified 16 main types and additional subtypes)8 would represent differing forms of wealth: cattle, goats, and pots of wheat or barley. Thus, a wealthy landowner had a complete listing of his or her equity position. Additional goods acquired, consumed, or traded were reflected by updating the token inventory. Accountants could line up tokens by type of goods. In addition to counting, these could be used for transactions. Tokens seem to have been thrown away rather than reused, probably when transactions were completed such as after the harvest, with some possibly representing the earliest taxes. Plain tokens were found throughout the Fertile Crescent, including Anatolia (roughly Turkey), Palestine, and Persia. Their shapes and sizes were fairly standard. Only the number found varied, from a handful to over a thousand at Jarmo in Iraq. Schmandt-Besserat believed this was part of a new social order. Plant domestication requires seasonal planning, as well as seed and grain storage. Rectangular storage silos and rising populations suggests a food surplus and a changing culture, requiring adequate recordkeeping. There was no evidence of animal domestication at the earliest sites when tokens first appeared, nor any direct relationship to trade.

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Simple tokens were discovered in clay “envelopes,” hollow round cases averaging about 4” in diameter and covered with seal impressions. These were used after 4000 BC in Sumeria, some 4,000-plus years after the invention of tokens. The tokens were hidden and scribes solved this problem by impressing each token on the outside of the envelope (the first seal impressions). About a dozen signs were found on envelopes, mainly from tokens. These markings led to numerals (moving from counting to the abstract concept of quantity). Initially, three small measures of wheat might require three wedges, two bushels of barley, two circular markings. These were eventually replaced by a pictograph for the object (a jar of oil, perhaps), followed by a specific sign for a number. A circle might be a 10. The envelope can be considered a “summary document,” with the tokens inside an inventory, a form of internal control. This can be interpreted as a potential accounting system with some complexity. Mattessich suggested that the envelope was a simple balance sheet, representing both the entire inventory and equivalent equity (or possibly debt). An envelope may have functioned as a personal account of a debtor or steward or a specific trade transaction. The envelopes could be from a temple, the ruler’s accounts, or a wealthy trader.9 The move from tokens to envelopes or tokens attached to strings represented the need for greater accounting and control needed for a more complex society. Hierarchical levels above farmer or commoner grew increasingly complex as cities increased in size and roles for kings or aristocrats and priests rose in power and sophistication. The commoners produced greater surpluses that were collected in various forms (tribute, taxes, or community collections for later redistribution). The concept of increased accounting sophistication as civilization became more complex proved to be a recurring theme.

The Sumerians About 5500 BC farming villages were established along the Tigris and Euphrates Rivers in Mesopotamia. Within a thousand years non-Semitic nomads moved in, the Sumerians (Sumer being “the land of the civilized kings”). Uruk was formed about 4000 BC, one of the first Sumerian city-states. Within the next thousand years, the city had a population of



Accounting and the Ancient World 15

40,000 to 50,000 surrounded by 100 or so villages and nomadic herdsmen beyond that. Religion seems to have played a central role in Uruk life, with the city ruled by priests and elders. The temple was the center for religion, commerce, law, and government. As food surpluses accumulated, the temple became the repository and distribution center and much of daily commerce was directed from the temple. Recordkeeping became increasingly important and the Sumerians solved the bookkeeping problems by extending the existing token system to the invention of writing. By 2800 BC kings had political control, although priests and elders continued to have considerable power. Below them were rich landowners and merchants, then bureaucrats and tradespeople, lower class freemen, and slaves. The more complex social structure required laws and the first written legal codes discovered were developed. Other innovations and inventions were attributed to the Sumerian civilization. The wheel was in use by 3500 BC, initially for pottery to shape utensils, then expanded to two-wheel and four-wheel carts. The wheels were made of single slices of wood from large trees, then fastened together by metal strips with copper bands attached to the rims. After the invention of writing, the Sumerians developed literature. The Epic of Gilgamesh was the legend of a king of Uruk from about 2700 BC. The Akkadian Empire under Sargon came to dominate the region and united Mesopotamia by around 2270 BC. The destruction of advanced cultures by more primitive, militant empires happened repeatedly.

Complex Tokens and Clay Tablets The related inventions of sophisticated recordkeeping and writing were a 5,000-year work in progress. Simple tokens have been found throughout the Middle East including Mesopotamia, a process possibly encouraged and expanded by traders to simplify transactions and increase financial control. Envelopes were found mainly in Mesopotamia, suggesting this as a Sumerian innovation. Complex tokens also are associated with Sumer. About 800 tokens came from Uruk, for example. Complex tokens were found within Sumerian temples beginning about 3700 BC. The major difference between plain and complex tokens was the use of surface markings. Complex tokens were covered with lines,

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notches, and other markings made with a sharp stick called a stylus. Complex tokens often had small holes to mount on a string attached to a larger oblong clay ball (called a bulla) which had seal impressions. The complex tokens represented a more sophisticated accounting system. Schmandt-Besserat relates the rise of complex tokens to the establishment of a coercive redistribution economy, a temple tax system requiring a bureaucracy and authority to implement taxes. Carvings exist from this time period seeming to depict the flogging of tax delinquents. Various shapes and markings on tokens represented specific goods. Cones and spheres referred to grain measures: ban (small) and bariga (large). Cylinders stood for animal counts. Complex tokens generally related to finished goods. Marked cones and ovals stood for processed foods such as bread, oil, or beer; triangles for luxury goods such as perfume. Certain types of disks referred to textiles, with specific markings relating to types of fiber, cloth, or specific garments. Textiles became a major manufacturing industry in Sumer and an important export. Manufactured goods such as tools, weapons, or vessels (e.g., pots and baskets) required even more detailed tokens. Once the use of envelopes became widespread in Sumerian administration, the tokens became less important. Writing was developed on clay tablets in Sumer, the next step from clay tokens and envelopes. Tokens could be impressed on clay tablets resulting in a sharp image. The tablets could hold the markings of many tokens, an important step toward writing. Tablets likely started as summary documents tabulating many tokens with additional explanatory markings. With improved signs, all information would be recorded directly on tablets, eliminating the need for tokens altogether. The use of clay tablets and the writing system developed would continue for nearly 3,000 years and symbols became increasingly abstract. The related innovation was standardization—a fundamental accounting feature, with all scribes using the same symbols and definitions.

Cuneiform Writing and Beyond The earliest texts found from Sumer consisted largely of pictures (pictographs) drawn on clay tablets with a stylus. These pictures were simplified and standardized to be easier to draw and understand. The



Accounting and the Ancient World 17

Sumerian script was called Cuneiform (Latin for “wedge”) because of its shape. The invention was dated from about 3500 to 3100 BC, perhaps at Uruk. The script evolved from some 2,000 pictograph signs to about 800 increasingly abstract markings. The early records from Uruk (3300–2900 BC) identified inventory goods and numbers. However, what is not clear was the intent of transactions (whether items bought and sold, a receipt for tax payment, or tribute) or measures of wealth. Abstract markings eventually came to represent syllables, which could form words and sentences. This seems to have been a difficult transition, essentially moving from inventory markings to complete ideas based on the Sumerian spoken language. Writing was invented by scribes—the accountants of their time, but became crucial to civilization when adopted for other purposes. The role of scribes expanded. Historical events were recorded. About 2600 BC the King of Kish became the first person commemorating his own achievements. Literature was born with The Epic of Gilgamesh—the king of Uruk (mythical or real). Regulations in the form of legal codes were not far behind. Eventually, writing was done at the most abstract level using the alphabet. Tablets from Ugarit were cuneiform using an ­ alphabet of 30  ­ characters. Various Semitic scripts, including Hebrew, used ­consonant-based alphabets. The Phoenicians appeared about 1600 BC and began to populate much of the Mediterranean coast as traders. Their most important export was the Phoenician script, with an alphabet of 22 consonants, adopted by Greek city-states. The Greeks added vowels to form the first modern alphabet. The Romans adopted the Greek alphabet with modifications into Latin, including most of the letters used today. Old English used Latin as the country converted to Christianity and over time added the letters j, u, w, and x.

Money, Banking, and Credit The Sumerians were rich, using both grain and silver for payments. About the time of the invention of writing, scribes developed the use of standardized weights of silver and other metals. The Sumerians were conquered by the Akkadians, who were in turn conquered by the Babylonians. The Code of Hammurabi (king of Babylon) from around 1750 BC

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was a detailed law code that included the regulation of contracts and commercial transactions.10 Loans were standardized by Hammurabi’s Code, with interest rates set at about 20 percent and payments based on fixed amounts of silver. Grain by volume was an alternative standard of value. Archaeologists in Mesopotamia found hordes of large silver ingots. Evidence indicates that silver was cut into strips or drawn as wires to determine correct weights for transactions. Gold was more abundant in Egypt and used in similar ways. The use of common measures of precious metals facilitated long-distance trade, because of the ease of exchange. The kingdom of Lydia in Asia Minor was a major source of electrum, an alloy of gold and silver. According to the Greek historian Herodotus, the Lydians invented coinage in the 7th century BC. The earliest coins seem to be blank ovals of electrum of standard weights. Later coins were stamped with punches, first with simple lines and then with more complicated designs. Lion heads and paws were particularly common. The largest cache found was 93 electrum pieces at Ephesus, on the west coast of modern Turkey. Greek civilization was a relative latecomer, although many of the concepts of civilization come from Greece. The Myceneans were powerful city-states known from the archeological digs at Mycenae and other ruins and, according to Homer, the sack of Troy about 1200 BC. Greece fell into a dark age after that, recovering about 800 BC, with Athens later becoming the largest city-state with 40,000 people. Athenians and other Greeks proved to be great sailors and developed a mercantile trade around the Mediterranean, bringing substantial wealth to Athens. Solon reformed Athenian law at the start of the 6th century BC, in part, to establish the legal standards of coinage and finance for a prosperous city. Athens moved toward democracy about 600 BC. The Golden Age of Athens was the age of Pericles (461–29 BC) and many major buildings, including the Parthenon, were built then. Athens and Corinth were the first Greek states to mint their own coins. Silver drachmas of the Athenian Golden Age had standard designs of Athena on one side and the owl on the other, inscribed with the city name. By this time the most important reason for coins was for trade. The state’s authority provided assurance of the quality and value of the coins and some protection against forgery. Financial transactions were



Accounting and the Ancient World 19

usually conducted in coined money. As the city increased its wealth and status, coins were minted in large quantities. Later, bronze coins were minted for low-value exchange and everyday use. Archaeological digs at Athens’ ancient Agora (market place) found thousands of coins, mainly made of bronze. Banking in Athens seems to have started late in the 5th century BC. The most common activity was money changing, because of coins minted all over the Mediterranean. Bankers accepted money on deposit, apparently paying no interest. The value of bank deposits was a place to store wealth, especially useful to foreign merchants, eliminating the need to haul bulky gold and silver around. Bankers lent money at interest rates probably of about 12 percent a year. The Temple of Athena served as something of a central bank, accepting deposits from rich Athenians and lending money to the state and perhaps to individuals. In 454 BC state and confederate (Athenian allies) funds were transferred to the Temple. A complete record of financial transactions was kept, insuring better control of financial management. State revenues included taxes, tribute, court fines, and revenue from mines, all controlled by the Temple. Budgets also were developed, which were later compared to actual performance, demonstrating early use of planning and control. Athens lost to Sparta in the Peloponnesian Wars, and all of Greece and much of the world conquered by Alexander during his short reign in the 4th century BC. Rome started as a small city-state under kings and then became a republic ruled by aristocrats through the Senate. With the development of a professional army, Rome conquered much of Europe, Asia Minor, and North Africa. Beginning with Julius Caesar an empire began, lasting 500 years in the west and another thousand years in the east. In addition to conquest, Rome built engineering marvels, including roads, aqueducts, indoor plumbing, and grandiose buildings—usually in the name of the emperor. Augustus bragged that he left Rome a city of marble, but Rome’s most important engineering feat was the mastery of cement. Rome was late to the money game, not minting coins until around 300 BC. As Roman power, culture, and wealth expanded, so did the finances. A new monetary system was established in 210 BC, based on the denarias, a silver coin equivalent to the Greek drachma. Much of the

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financial system (and the entire Roman structure) was based on military conquest. Money could be borrowed to raise an army of conquest. The bounty of victory could be huge and perhaps 75 percent of all minted coins were initially paid directly to the soldiers. A complex empire-wide tax system supported the high costs as did the expected booty. Roman accounting evolved from records kept by heads of families, using a day book (adverseria) for chronological transactions and periodic posting to a cash book (codex accepti et expensi). Citizens were required to submit statements from their cash books to be used for taxes and legal settlements. Public receipts and disbursements were maintained by Roman officials with extensive recordkeeping and checked by an audit staff. As the republic and then the empire expanded, public records became more extensive and the bureaucracy grew. Seven antecedents to bookkeeping were identified in Rome by Littleton: private property, capital, commerce, credit, writing, money, and arithmetic, all developed in ancient times.11 Rich Romans kept detailed bookkeeping records, although Roman numerals did not make arithmetic easy. Publicans collected taxes and a vast bureaucratic network ran the imperial government. Financial records on public accounts were rigidly kept, although corruption on a vast scale was the norm—the well-known politics of corruption. The financial and accounting systems were complex, but not yet the double-entry system so important to the development of Medieval Italy. The Roman Empire fell in the west in the 5th century, but the Byzantine Empire remained in the east for another millennium. That did not help Europe, which fell into the thousand years of darkness. Arab Empires rose beginning in the 7th century, becoming the new centers of culture and wealth and maintaining much of the accumulated knowledge of Rome. The classical culture of the ancient world along with Arabic numerals, coffee, and other advances would be reintroduced to Europe to welcome in the Renaissance.

CHAPTER 2

The Dark Ages to the Enlightenment In the great republics nothing was considered superior to the word of the good merchant. … The second thing necessary in business is to be a good bookkeeper and ready mathematician. … The third and last thing is to arrange all the transactions in such a systematic way that one may understand each one of them at a glance, i.e., by the debit (debito—owed to) and credit (credito—owed by) method. —Luca Pacioli Why was it among the scattered and relatively unsophisticated peoples inhabiting the western part of the Eurasian landmass that there occurred an unstoppable process of economic development and technological innovation which would steadily make it the commercial and military leader in world affairs? —Paul Kennedy The thousand years in Europe following the fall of Rome were known as the Dark Ages. The Catholic Church used the Roman administrative framework and remained, amassing (and often abusing) incredible wealth and power. As Rome crumbled in the 5th century AD, life in Europe became primarily local and rural. This was probably just fine for most peasants, as long as they were not overrun by barbarian hoards.1 Medieval economies were largely self-sufficient; however, cities started rebuilding with business conducted by shopkeepers, artisans, and those connected with the upper echelons of the growing feudal system. Trade was simple, often using barter rather than money, with little need for detailed records. Independent Italian cities maintained commercial ties throughout the Mediterranean and were in position to propagate a capitalist juggernaut.

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The Arab world kept much of ancient civilization alive and later introduced it back to the West. In addition to distilling and coffee were the introduction of Arabic numerals replacing the cumbersome Roman numerals, the perplexing concept of zero, plus algebra (al-jabr). Italian merchants slowly picked up the Arabic numerals as a useful addition to double entry. As trade and wealth expanded banking and finance grew and innovated. The Dark Ages were not entirely dark, even in Northern Europe. Detailed records popped up periodically, including Charlemagne’s Empire and the Domesday Book of William the Conqueror. Even medieval manors had account books, although usually primitive. The church helped maintain literacy (plus bookkeeping) in the West and often recorded the local history. Charlemagne, King of the Franks, became Holy Roman Emperor on Christmas Day, in the year 800 and instituted many education, economic, and banking reforms. He replaced a gold standard (in short supply) with a silver standard, which simplifying and expanded trade. Income and expense accounts were standardized and the king attempted to control prices on several goods. He formalized the role of central government, including professional judges and royal envoys enforcing royal commands and investigating local circumstances—serving something of a judicial audit function. Taxes were standardized, including tolls and various forms of sales and transportation taxes. Education was expanded through church schools. (Literate people could keep accounts.) Reforms followed by chaos were recurring themes throughout the Dark Ages, including descent back to darkness after Charlemagne. William of Normandy defeated Harold Godwinson for the English crown in 1066 and continued fighting to consolidate his holdings in England (and France). England was particularly useful as a tax source for financing the various wars, using the sophisticated administrative system of the Saxon governments that preceded him, especially at the local level. In 1086 he called for a census of England subject to tax (excluding tax-exempt cities such as London and the northern and western parts not under his control), probably the most thorough census since the Roman Empire. As stated by the Anglo-Saxon Chronicle: “So very strictly did he have it investigated that there was no single hide [about 120 acres] nor a

The Dark Ages to the Enlightenment 23

yard of land, nor indeed … not one ox nor one cow nor one pig was left out.”2 An obvious overstatement, but the commissioners did check for fraud. The result was the Domesday Book, effectively judgment day for the forthcoming taxpayers—and emphasizing the coercive nature of the census. An important factor in English progress was the development of common law, the evolution of contract and other legal rulings from local courts attempting to apply general rules. These rulings were used as precedent for later rulings in different parts of the country, which was “incremental, evolutionary, and decentralized.”3 The focus on the importance of contracts and defending property rights was considered “market friendly,” ultimately key to English capitalism and the Industrial Revolution.4,5 The English bureaucracy, both before and after the Norman Conquest, were great record keepers, convenient for historians on the trail of accounting progress. This was partly because of an extensive judicial system, which, for example, settled disputes over land ownership—quite important when Norman lords claimed much of the kingdom for their own.6 The evolving system of court procedures, local government, and property rights (all parts of the rule of law) became increasingly important to the eventual development of capitalism.7 Of more importance to William and his successors was the ability to raise large sums of money quickly—viewed as effective bureaucracy or extortion on a vast scale (the later, the interpretation of Saxon peasants who had the heaviest burden of compliance).

Italian Merchants By the year 1000, merchants were becoming leaders of the rich city-states of Florence, Genoa, Pisa, Milan, and Venice. Conveniently, these cities avoided most of the rigidity of the feudal system. Survival and success meant ruthlessness, which the Italian merchants and rulers mastered (think Machiavelli). Trade and limited manufacturing brought wealth and accumulated wealth meant power—sometimes making the successful merchants hereditary rulers such as the Medici (and the occasional pope). The rising sophistication of accounting increased economic growth and profits. The patronage of the mercantile families as well as the rising

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wealth associated with the growth of trade were largely responsible for the Renaissance. Medieval banking was evolving, initialing focusing on money changing when multiple coinage from different locals were used. As trade expanded, bankers focused on transferring funds, often in foreign locations and to avoid using bulky gold and silver coins. The bill of exchange was a basic mechanism, plus various similar forms that could be considered bank checks or similar to paper money. Bank lending became common, although usury restrictions resulted in innovative ways to charge fees rather than interest. One way was to use different currencies and adjust the exchange rates. Or establish a note at a face rate and pay out cash as a discounted rate (say a note of 1,000 ducats for which the borrower received 950 ducats). Another was to have no mention of interest up to a due date, say in one month, and then charge a penalty for “late” repayment. In any case, Italian bankers could get extremely rich, although large loans to rulers could results in bankruptcy (and occasionally worse) if the rulers later balked at repayment. The Crusades brought Europeans in contact with the exotic East. Many returning crusaders discovered silks and spices they could no longer live without. Italian merchants were in position to exploit expanding trade from Europe to Constantinople and beyond. The most successful merchants developed complex trading networks across Europe, which required advanced shipbuilding, money, credit, insurance, a commercial legal system, and improved accounting. These were high-risk enterprises, demanding tough and ruthless men. Many of the international trading networks developed from Northern Italy through merchant partnerships. Money was deposited, bills of exchange issued to transfer funds across large distances without the use of coins, and clearing houses for settlement of debt were established in about a dozen major European cities. Genoese banks also developed interest-­ bearing deposit accounts. Syndicates sprung up to provide insurance, often funded by the same merchants and bankers. Public debt also started in Italian city-states. The outstanding debt of Florence rose to 3 million gold florins by 1400, used to fight off the French, other Italian states, and rival claimants to the dukedom. Banking was a specialized profession in Italy by the 13th century, although it would take another 400 years

The Dark Ages to the Enlightenment 25

before central banking and circulating notes established the beginning of modern monetary systems.

Double Entry Medieval business was conducted by artisans and village shopkeepers, with little need for detailed records—a good thing because most of them were illiterate. Venice had a near-monopoly on salt and developed mercantile relations with Constantinople in the 9th century. Italian merchant trade expanded across the Mediterranean and beyond from the Crusades (1096 to roughly the end of the 13th century), which brought the West in contact with the good living of the Arab states—spices, silks, and other delights. The barbaric European nobles returning home liked these Eastern refinements and willing to pay high prices to import them. The Italian merchants were accommodating, developing trade networks from Constantinople and Arab ports of call to Northern Europe—even that distant backwater, England. Evidence suggests double-entry bookkeeping was invented in the Genoa-Venice-Florence area after the Crusades started the movement of both people and goods, part of a vast commercial revolution with these city state firmly in the middle.8 The merchants traded goods at convenient locations and sold the products throughout the known world. These were relatively small operations, but profitable enough for merchant partners to become rich—primarily because they set prices and learned how to calculate costs and profits. Merchants developed bookkeeping techniques to meet their needs as business expanded both in size and complexity—a recurring theme. Partnerships initially were usually short term, started and terminated within a few months to a few years, sometimes serving only for a single voyage. Then the books were closed, accounts settled, and new books opened for new opportunities—often with the same partners. Simple accounting worked reasonably well, with the purpose of keeping track of assets and liabilities. The books were closed and profits represented the remainder after initial net assets returned to the partners. Parchment with the old accounts likely would be washed or scraped and reused by the new firm. Partnerships became longer term as operations got bigger and more

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complex, retention of financial information became more likely, as did the need to document financial transactions in more detail. Few financial records remain from this period. Parchment was too expensive not to reuse when original records were no longer needed, paper less likely to survive. Fragments of merchant records did manage to survive in various archives in Italy and elsewhere. The Pisan Document (from Pisa—of Leaning Tower fame) dates from the early 12th century, discovered in the Free Library of Philadelphia of all places. Relying on primitive bookkeeping using Roman numerals presented in paragraph form, it recorded expenditures of a Pisan shipbuilder constructing or repairing a galley. This was a simple set of sequential records in paragraph form, systematic bookkeeping but not remotely close to double entry.9 Parchment fragments of a ledger from an unknown Florentine banking firm date from 1211, mainly relating to loans. Entries were in paragraph form, not in chronological order, using Roman numerals and various currencies with no attempt made to total or balance the accounts— primitive and not much closer to double entry.10 Other fragments include the Castra Gualfred and the Borghesia Company from 1259 to 67; Gentile de’ Sassetti and Sons, 1274 to 1310; and Bene Bencivenni, 1277 to 96. The most complete records were from Rinieri Fini and Brothers, 1296 to 1305 and Giovanni Farolfi and Company, 1299 to 1300. These last two have the major characteristics associated with double entry. Giovanni Farolfi was a Florentine partnership with Farolfi the senior partner. Amatino Manucci, a Farolfi partner, ran and kept the books for the Salon (a market town in Provence, France) branch. Salon was an olive oil production center and convenient for buying wheat, barley, oats, wines, wool, and textiles. Farolfi also was a banker, dealing in lending and money changing. In other words, seemingly simple operations got complex quickly.11 Manucci used at least 6 account books, but only 56 pages of a “general ledger” are known (of 110 total pages for the 1299–1300 fiscal period). Financial information was in paragraph form recorded in French livres.12 Each entry had a single debit and credit, fully cross-referenced. Summary accounts show “transfers” from other account books. Each page was totaled, with a grand total for debits on page 91 (the credit total was lost). As analyzed by Geoffrey Lee:

The Dark Ages to the Enlightenment 27

The books were logically subdivided, with segregation of cash and goods accounts from the main ledger, a perpetual inventory of each line of agricultural produce and each grade of cloth or yarn in, and full records of debtors and creditors, expenses, profits, interest, and partners’ drawings…13 Is this double entry? Lee identified six necessary components: (1) the concept of the business partnership as an accounting entity; (2) algebraic opposition, debits equal credits; (3) a single monetary unit; (4) a capital or proprietors’ equity account; (5) the concept of profit and loss as a separate component that will increase or decrease equity; and (6) the use of an accounting period.14 Earlier fragments had some, but not all, the components; the 1211 Florentine bank met only the first three, for example. Existing fragments from the late 13th century were missing key components. Manucci’s books met all criteria. Manucci did not invent double entry, a process taking several centuries. If he didn’t finish the process himself, it did not happen long before. Surviving Italian account books over the next few centuries ranged from primitive to slightly more advanced than Manucci, typically with some but not all the characteristics of double entry. Fragments of the account books of Rinieri Fini and brothers (also Florentine merchants) at the Fairs of Champagne from 1296 to 1305 were contemporary with Manucci and likely double entry as well. Tuscan merchant Francesco Datini created a huge trading empire before his death in 1410. His 573 ledgers and account books plus an additional 150,000 business papers were discovered in 1870 and archived in the Prato Museum in Tuscany, providing considerable detail about the life of a wealthy merchant. Of more interest, it showed an accounting evolution that eventually moved to double entry by 1390, suggesting the need to improve accounting records as operation complexity increased. In addition to his “public record” (used for tax purposes), Datini maintained his “secret book” (libro segreto), the real transactions of business and personal life. Accounting, after all, can be used for illicit purposes. Powerful leaders of all types relied on bookkeeping, including the Medici family. Cosimo de’ Medici (1389–1464), the ruthless banker of Florence, turned riches into political power. As summarized by Soll:

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If Cosimo’s father made the Medici rich, Cosimo made the bank into an international superpower and became the richest man of his age in all of Europe. The Medici’s carefully collected riches would be used to pay for the artistic glory of the Florentine Renaissance and the political power of the Medici themselves. Thus the glories of the Renaissance would sit on the mundane foundation of good bookkeeping.15 Later members of the family became less interested in business (and accounting), relying instead on political power and the rich coffers of public treasuries—the most famous being Cosimo’s grandson, Lorenzo— called “the magnificent.” Manucci and his contemporaries used Roman numerals, a big limitation for complex enterprise manipulations and analysis. Arabic numerals were introduced by Fibonacci (Leonardo da Pisa) about the same time as Manucci’s books. Unfortunately, merchants initially took a dim view of them and used them with reluctance, for example, considering fraud and errors more likely when using Arabic numerals. However, they eventually took the plunge. Venetian merchant Jachomo Badoer used Arabic numerals for bookkeeping during 1436 to 39. It was not until the end of the 15th century that the Medici bank transferred entirely to Arabic numerals. Another promoter of Arabic numerals was Pacioli.

Luca Pacioli: The Father of Accounting Luca Pacioli (1447–1517), Franciscan monk, mathematician, and Renaissance man, was a friend of fellow Renaissance men Leon Battista Albereti and Leonardo de Vinci. His most important work was Summa de Arithmetica, Geometrica, Proportioni et Proportionalite, published in 1494. It was a summary of existing mathematical knowledge and contained a section, “Details of Accounting and Recording” (Particularis de Computis et Scripturia) that described the “system used in Venice.”16 He was born in Sansepolcro (Tuscany), as was Piero della Francesca, a great mathematician and painter, a proponent of Arabic numerals, and possibly one of Pacioli’s teachers. While still in his teens, Pacioli started as a tutor to Venetian merchant Ser Antonio de Rompiasi’s three sons. Pacioli also learned about commerce and accounting in the “Venetian

The Dark Ages to the Enlightenment 29

style,” partly by working as an agent for Rompiasi. His travels continued throughout much of Italy and beyond, including taking the vows of a Franciscan monk and starting on Summa in the 1470s. He received a chair of mathematics at universities in Perugia and later Rome. The other great 15th century invention was Johannes Gutenberg’s printing press with mechanical movable type, creating the printing revolution at mid-century. After Gutenberg, printing spread throughout Northern Italy and Germany and then across Europe. By 1500, over 200 printing presses cranked out exact copies. Venice became the printing center for much of Southern Europe. Paganino de Paganini started a print shop in Venice in 1483 and Pacioli returned to the city in 1494 to get his soon-to-be-bestseller Summa published by Paganini. Although the title was Latin, the text was written in Tuscan vernacular, apparently to seek the widest readership. The large volume included chapters on arithmetic, algebra, and geometry and introduced the use of Arabic numerals. Chapter 9 covered commerce, including the use of barter, bills of exchange, exchange rates, weights and measures, and a section on bookkeeping. Summa was massive, about the length of War and Peace, but the section on bookkeeping was barely 24,000 words and probably the only part of Summa actually translated into English in later centuries. This section spread throughout Europe and became the mercantile standard. The book generated enough fame to have Pacioli’s portrait commissioned—possibly the first portrait of a mathematician painted from life. The painting shows Pacioli in Franciscan monk’s robes apparently giving a lesson to a student (possibly Guidobaldo, Duke of Urbino or Albrecht Durer, the German painter visiting Venice late in the 15th century). Soon after Pacioli moved to Milan, he met and collaborated with Leonardo da Vinci. Pacioli’s later book on the mathematical basis of the arts, De divina proportione, illustrated by da Vinci, was Pacioli’s best known book of the period. Summa Summa was the first thorough description of double-entry bookkeeping, complete with Lee’s six components.17 Three books were required: memorandum book, journal, and ledger. The memorandum book summarized

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the transactions, as they occurred. Entries were posted in the journal with debits, credits, and explanation in one continuous paragraph. Unlike the earlier Florentine accounts which incorporated both debits and credits down the page, Pacioli’s Venetian ledgers separated debits and credits into two columns as is still done today—debits on the left, credits on the right. Although many currencies were in use, Summa required all transactions translated into a single monetary unit. A trial balance was prepared when books were closed. The balance from the profit and loss was entered to a capital account. Debits were listed on the left side of the balance sheet, representing assets, and credits on the right, representing debts and equity. If the two totals were equal, the ledger was balanced. This basic system has remained relatively unchanged for over 500 years, making Pacioli the “Father of Accounting.” Pacioli emphasized other important points. First were the things necessary to be a good merchant, including mathematics and a systematic way to understanding all transactions, namely double-entry bookkeeping. Chapters 2 and 3 focused on inventory and how to conduct it: “He must always put down on a sheet of paper or in a separate book whatever he has in this world, personal property or real estate, beginning with the things that are most valuable and most likely to be lost.”18 Another point stressed by Pacioli was the importance of authentication by a mercantile officer (“such as the Consuls in the City of Perosa employ”),19 which served as something of a legal contract and proof of transactions. He had a separate chapter on partnerships (Chapter 21), whose books should be kept separate. Chapter 24 covered dealing with banks: you may leave your money in the bank as a place of greater safety, or you may keep your money in the bank as a deposit in order to make therefrom your daily payments to Peter, John and Martin, for a bank draft is like a public notarial instrument, because they are controlled by the state.20 Pacioli received a 10-year copyright on Summa, one of the first writers to receive one.21 A 20-year copyright extension was issued in 1508 and a 2nd edition of Summa published in 1523. After that, bookkeeping texts appeared across Europe, often translations with only limited additions to

The Dark Ages to the Enlightenment 31

Pacioli’s original text (usually without attribution). In 1540 D ­ omenico Manzoni’s bookkeeping added examples of journal entries and ledger ­postings to Pacioli’s text without mentioning Pacioli. Slightly ­earlier, the book appeared in a German translation published in N ­ uremberg, followed by Dutch and French versions in 1543, then published in English by 1547. As commerce expanded in Northern Europe, Pacioli’s text proved invaluable. Although the basic mechanisms of double entry remained almost unchanged, accounting grew increasingly sophisticated and complex.

From the Renaissance to the Enlightenment The Renaissance emerged out of medieval success: the growing wealth from trade, exploration of a new world while attempting to find water routes to Asia, Gutenberg’s printing press, and a more secular culture starting in Italy. The wealth of the city-states of Florence, Venice, Milan, and others financed the cultural change. By 1400 Florence was a self-­ governing city-state of 60,000 under the de Medici family. Wealth was primarily based on the wool cloth trade and banking. Ghiberti’s bronze doors of the Baptistry in Florence (1403–24) is one possible start date for the Renaissance. Artists included Michelangelo, da Vinci, and Botticelli. Brunelleschi built the great dome on the Florence cathedral. Machiavelli wrote The Prince, Dante The Divine Comedy. Merchant wealth was essential, assisted by information provided by double-entry bookkeeping. Columbus discovered the New World, which was quickly exploited in the 16th century. Copernicus, Galileo, Kepler, and others demonstrated the importance of science and the scientific method. As printing revolutionized the spread of knowledge, mathematics and optics revolutionized science, gunpowder transformed warfare. From the Renaissance emerged the Reformation, the development of the nation-state, and the Age of Enlightenment. Martin Luther and others challenged the dominance of a corrupt Catholic Church, resulting in many Protestant denominations. Spain, France, and Britain became great nations. Philosophers expanded concepts of reason and humanism. Science advanced from the development of scientific societies and the publication of scientific research. The United States started as a great

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experiment in democracy. The Age of Enlightenment would end with the brutality of the French Revolution of 1789, but the beginnings of the modern world were well established. Accounting evolved over hundreds of years. By the start of the Renaissance, double-entry bookkeeping was widely used by Italian merchants. With Pacioli’s Summa and the ease of making Summa available with Gutenberg’s printing press, double entry spread throughout Europe. As industry developed and worldwide trade expanded, double entry was available to assist entrepreneurs and treasurers. Few accounting innovations were much in evidence before the Industrial Revolution, but the basic bookkeeping structure made finances more manageable. A number of specific factors were important to accounting and ­civilization on the road to Enlightenment. First was the increasing importance of nation-states, ultimately England and the Industrial Revolution. ­Second was the use of manufacturing before industrialization. The need for goods predated steam power and small firms developed processes, transportation, and marketing tools. Finally, it led to the rise of national banking and capital markets. Accountants were there to analyze the growing complexity. The Rise of Nation-States The growth of nation-states and empires proved a slow process during the Dark Ages, often with powerful kings (Charlemagne the most obvious example) followed by weak successors. Holy Roman Emperors developed around an Austrian core to include much of central Europe, Spain and the Netherlands, mainly through convenient marriages rather than military conquest. Spain developed as a separate kingdom under Philip II, while the Netherlands would revolt against the Spanish. The Normans under William the Conqueror and his descendants built on the Anglo-Saxon bureaucracy to control England, most of the British Isles and claim much (or all) of France. Each country had different stories to tell of success and failure, with accounting (defined broadly to include public budgeting and finance) a major player. After Charlemagne, the Holy Roman Empire had several incarnations (under various names and revived as Holy Roman Empire of the Germans

The Dark Ages to the Enlightenment 33

in 1512. Charles V became Holy Roman Emperor in 1519 and, mainly thanks to strategic family marriages, also was King of Spain and Lord of the Netherlands. After he stepped down, his brother became Emperor and his son, Philip II, King of Spain and Lord of the N ­ etherlands. ­Spanish conquistadors made Spain the superpower of the age, with help from high taxes on Dutch trade. Philip became “the king of paperwork,” a true bureaucratic king mainly to keep the taxes rolling in.22 The royal system was designed to limit fraud, but proved not very effective. A 1574 budget (based on primitive accounting and faulty assumptions) showed annual revenues of 5.6 million ducats and debt of 74 million ducats, thanks to embezzlement on a massive scale and wars seemingly everywhere—with the Armada fiasco against England the most memorable (at least in Elizabethan England). Accounting was improved, incorporating d ­ ouble-entry bookkeeping and reforms instituted, but corruption remained and state financing failed with some regularity. Despite massive quantities of silver and gold, Spain fell from superpower to also-ran. Somewhat to the east of the Austrian-based Holy Roman Empire was the Ottoman Empire. After the capture of Constantinople in 1453, the dynamic Turks pushed west into Europe and east to the Persian Empire. Moving into much of North Africa, the Ottomans were driving out the Venetians and other Italian city-states and raiding throughout the Mediterranean. Moving through Hungary, the Ottomans besieged Vienna— their furthest extent into Europe. The Dutch proved to be the most innovative, tenacious, and at least equally ruthless as the rest. Like the Italians, the success of the state was based on a merchant plutocracy. With an effective tax system, sophisticated accounting, and a thriving banking sector, the Dutch issued bonds at relatively low interest (4 to 5 percent), the AAA bonds of their time.23 The Dutch rose up against their Spanish overlords in an 80-year war (1568–1648) largely over high taxes and corruption, which ultimately proved effective (and a major reason for Spain’s ultimate financial failure). Amsterdam became perhaps the world’s leading finance, commerce, and accounting center by 1600. The founding of New Amsterdam in the New World suggested that Holland was the center of world commerce. The government attempted to regulate shady practices and market manipulation techniques, such as

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syndicates, short selling, bear raids, and stock corners, with the usual limited success. Dutch traders also experienced the first market bubble and collapse, “tulip mania” in the 1630s. The Dutch learned the painful lesson of the ups and downs in a capitalist system. Dutch engineer Simon Stevin wrote Accounting for Prices in 1604, which recommended both double entry and accounting for government finance, in part to reduce the potential for bureaucratic fraud. Holland depended on dikes and water management to avoid sinking into the sea, a major reason for adequate government bookkeeping and public finance. As Stevin stated: “Why do government clerks and bailiffs become rich yet leave their offices in debt and financial chaos?”24 Holland was ultimately too small to be a superpower, outdistanced in the 17th century by England and others, including the surrender of New Amsterdam to the English in 1664—soon renamed New York. France developed a powerful nation-state and created a centralized bureaucracy, but failed to establish a sustainable structure. Although a near-absolute monarchy, the aristocracy, clergy, and other powerful gentry had enough power to avoid major taxes and other limits to effective government. The French government, seemingly in perpetual wars, was always short of cash. Rather than tax reform programs, the government sold state offices to the highest bidder. The right to collect taxes also was sold and taxes fell mainly on peasants. These included direct taxes on farm output, poll taxes, and various sales and transportation taxes. Jean-Baptiste Colbert, perhaps the most influential mercantilist economist (promoting domestic manufacturing and colonies to provide raw materials and markets for finished goods), was trained as an accountant and as a young man worked in Lyon as an international banker.25 Colbert became Controller General of France in 1665 and worked both to improve French manufacturing and to end corruption by senior officials pilfering government funds, including the “greatest of the royal embezzlers,” Nicolas Fouquet.26 Colbert kept the royal books and created a relatively sophisticated set of state accounts using double entry. It was not enough. A continuing series of wars, the return of state pilfering after Colbert’s death, and the regressive tax system led to the continuing failure of French finance (and ultimately the French Revolution in 1789).

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Early Manufacturing Throughout the ancient world and Middle Ages, substantial manufacturing took place, in part using water, wind, human, and horse power. Unfortunately, productivity was low and stayed low, because horsepower meant horse power. Output in prosperous Europe was not much different from seemingly underdeveloped Asia. Of course, tools existed, sometimes on a vast scale, such as those used at Rome’s gigantic engineering projects, relying on waterpower, massive cranes and levers. Roman wonders included aqueducts, bridges, roads, and buildings. Water and wind power continued through the Middle Ages, including grist mills and saw mills. Monasteries often became wealthy, partly though contributions by major sinners (merchants and bankers did bad stuff in the eyes of the Church), and often ran large farming and manufacturing operations, including wine, flour mills, and bread-making. Particularly important for the development of commerce were the craft industries: textiles, clothes, metal- and woodworking, food, brewing, and lumber. Even during the darkest of the Dark Ages, these could be fairly large operations. Wool and cloth were important trade goods during the Middle Ages from England to Italy and beyond. Capital was scarce, typically coming from the family, with local merchants sometimes joining as partners. Little accounting expertise was required; consequently, single-entry cash-basis bookkeeping with little supporting documentation considered adequate. Guilds appeared in European cities by 1100, groups of self-employed craftsmen functioning as cartels. The guilds had privileges granted by the state and municipal oversight. Guilds helped standardize quality and provided a level of protection for both guild members and customers. The main purpose was to maintain monopoly power over production and entry into the specific profession (generally granted only through apprenticeships). Guilds therefore stifled competition and could both underperform and overcharge—based on the power of the particular guild. They generally opposed free trade and innovation. Guilds could be important politically. Gene Brucker writes of the guilds in Renaissance Florence: “Guild affiliation was a prerequisite to membership in the political community, and to the right to hold communal office.” The guilds

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declined when they hindered business and trade, especially by the start of the Industrial Revolution in the 18th century. Capitalism won out and corporations began to replace the guilds.27 Local merchants could employ craftspeople on a substantial local basis, a growing system especially in textiles. Initially, craftspeople and small craft shops bought or built looms and other equipment and sold products to wholesalers for relatively local distribution. Entrepreneurs consolidated the processes from buying and processing wool to the individual manufacturing processes, usually by maintaining groups of craft shops on a piece rate basis, and distribution. The introduction of improved tools and machines increased standardization. Raising machine efficiency and the ability to increase operating size (assisted by expanded markets because of better transportation) improved economies of scale and potential profit for the owners. Part of the process was improved accounting as complexity increased. Banking and Capital Markets Italian banking proved lucrative and bankers innovative in moving money and facilitating trade across the Mediterranean and much of Europe. Pacioli referred to banks as a “place of greater safety … with a written record for you surety” and a bank draft as equal to “a public notarial instrument.”28 Cosimo de’ Medici made the family fortune in 15th century Florence by being the banker to the papacy—later followed by a couple of Medici popes (who contributed mightily to papal corruption leading to the Reformation). Cosimo was a master accountant and banker, not true of his descendants and the Medici fortune declined even as their political power increased. Moneylenders, goldsmiths developing commercial banking practices, commodity dealers, and other practitioners of financial services expanded across Europe, with Amsterdam leading the way. Countries could find buyers of bonds to finance the continuing wars. Wars did, in fact, enhance capitalism, both in terms of financial markets and growing demand for products. Dutch innovations began with the creations of capital markets when the Amsterdam Stock Exchange opened in 1602, soon followed

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by forwards and option derivatives,29 plus the corporation with limited liability. After successful voyages in the 1590s laden with Indian spices, an early public offering created the Dutch East India Company in 1602, which profited from Far East spices. The stock traded on the Amsterdam Exchange, making it one of the world’s first publicly traded corporations. The company’s charter required professional accountants and the right of the board to regularly audit the books. A major shareholder of the Dutch East India Company, Isaac Le Maire, also was a master manipulator. His schemes included short selling while supporting rival companies, bribery of company officials, creating bogus shares, and embezzlement. Years without audits or required reporting of the company early in the 17th century led to accusations of insider trading and worse. Two lessons in capitalism: (1) the crooks are as innovative as the entrepreneurs and (2) the entrepreneurs also can be crooks.

SUPPLEMENT B

Double Entry: A Brief Primer Genius is the summed production of the many with the names of the few attached for easy recall. —Edward O. Wilson Double-entry bookkeeping can be added to the list of genius inventions, along with tokens, the concept of number, writing, coins, and banking. A multitude of originators are summed up with the name Amatino Manucci, the Italian merchant partner given credit here. But what exactly is double entry? One (or more) debit is needed for each transaction along with at least one credit, with a debit usually associated with increasing an asset or expense, also decreasing a liability or equity; and a credit increasing a liability, equity or revenue, also decreasing an asset. It is a simple system, but at first glance seems wrong. How can both an asset and expense be debits? Important concepts are built in, requiring centuries of though and trial and error. Plus, someone to put it all together—presumably Manucci. Perhaps the easiest way to explain the system is an example.

An Example Assume Manucci contributes cash into the Farolfi Company (for the Salon branch) of 1,000 ducats, the entry (in modern form) is: Cash 1,000   Partnership [Equity] 1,000 One debit (cash in ducats, an increase in assets), one credit (an increase in equity), and the entry balances. Manucci buys 16 tons of raw wool, paying 800 ducats (50 ducats a ton):

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Inventory—Cotton 800  Cash 800 A debit and credit increase on asset (inventory), offset by a decrease in cash. Manucci sells 10 tons of cotton to cloth manufacturers in Lyon at 120 ducats a ton in cash. This involves two accounting entries, one for the revenue generated (10 @ 120 ducats = 1,200 ducats) and the cost of the decrease in inventory (10 @ 50 = 500 ducats, now recorded as an expense called cost of goods sold): Cash 1,200  Revenue 1,200 Cost of Gods Sold 500  Inventory—Cotton 500 This is a more complicated set of entries involving both operations (the nominal or temporary accounts of the income statement) and wealth (the permanent account of the balance sheet). Double entry provides the focus on operations showing an operating profit of 700 ducats (1,200 ducats in revenue for the sale of cotton less the cost of the cotton of 500 ducats). Net assets (total assets minus total liabilities, equal to total equity) are increased by the 700 ducats, but represented on the balance sheet by an increase in cash of 1,200 ducats less the reduction in inventory of 500 ducats. These and all other journal entries are recorded in the general ledger, but ignored in this simple example. At the end of the financial period (a fiscal year of 12 months) the nominal (income statement) accounts are closed out and the financial statements are prepared. The closing entries (in modern terms) would be: Revenue 1,200   Cost of Goods Sold 500   Income Summary 700 Income Summary 700   Partnership [Equity]

700

This seemingly strange set of entries closes (zeroes out) the income statement accounts (revenue and cost of goods sold) and transfers the 700 ducats of income to the balance sheet as an increase in equity.

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Finally, the financial statements are prepared. The important financial information is found in these documents. The income statement summarizes all operations for the period to arrive at a single profit number. Income Statement, Farolfi & Co. Salon Revenue 1,200 ducats   Less: Cost of Gods Sold 500   Profit 700 ducats The balance sheet (conveniently assets = liabilities + equity) is the financial position (i.e., the assets of the company against all the claims against those assets—liabilities and equity) at a point in time, the end of the accounting period. Balance Sheet, Farolfi & Co., Salon Cash 1,400 ducats Inventory—Cotton 300   Total Assets 1,700 ducats Liabilities 0 Partnership [Equity] 1,700 ducats Farolfi made a profit at the Salon branch of 700 ducats, which increased equity by the same amount. Charles Sprague in “The Algebra of Accounts” published in 1880 summarized the essential equations at the heart of double entry: debits = credits; assets = liabilities + equity; revenue—expenses = profit; plus, profit increased equity; the whole system remains in “balance.” The genius of the system is a simple system with this complete set of characteristics. Why Medieval Italy? By the 13th century, private property, capital, commerce, credit, writing, money, and arithmetic all were available (the “antecedents of bookkeeping”).1 Property and contracts were essential to Italian merchant partnerships. The operations became increasingly complex, the partners needed a system to determine costs and profits. Amazingly, it took 600 years before this could be explained as an elegant system of equations.2

CHAPTER 3

Britain and the Industrial Revolution Mechanization involved isolating parts of the production process that could be accomplished through highly standardized, accurate motion and then applying to such motion equipment that could be linked to power sources. —Peter Stearns The reasons for the massive increase in post-1800 productivity have always been at the core of studies of growth. They have to do with changes in the intellectual environment that promoted the emergence of modern natural science, the application of science and technology to production, development of techniques like double-entry bookkeeping and supportive microeconomic institutions like patent law and copyright that permitted and encouraged continuous innovation. —Francis Fukuyama Pacioli’s Summa was published not long after Columbus’ return from the New World, a key event in the decline of Italian states and the rise of Spain as a world power. First Spain and Portugal, then Holland and England became great sea powers. England gradually gained the upper hand, through trade, industrialization, and imperialism under the Mercantilist system—all supported by a superior banking system. British industry initially was based on a crafts system, with wealth based largely on land and merchandising. The evolving common law provided property rights and the growing power of Parliament protections from a sometimes predatory monarchy. The start of the Renaissance in England could be Tudor rule, with the future Henry VII defeating Richard III at Bosworth Field in 1485.

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After an initial rough start, Henry focused on domestic stability and building the royal treasury. England, however, remained a relative commercial and financial backwater. Henry VIII’s succession problems led to creating the Anglican Church as part of the broader Reformation throughout much of Europe. Henry’s financial problems were temporarily solved by raiding the monasteries, which remained faithful to Rome. The rise of Parliament proved an important part of the story of public policy, rule of law, property rights, and fiscal prudence. The ability to raise taxes and maintain credit would prove important in the power struggles over the centuries. France was a bigger country, but England developed better financing. Britain relied on land taxes as the major direct tax and excise duties. Income taxes would not be tried until the end of 18th century to fund the expensive war against Napoleon. From 1688 to 1815, Britain borrowed over £670 million, a third of the total spending, to fight the various wars—an ability the French (the usual opponent to Britain) were not able to match.1 A host of cultural preconditions (a “cognitive revolution”) existed before the Industrial Revolution could take off, to some extent based on the Enlightenment—that 17th- and 18th-century Age of Reason. Out of this period came the scientific method of Francis Bacon and others, the move toward modern universities, scientific societies and journals, science-based technologies, plus developing legal systems protecting commercial property rights and the birth of widespread capitalism. England was unique in certain respects, especially in the development of rule of law, contracts and property rights, which reinforced the concepts of individualism. Many philosophers, economists and others viewed social order as a “top-down” process, beginning with Thomas Hobbes’ monarch-based social contract. John Locke, Karl Marx, and many other used the social contract view in various concepts. Locke’s view of universal individual rights influenced the American Declaration of Independence, while Marx’s views led to the communist Soviet Union. Twentieth-century economist Friedrich Hayek challenged this “constructivist view of the origin of law” and based his social order theory on England’s common law. Rather than top down, the most legitimate social order was based on the evolution of thousands of individual local court cases over hundreds of years (“incremental, evolutionary, and



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decentralized”). In Hayek’s view, legislation came later and built on the foundation of common law. This perspective fit Hayek’s libertarian perspective, shared with Adam Smith’s laissez faire and free-market capitalism. The argument between top down social contract and common law evolution has been a long-term debate by legal scholars.2

English East India Company and Other Joint Stock Companies Britain picked up on the Dutch-invented joint stock company. The joint stock company was owned by shareholders, the company legally separate from the investors with the added benefit of limited liability (investors could only lose their investment in the company). The rich and powerful (aka, plutocrats) usually were the first to invest. The first in England seems to have been the Company of Merchant adventurers to New Land chartered in 1553, followed shortly by the Muscovy Company. Several of the American colonies started with joint stock companies, including the Virginia Company (which founded the Jamestown Colony in 1607) and the Plymouth Company. East India Company London merchants seemed particularly cocky after the defeat of the ­Spanish armada in 1588 and petitioned Queen Elizabeth to sail to India and other points in the East. Permission was granted and ships set sail with mixed success in the 1590s. Of course, chartering took political clout and strategic bribery, in part with company shares. Those that returned were profitable enough for more permanent ventures. The English East India Company received a royal charter in 1600 with monopoly rights between Cape of Good Hope and the Straits of Magellan (but subject to the Dutch and other well-armed British competitors), which proved profitable. Pepper, nutmeg, cloves, and other spices were more valuable than gold and available in India and the Spice Islands of Indonesia and beyond. The company had little fixed capital and the operators expecting to issue stock for each voyage. Long-term investments or national power were

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not part of the original plans. The aim was short-term profits. During the early years, stock was indeed issued for single voyages, then the stock liquidated and the proceeds divided among shareholders. Similar to earlier Italian experience, this reduced legal entanglements and got by with simple accounting. Although competing with the Dutch, Spanish, French, and Portuguese, the early ships returned with Asian spices and other riches, providing profits for the investors and allowing continuing funding for new voyages (the average sailor was not so lucky). Many of those investors interested in a quick buck wanted out after the return of the first ship. Long-term investors, usually the wealthy looking for diversification, favored continued investing. Fortunately, the early voyages continued to return to London filled with spices and enough profits raised to continue (partly because the directors, called the Court of Committees, insisted that £200 of every £250 from the first ships support the second). Important to the success of the East India Company was Thomas Stevens, the first accountant general to 1614. Unfortunately, no accounting records survived before 1657. Accounting was provided separately for each voyage. During the first 12 voyages before 1613 profits averaged 155 percent, then fell to about 12 percent from 1617 to 22—in part because of mismanagement and fraud.3 A new charter in 1657 provided for permanent stock and the public offering raised £786,000. Bribes may have topped £80,000 to get the charter, an amount considered extraordinary for the time—not the existence of bribes, just the amount. The charter allowed the company to hold overseas territories including fortification and armed camps, essentially making the company a quasi-government entity with military powers. The bureaucracy remained, churning out paperwork. As stated by Keay: “Merchants and accountants by profession, the Company’s men lived by the ledger and ruled by the quill.”4 Success continued, although revenue and profit growth were erratic. Investors still benefitted. Stock purchased for £100 in 1657 would rise to a high of £500 by 1683, with shareholders expecting an annual 8 percent dividend (later as high as 12.5 percent). By 1710 imports rose from an average £400,000 to £700,000. Operations varied over time. Early imports were pepper and other spices, with English woolens and other manufactured goods used for trade. The British goods were not enough and the Company bought



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much of the goods with silver coin (and later bullion). The silver generally was provided by various companies trading with Spanish and other New World colonies. The imports varied over time. Cotton became an increasing import and later tea. The East India Company effectively ruled most of India from the mid-1750s. The Company suffered hard time in the 1770s, leading to the Tea Act of 1773 giving the Company monopoly rights in the tea trade to the American colonies. The colonies boycotted the tea (in part, by shifting to coffee), leading to the Boston Tea Party. The result was the American Revolution, which did not go well for Britain. Britain focused more on India and the British crown took control of the massive continent in 1858. After decades of declining power and loss of monopoly rights, the East India Company liquidated in 1874. South Sea Bubble5 The South Sea Company was another joint stock company, founded by Lord Treasurer Robert Harley and schemer John Blunt, receiving a royal charter in 1711—another example of political influence (including massive bribes), in this case to receive monopoly rights to trade with Spanish colonies. Harley was interested in better management of the national debt, while Blount was interested in profit. Blount was a director of Sword Blade Company, which (despite its name) provided banking services to the South Sea Company. The concept seemed flawed from the start, but speculative fever caught on. Outlandish maybe, but marketing genius claimed vast future wealth awaited investors. Blount came up with the scheme. The Company would take over much of the national debt of England for an annual annuity of about £600,000 (6 percent of £10 million)—to be paid from customs duties. The Company would persuade national debt holders to exchange their bonds for South Sea stock, which happened. The Company was granted monopoly rights to trade with Spanish colonies (geography-deficient Brits considered South America part of the South Seas at the time). An agreement between the two countries provided a share of the trade profits with the Spanish crown. South Sea trade, it turned out, remained small and often unprofitable. Rather than the combination of a government annuity plus massive trading profits

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with from New World trade, the Company sold more stock for government debt (up to about £12 million) and created a giant Ponzi scheme. Dividends were paid and stock price went up and up in the face of speculation fever and Company-generated rumors of future riches. When war broke out against Spain in 1718, the Spanish confiscated Company assets around South America, which ended most of the potential profit from South Sea trade. Investors remained unaware of the Company’s plight because of company-generated rumors (that is, fraudulent claims), government support, and fraudulent profit reports. Stock price continued up to almost £1,000 in August 1720 (face value of the stock was £100), at which point speculators starting cashing out—the classic bubble and bust cycle. Stock price soon fell back to the £100 range. Investors buying stock on credit found themselves in debt and many in bankruptcy (Isaac Newton proved to be one of the “mad men,” losing some £20,000 in South Sea speculation.). Parliament investigated under the “Secret Committee” and discovered widespread corruption among company directors, managers, and government (including the chancellor of the exchequer and other cabinet members—several were impeached and a few jailed). Charles Snell was hired to conduct a financial review after the collapse (perhaps the first civilian auditor), but most auditing innovation had to wait for English entrepreneurs of the 18th century. Blount confessed about £1 million spent on bribes and how cashier Robert Knight cooked the books—Knight fled to France with much of the incriminating evidence, including the secret ledger called the Green Book. Property belonging to the directors and others was confiscated to make up part of the losses and Company stock dividends between the East India Company and Bank of England. The Company continued after restructuring, including minor trade with Spanish colonies and annuities from the national debt (until 1853). Joint stock companies fell into disfavor with the bursting of the South Sea Bubble due to large-scale fraud and speculation. Under the leadership of Robert Walpole (1676–1745), considered the first prime minister, government corruption remained, while ­Walpole’s allies avoided prosecution for South Sea corruption.6 The company survived under Walpole’s political leadership based on a government bailout and Bank of England support, partly to save his own financial skin and



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allowing investors to recoup about 50 pence on the pound. Despite his own corruption, Walpole managed to lower British debt from £40 million to £27 million by the time he left office in 1742.

Bank of England The Bank of England, now the Central Bank of Britain, serves as fiscal agent for the government, issues paper currency, regulates money, interest rates and credit, makes loans, and accepts deposits as a commercial bank. The “Old Lady of Thread-Needle Street” was established in 1694 as a joint stock company to facilitate credit and service government debt. Wars with France, a crushing public debt, and need for massive public funds required action. As summarized by Ahamed: In 1694, after several years of fighting a country many times its size, England found itself close to bankruptcy. A group of City merchants, all Protestants … approached the Chancellor of the Exchequer, Charles Montagu, offering to lend the government £1.2 million in perpetuity at an interest rate of 8 percent. In return, they were to be granted the authority to set up a bank with the right to issue £1.2 million in banknotes—the first officially sanctioned paper currency in England—and to be appointed sole banker to the government. Montagu, desperate for money, jumped at the idea.7 Much of the £1.2 million was raised within days and the bulk of it used to refurbish the navy. The Bank was to further serve the interests of the government, making short-term loans and buying long-term debt. The initial charter was for 10 years and rechartering generally occurred with new governments and financial restructuring (usually with the Bank taking on new public debt at a government-friendly rate). The Bank of England was the only joint stock company bank of the time and able to raise capital through equity issues. Other banks were partnerships with much more limited capital. The Bank operated as a commercial bank, taking in deposits, making loans, issuing banknotes, with the additional advantage of servicing the government. The Bank came to dominate

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credit and the money supply, and over time developed all the functions of a central bank. With much of its assets in British bonds, the Bank created a market in UK debt, resulting in greater liquidity and lower interest rates on these bonds. The bank’s services also usually involved maintaining the gold standard, low inflation, and moderate interest rates. The Bank was given the sole right to issue banknotes in England and Scotland with the Bank Charter Act of 1844, but the Act required the notes to be backed by gold. By the same token, the notes were usually convertible into gold except in time of war. Thanks to the sophisticated banking system developed in Britain, the government could count on the needed liquidity and credit availability to survive wars and depressions. When Clement Attlee’s Labour government took power in 1945, the Bank of England was nationalized and officially became the Central Bank of Britain. In 1946 the Bank was given the legal powers to regulate Britain’s banking system.

Industrialization Initially, British industry was similar to the rest of the world, with most manufacturing related to land and agriculture, beginning with bread and wine making. Spinners, weavers, and other textile industries relied on sheep, while tanners, shoemakers, and others used cattle. Carpenters needed timber. Coal, pottery, iron, and steel relied on mining the land. A huge percent of the farming population also were craftspeople especially during the winter. Towns were centers of trade, becoming manufacturing centers in their own right with regional specialties in textiles, metal works, and so on. Products were mainly consumed locally. England’s rising dominance over world trade and the development of a colonial empire resulted in both rising imports (such as sugar, tobacco, coffee, and tea) plus expanding export markets, especially woolens, metals, and various manufactured goods. In addition, new industries developed, particularly cotton textiles. The rising markets attracted entrepreneurs, investors, shippers, and traders, plus assorted others such as mechanics and engineers trying to make a buck from new opportunities. Primitive single-entry accounting usually proved adequate for these simple operations. Double entry expanded, but remained relatively



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unsophisticated. The accounts could be used to determine asset and liability positions in addition to overall profitability; however, detailed records had to wait until operations became so complex that records had to be maintained on individual operations and revenues and expenses could be matched to specific items. Owners usually did not concern themselves with additional accounting needs until on the brink of insolvency and desperation set in.

Industrial Revolution The Industrial Revolution dramatically increased per capita production through mechanization. The year 1750 seems a good start date for the Industrial Revolution, around the time industrial change became noticeable. A hundred years later the results were obvious. The rise in productivity in Britain was dramatic, over 2 percent a year in gross national product (GNP)—a miniscule amount annually but incredible over the coming decades. In 1750 per capita production was similar around the world. If British productivity was 100 in 1750, then the Third World was 70 and the rest of Europe at 80. By 1900 British productivity was 1,000. By 1860 Britain produced more than half the world’s iron and coal, conducted 20 percent of world trade and 40 percent of manufacturing trade.8 Despite the name, industrialization in Britain proceeded at a glacial pace; it was a revolution because it changed everything: most people worked away from home, often in factories; time was treated differently, employees were now on the clock; goods and processes became increasingly standardized and shipped farther in bigger amounts; business cycles became regular features of the economy, with depressions common and severe; urban living expanded while rural life contracted; cities became places of greater opportunities but also overcrowding, poverty and pestilence. Eighteenth-century England changed from an agrarian and craftbased society to an industrial power. However, the concept of the “industrial century” of 1750 to 1850 is a vast oversimplification of a set of dynamic processes over half a millennium. Advances in industrialization (and concomitant changes in banking, transportation, financial markets,

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technology, and accounting) started in the Middle Ages especially in Italy, spread north and eventually into England. English industrialists borrowed as well as innovated. Water was the major power source from ancient times. Progress was made industry by industry. A major development was the rise of coal for fuel as lumber disappeared, which Britain had in abundance. Most of the coal was used domestically, with perhaps 20 percent exported. In addition to use in stoves for cooking and to keep warm, coal use expanded to iron production and other technologies leading to the Industrial Revolution. Some of the early innovations were in coal mining, such as steam-powered pumping engines to drain water from the mine shafts, deeper shafts, and tramways to move more coal. Scale economies led to larger firms, partially funded by various investor groups. Iron making improved thanks to technology resulting in better furnaces and ovens. Coal and coke use expanded to many metal industries, including copper, tin, bronze, tools, pans, and even pins—made famous by Adam Smith’s Wealth of Nations.9 Textiles The textile industry is almost as old as civilization, with spinning and weaving initially done by hand. When the Romans invaded England in 55 BC, they discovered a well-developed woolen industry. Throughout the Middle Ages, England was a major exporter of wool to the Continent. When William the Conqueror, Duke of Normandy, invaded in 1066, wool production and exports quickly became a major Norman tax source. Spinning, fulling (plus carding and combing to get fibers ready for spinning) and weaving were each British industries. The loom was ancient and the spinning wheel an early Medieval invention. Woolen manufacturing improved and cloth exports expanded. The domestic process was used, with households using spinning wheels and hand looms, a system that worked because it required little capital and households could specialize in textiles or work at farming and shift to spinning and weaving during farming downtime. Textiles became the major industry in Britain by the 18th century. Major mechanization in textiles had to wait until the 18th century and initial inventions improved the household system. However, most of



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the mechanization began with cotton rather than wool, because cotton was easier to work with. Cotton was common in India and points East, but a recent import to Britain in that century. Indian cotton clothing seemed to be discovered by Alexander the Great and later used in Egypt and Indian-Arab trade. It became known in Medieval Europe. Apparently, British interest began with the East India Company, including imports of Indian calicoes and other cotton fabrics. Manufacturing made cotton attractive in Britain and later became a major part of the mercantilist system: importing cotton and exporting finished goods to the colonies. John Kay’s flying shuttle was the first major improvement on the Medieval loom. This “power loom” for hand weaving automatically moved threads horizontally through a frame (the weft through the warp threads) using a foot pedal, essentially doubling production. Kay apprenticed as a hand-loom maker and continued to improve textile machines. Early patents included cording and twisting machines and in 1733 he received a patent for his most famous invention, the flying shuttle. He started a partnership to manufacture them, which proved to be an early disruptive technology. Kay improved the shuttle and invented other machines but had trouble both with collecting license royalties and keeping other manufacturers from infringing on his patents. Alas, he did not make money on his inventions in Britain. He moved to France, collecting a pension from the French government for his technology—which can be considered the beginning of textile mechanization in France. Kay had the same problem in France: Rivals produced copies of his flying shuttle without compensating Kay. James Hargreaves invented the spinning jenny for domestic use around 1764, a machine which twisted cotton fibers into threads, although of relatively poor quality. The concept was several spindles could be placed side by side to make multiple threads simultaneously. He sold a few locally, which were well received until the price of yarn fell as production expanded. Hargreaves received a patent in 1770 and ran a small mill as a partnership until his death in 1778. Richard Arkwright invented an improved spinning frame for cotton threads in 1769. Fibers were twisted and wound into threads using continuous operations of “flyers and bobbins.” With wealthy partners, he built his own factory, initially powered by horses. He converted to water

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power in 1771, the first water-power textile mill in the world and his invention came to be called the water frame. Conveniently, it could also use steam power. Arkwright built several plants in various locations and hired thousands of low-skilled, low-paid workers. Much of his fame rests on the disciplined factory system established. Although Arkwright had trouble protecting his patents and ultimately failed in the legal battle, his business remained successful and profitable. Samuel Crompton combined these earlier inventions into the spinning mule, initially for domestic use. Crompton started spinning yarn at an early age using Hargreaves’ spinning jenny, noting its deficiencies. About 1779 he produced the spinning mule, which spun yarn combining the Arkwright water frame with the spinning jenny. He hoped factories would pay licensing fees, but few did—another inventor without economic success. The machine, on the other hand, was widely copied and improved. The automatic mule was patented by Richard Roberts in 1825; eventually some 50 million mule spindles were said to be in use. Edmund Cartwright invented a power loom which was patented in 1785 (with further patents as he improved the machine), but his factory failed. Another factory with Cartwright looms was destroyed by hand-loom weavers interested in jobs over progress. Power looms did not become widely used until early in the 19th century—some 250,000 by 1850. By then most British textile production was done in factories, with more and more converting to water and steam power and building or buying new technology.10 Water power was used extensively during the 18th century (especially for spinning), increasingly replaced by steam power by the end of the century and beyond. Iron and Steel Iron is one of the most common elements on earth, but requires substantial processing to be useful—basically into one of three major groups: wrought iron, cast iron, or steel. Small quantities of wrought iron were first produced in simple furnaces some 4,000 year ago. It took another 3,500 years before the blast furnace was invented to form cast iron, which made its way to Britain by 1500. Blast furnaces had to be operated 24 hours a day, allowing much more iron to be produced. The furnaces



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were established near major sources of iron ore and timber (later, coal), and also created a polluted hell on earth—perhaps a good metaphor for the darker sides of capitalism. Molten iron would be formed in molds for everything from cooking utensils to cannons and cannon balls, engines, and machine parts. The iconic iron bridge conveniently constructed at Ironbridge in 1779 was the first large (spanning a hundred feet) and perhaps the most famous iron structure in the country. The problem with using coal for blast furnaces was the sulfur in the coal which ruined the iron. This issue was solved by Abraham Darby in 1709 by converting coal to coke which eliminated the sulfur, leaving relatively pure carbon. It took a century for Britain to switch almost all furnaces to coke-fired. The reverberating furnace was first used for iron making in 1784. Waterwheels were initially used to power bellows in blast furnaces. The introduction of productive steam engines in the late-18th century expanded to iron-making and expanded the demand for iron and later steel across many manufacturing industries. Over 200 British blast furnaces were in use by the early19th century. The rolling mill was a 16th-century English invention, made into a major manufacturing process by Henry Cort (1783), Joseph Hall (1816), and others. The iron was passed through a pair of flat rolls, initially using water power. By placing multiple sets of rolls in tandem, the continuous mill was created. These inventions increased efficiency, lowered costs, improved quality, introduced new products, and simultaneously increased demand. Henry Bessemer tried to improve wrought iron in 1856, but his process differed and proved to be a great improvement for virtually any purpose at a lower cost. His secret was to blow cold air through molten cast iron in a converter, which burned out most of the carbon creating Bessemer steel. Steel production went from almost zero in the mid-1850s to millions of tons by the end of the century. Bessemer faced competition from the open-hearth process invented by the German-born engineer William Siemens in the 1860s, building his own steelworks in Wales. Steam Engines The steam engine was first patented in Spain in 1606, soon followed by a Dutch version. Thomas Savery obtained the first English patent

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for a steam pump, used to pump water from flooded mines. Thomas Newcomen produced the first steam engine using a piston in 1712, again used for mine pumping. These were inefficient, low-power machines. Producing an efficient commercial steam engine proved to be a lengthy process requiring several inventions and improvement over many decades. The most important inventor in this process was Scotsman James Watt. Watt patented a rotary steam engine in 1781, the first engine that could be built anywhere and used for multiple purposes. It did require substantial amounts of coal and water. Watt was an instrument maker at Glasgow University working with a number of professors. With their help, plus ironmaster John Wilkinson and others, he came up with a number of improvements to the steam engine including a separate condenser so that the cylinder’s piston stayed hot, taking out his first patent in 1769. He later partnered with Birmingham industrialist Matthew Bolton, manufacturing their first steam engine in 1795.11 Wilkinson was one of the first to use a Watt engine, specifically to drive hammers and rolling his iron stock. In addition to ironworks and mining, steam engines were used by textile manufacturers and to a minor extent brewing and ceramics. Watts and Bolton built some 500 steam engines before their patent expired early in the 19th century.12 With improved technology, efficiency rose while unit costs declined. A close connection developed between iron foundries and steam engine manufacturers, which was the most complex machine of its age. Ironworks, such as Darby’s, cast cylinders and other parts and sometimes these foundries became steam engine manufacturers. The need for machines created the role of the mechanical engineer and later promoted civil and other engineering professions. Engineers would prove to be creative accountants and added a number of new techniques to cost accounting. Steam Ships, Railroads, and Financing A sophisticated banking or finance system and adequate transportation were necessary components for the revolution. Banks mainly provided short-term loans for operating purposes and at least initially seldom interested in financing risky manufacturing adventures. An inventor or



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entrepreneur generally needed either substantial family wealth or willing business partners. The role of finance changed with large infrastructure projects, including canals and later railroads, as well as municipal utilities such as lighting, water, and sanitation. Water was the most efficient transportation means over long distances, giving the advantage to operations near the ocean or on large lakes and rivers. Canal building began in the late-18th century, followed by locomotives from about 1830. With mass transportation, the acquisition of large quantities of raw materials and the distribution of finished products over large distances became possible. Jonathan Hulls received a 1736 patent for a steamship powered by a Newcomen engine. Ships became more reliable with Watt engines, although early models had the unfortunate habit of blowing up or sinking. In addition to England, steamships were built in France and the United States, including the Marquis Clauder de Jouffroy (1783) in France, John Fitch in Pennsylvania (1785), and William Symington (also 1785) in Scotland. Symington-designed ships became practical and British shipping would lead the world. Over the decades, ships got bigger, more efficient and safer. Warships would get iron hulls and larger cannon. Overland transportation of heavy goods became increasingly important as industry and commerce shifted from a local focus to national and international production and distribution. Roads and stages were slow, undependable, and expensive. By the middle of the 18th century, canals were constructed and became the primary means of moving heavy goods such as coal until replaced by railroads. These were large infrastructure projects requiring upfront capital, out of the reach of family and merchant partners. Capital markets expanded to provide both debt and equity funding, with public funding also common. Railroads had a long history, with horses and mules pulling mine cars on rails by the 17th century. Early improvement included replacing wooden rails with iron and improved cars. Locomotives arrived with the concept of turning a steam engine on its side to run the wheels and the great industry of the 19th century was born. Mining engineer Richard Treyithick invented the first locomotive based on his 1802 patent for a high-pressure steam engine, which moved 5 wagons of cargo and 70 passengers 10 miles from an ironworks to a canal in Wales in 1804.

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Civil Engineer George Stephenson built a number of experimental locomotives early in the 19th century. He became engineer-in-charge of the Darlington Railroad which ran 26 miles from Stockton-on-Tees to Darlington (in northeast England) starting in 1825 with Stephenson’s appropriately named Locomotive No. 1 pulling the first public railroad. Stephenson’s more optimistically name Rocket won the competition for the best design in 1829 to power the rolling stock of the Liverpool and Manchester Railway. Service was started in 1830 to much fanfare—making Stephenson the “father of railways.”13 George and son Robert Stephenson’s Newcastle works would build more than a thousand locomotives by the mid-1850s. Locomotives by the hundreds were built in England during the 1830s, of increasingly advanced design as relatively small railroads began to pop up across the country. Some thought big, including Isambard Kingdom Brunel as Chief Engineer of the Great Western Railway, started in the 1830s from London to Bristol (and beyond). Brunel wanted to add steamships to New York and the Great Western Steamship Company was born.14 Britain locomotive works would build thousands of locomotives of increasingly sophisticated design throughout the 19th century, a large percentage exported to continental Europe and other countries— including the United States.

Josiah Wedgwood and the Genesis of Modern Cost Accounting Josiah Wedgwood (1730–95) is well known as a potter and as grandfather of Charles Darwin. His research of materials, use of skilled labor and successful business organization made him a leader of the Industrial Revolution. At a time known for the craft of pottery, Wedgwood became a pottery manufacturer, a pioneer in production. He established his first pottery works in 1759, beginning with an improved cream-colored earthenware later called “queensware.” In 1782 his was the first factory in the industry to install a steam engine. Wedgwood initially made little use of accounting. His focus was clay chemistry and ceramic production. High prices were charged, resulting in substantial profits even though costs were poorly tracked.



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The circumstances changed with the depression of 1772. Demand dropped, inventories rose, and prices were cut. Could he cut costs enough to avoid bankruptcy? His answer involved understanding cost accounting in enough detail to make informed decisions. An early discovery was a history of embezzlement by his head clerk, when the accounts didn’t agree. A new clerk was quickly installed and a weekly accounting implemented. Wedgwood was able to determine costs for materials and labor for each manufacturing step for each product. This involved keeping track of individual costs, beginning with materials, then labor, and tracking them by category and how they were used for producing individual products. An attempt was made to allocate such overhead costs as breakage and interest as well as transportation costs. He discovered that certain products cost considerably more than others to manufacture, with a correspondent effect on prices and therefore profit. He also became aware of both the concepts of economies of scale and sunk costs. The large percent of fixed costs suggested the importance of greater overall volume. Based on his cost analysis, the high-price policy for pottery was changed. Lower prices could be charged differentially, increasing both demand for some products and greater overall profit. Demand became key to policies. The market could be divided between high-price high-quality products for richer customers, while a mass market could be appealed to with lower-cost lower-priced products. The cost system influenced wages paid, types of employees (e.g., apprentices were paid about one-third of experienced workers and were useful for certain tasks), amount of products produced, and specific techniques used. Prices were based on relative costs, demand, and how demand could be stimulated. Because of his pioneering accounting system Wedgwood survived, unlike hundreds of his contemporaries. In fact, the company he founded is still in business, although no longer under Wedgwood family control. Was Wedgwood typical of entrepreneurs at the start of the Industrial Revolution? Fleischman and Parker analyzed 25 large British manufacturing companies from 1760 to 1850. Most were in the textile (13) or iron (6) industries, with one potter—Wedgwood. Cost-accounting progress was made at many of these firms, some perhaps at a level of sophistication similar to Wedgwood at about the same time. Fleischman and Parker

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estimate that only 10 percent of Industrial Revolution firms survived through the 1840s, typically the ones with adequate accounting.15 One example of success was Carron Co., a pioneer iron foundry in Scotland founded the same year as Wedgwood, 1759, receiving a royal charter in 1773. It was the first firm in Scotland to smelt iron with coke, using the Darby method. Out-of-control costs, lack of profit, and poor liquidity were major concerns—requiring cost analysis. Cost estimates, monthly cost comparisons (costs per ton), performance measures for each department head, calculation of revenues and expenses for each cost center, and overhead allocation (including depreciation on an ad hoc basis) were some of Carron’s innovations contemporary with Wedgwood. Competition was fierce and the company withdrew from the anchor trade and nails production because cost evaluations proved them to be unprofitable. Carron became a large-scale, vertically integrated company which included specialty products. Complexity stimulated product quality control and overhead allocation. Carron became the largest ironworks in Europe early in the 19th century and survived until 1982.

SUPPLEMENT C

What Is Capitalism and Why Is It Important to Civilization? Capitalism came in the first ships. —Carl Degler Capitalism is defined as a system where the means of production are owned and used by the private sector, a relatively unhelpful explanation. These characteristics are generally true but exceptions exist (consider modern China) and it does not begin to explain why it took root and has been extremely successful (but with major down sides). A good starting point is Feudal Europe. Definitely not capitalism, except for developing pockets of industry, especially in somewhat independent cities. Guilds were Medieval and not capitalist; they produced goods and services but received monopoly rights and protections. Merchants and bankers (sometimes the same individuals and partners) got their start in cities. They sought as much freedom from government interference as possible, except for monopoly privileges when available at a reasonable price.1 Key characteristics in developing capitalism were property rights (as part of rule of law), competition, markets that were relatively free, and ability to raise and accumulate capital. Capital was originally associated with money, later expanded to represent all assets with a commercial value. Modern concepts of paid labor developed later. The developments of trade across Europe and into Asia expanded in the late-Middle Ages, along with the growth of multistate banking and related financing such as insurance. Merchant capitalism (also called emerging capitalism) had most of the characteristics now associated with capitalism: private parties,

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competition, developing contract and property rights, transportation routes, increasingly sophisticated banking, and incentives for vast and growing wealth.2 The increasing complexity required double-entry bookkeeping, which the Italian merchants developed basically out of necessity. Its monetary success brought in the Renaissance and, at least indirectly, the Enlightenment.3 The 16th- and 17th-century Dutch expanded financial capitalism with the innovations of the joint stock company and stock exchanges. They soon developed key strategies and instruments to exploit the market, including futures and options, short selling, and multiple forms of manipulation and speculation. They also discovered bubbles and busts, made especially famous from Tulip Mania in the 1630s. European mathematical discoveries would add to the knowledge of risk and uncertainty. Markets made capital a commodity, subject to both speculation and risk. England’s chartering of the Bank of England in 1694 would lead to central banking to, hopefully, limit financial extremes and potential collapse. Many authorities consider capitalism starting with industrialization and the factory system (conveniently called industrial capitalism), causing amazing increases in productivity and wealth creation. First Britain, then the United States and much of Europe adopted machine manufacturing and the steam engine, then built railroads and steamships. Components of industrialization according to Kocka included: First of all, innovations in technology and organization, from the development of the steam engine and mechanization of spinning and weaving in the eighteenth century to the digitization of production and communications in the late twentieth and early twenty-first centuries; second, the massive exploitation of new energy sources (initially coal, later electricity from different sources, then oil, atomic energy, and renewable energies) that has fundamentally changed and endangered the relationship of humankind to nature; third, the spread of the factory as a manufacturing plant that, in contrast to the old putting-out system, was centralized, and in contrast to a craft workshop, used motors and machine tools and made a clear distinction between management and execution.4

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Increasing incomes (especially as labor gained power) created a middle class, but with the downsides of continued business cycles, substantial poverty, and continued income inequality. A major component of the overall problem of economic fluctuations was unregulated finance, with the ability to generate vast wealth through risky ventures and the concomitant potential of mass financial disaster. A major problem of developing industrial capitalism beginning with Britain was the growing income equality gap, with workers (often farmers thrown off their land) working long hours in unsafe conditions for a pittance and subject to layoffs in depressions. With a zero safety net workers could expect no help for government, particularly bad living conditions with rampant diseases, and no education. Stealing bread apparently could be punished with long jail time or even execution. This existed when Karl Marx was researching capitalism and coming to the conclusion that the system was unstable and would be overthrown. Instead, social relief and increasing power to labor were eventually forthcoming.5 Economic and sociological concepts of capitalism go back at least as far as Adam Smith’s 1776 Wealth of Nations. Smith was a believer in free markets, laissez faire, self-interest, and introduced the term “invisible hand” for how markets (at least for consumable goods) behave. Smith considered a regulatory system necessary, requiring at least limited government action to promote efficient use of markets and enforcement of contracts. Later thinkers built on the Smithian model. A key point recognized by Smith was the complete change of culture to the “commercial society,” such as the importance of time to clock in and out. Economists developed first classical then neo-classical models. The Austrian School and others focused on a libertarian perspective, while Karl Marx led the charge for the complete overthrow of capitalism in favor of a socialist system. The socialist critique by Marx and others included injustice, exploitation of workers and many others, plus moral erosion.6 German sociologist Werner Sombart, writing around the turn of the 20th century, contrasted “early capitalism” (before the Industrial Revolution) from “high capitalism” (beginning in the mid-18th century).7 Sombart gave considerable credit to Jewish business people, excluded from guilds and other Medieval European institutions, for developing competition and other elements of capitalism. Sombart considered

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double entry a key precondition to capitalism. Maximillian “Max” Weber, a contemporary German sociologist of Sombart, viewed culture as a key to understanding capitalism and viewed the “Protestant ethic” essential to industrial capitalism.8 Weber and others emphasized the relationship of markets, competition and the search for profits relative to political and legal social elements (e.g., the enforcement of contracts and property rights). Austrian economist Joseph Schumpeter, writing in the mid-20th century, considered innovation a major component of capitalism and the catalyst for economic development. The result is business cycles caused by creative destruction because new technologies and strategies make older systems obsolete. In summary, one definition of capitalism: Emphasizes decentralization, commodification, and accumulation as basic characteristics. First, it is essential that individual and collective actors have rights, usually property rights, that enable them to make economic decisions in a relatively autonomous and decentralized way. Second, markets serve as the main mechanisms of allocation and coordination; commodification permeates capitalism in many ways, including labor. Third, capital is central, which means utilizing resources for present investment in expectation of future higher gains, accepting credit in addition to savings and earnings as sources of investment funds, dealing with uncertainty and risk, and maintaining profit and accumulation as goals.9

Capitalism Around the World The concept of “Western Civilization” seems rooted in capitalism. The economic growth from industrial productivity made the capitalistic West different from most of the rest of the world. Many (even in the West) fought against the materialism and self-interest built into the system, but the solutions to urban problems (e.g., drinking water and sanitation, public health, near-universal education, mass transportation, economic opportunity) were hard to resist. Political order became a

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common characteristic, based on a professional administration (bureaucracy), rule of law, and accountability through democracy and accounting or auditing systems. The West, in fact, now has mixed economic systems, with government playing a large role, not only regulations but ownership of some means of production (particularly “natural utilities” such as gas and electric companies). Northern European countries tend to have larger government shares and more regulation than the United States, although this has run in cycles. The United Kingdom moved toward socialism with the Labour government of Clement Attlee in the late-1940s, then switched to the right with the Conservative government of Margaret Thatcher beginning in 1979. Scandinavian governments (“Nordic social democracy”) tend to have large shares of public spending, a substantial welfare state, and powerful labor. Free markets are stressed, but with a big share of state-owned enterprises (sometimes called “cuddly capitalism”). Global trade brought imperialism, sometimes useful (consider Hong Kong or Singapore), sometimes disastrous (much of Africa), largely based on relative political order and who took charge.10 Much of the world adopted some characteristics of capitalism, democracy, and rule of law, but usually deviating from the “West” in major ways. Japan industrialized under the Meiji Empire beginning in the 1870s. Mitsubishi and other powerful conglomerates (called zaibatsu)11 were given substantial government support—including a subsidy system to promote national interests to develop major export markets. Capitalism, but with characteristics quite different from most of the West. Other Asian countries (especially Taiwan and South Korea) generally followed the Japanese model after World War II. As summarized by Studwell: An historical review of east Asian economic development shows that the recipe for success has been as simple as one, two, three: household farming, export-oriented manufacturing, and closely controlled finance that supports these two sectors. The reason the recipe worked is that it has enabled poor countries to get much more out of their economies than the low productive skills of their populations would otherwise have allowed at an early stage of development.12

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China is a special case, a communist dictatorship adopting a unique capitalistic model beginning with Deng Xiaoping in the late-1970s. An empire with a strong bureaucracy developed two to three thousand years ago with a strong cultural identity rooted in Confucianism. After so-called agricultural reform, China privatized some state enterprises— with ownership concentrated in the elites. Ian Bremmer called this “state capitalism,” authoritarian regimes using state-owned companies and select private companies generally to maximize state power.13 The strategy relied on low wages, exploited workers (a relative term), and mass exports (somewhat similar to the earlier Japanese example). Although China remained a corrupt totalitarian state, the economy expanded and a gigantic middle class created. After the collapse of the soviet system around 1991, Russia became a case study of an attempted but failed shift to capitalism. Privatization meant the creation of wealthy oligarchs. Income inequality exploded and the economy basically retrogressed. The government under Vladimir Putin remained a corrupt police state, subject to his whims and those of the energy market. The story of capitalism is mixed, with the potential for unprecedented economic progress, but also potentially bad social consequences, included increasing corruption, “crony-capitalism,” and market or economic volatility. History suggests the importance of the capitalist system, but the need to “get it right”: appropriate regulation including rule of law and taxes, relatively free markets subject to professional oversight, the need for accountability (especially transparency and inspections or audits), plus a balance of corporate governance, customer rights, fair treatment of workers, and consideration of the public and environment.14

CHAPTER 4

The Early American Experience Merchants such as John Hancock were sent to London to learn accounting as apprentices. —Jacob Soll The English colonies in North America were founded to practice religion in peace or find riches. The Plymouth Colony is the one most remembered, based partly on fact and partly myth. Most colonies were structured as joint stock companies and funded by British investors. These required royal charters and prospects for wealth. Gold was not found and none of the stock companies actually made much money. Consequently, other means of success were found. Each colony had a unique structure and history and, in the beginning, little contact with other colonies. Early on, survival was key rather than profitability. The Virginia Company (a joint stock company interested in generating income for investors) established the first permanent settlement, the Jamestown Colony in 1607. Others included the previously mentioned Plymouth Colony in 1620, the Massachusetts Bay Colony in 1630, and so on. The last colony was Georgia in 1732, established as an alternative to debtors’ prison and other “worthy poor.” America started with a focus on profit-making, a good starting point for capitalism, where production and distribution of goods are set by private markets based on supply and demand. The major attraction was vast stretches of land and long established British property rights (with little regard given to the native Americans). Most colonists were farmers, some 95 percent of the population in 1770.1 The South in 1770 was the most populated section with 1.5 million inhabitants, with about a half million each in New England and

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the Middle Colonies. The soil and weather made the South ideal for agriculture and major exports included tobacco, rice, and indigo. Generally, these were traded directly with Britain. The Middle Colonies of Pennsylvania, New York, and New Jersey produced livestock and grain, exported mainly to other colonies rather than Britain. New England had small, mainly self-sufficient farms. They exported timber, fish, and whale oil. With extensive shipping, New Englanders became shipbuilders and merchants.2 The four major port cities in America became thriving commercial centers. By 1770, these cities were importing some 137 tons of cargo: Philadelphia at 47,000 tons, Boston 38,000, Charleston 27,000, and New York 25,000. The colonies relied on trade and some 15 to 20 percent of incomes came from foreign trade.3 Because of British regulation there were no banks and no (legal) domestic mints for coinage. Bank of England banknotes and English coins were not common in the colonies, by regulation. Some colonies issued paper money, especially in times of war and various foreign coins were used. The Spanish eight reales coin became the “Spanish milled dollar,” the most common currency in America. At the same time, colonial merchants relied on credit from British merchants, especially in the South. In turn, colonial merchants gave credit to their customers. As part of the process, bills of exchange could serve as nominal paper money.

Colonial Grievances The colonies were thrust into European history because of the continuing conflicts among the European superpowers over the 17th and 18th centuries. There were many wars, which would involve the colonies and increasing restrictions consistent with Britain’s mercantile system. After the Treaty of Paris ended the French and Indian War (Seven Years War in Europe) in 1763, regulations, taxes and other restrictions became more severe. Britain won and had control of the seas and trade routes, not to mention the American and Canadian colonies as well as various Caribbean islands. Britain also accumulated massive debt, hopefully to be partially funded by the colonies. Various British regulations from 1763 to 1776 and stricter enforcement led directly to the American Revolution.

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Under the mercantile system, colonies were expected to ship raw materials to England and buy English finished goods (the Industrial Revolution was beginning). Various regulations and mother country officials were in place to insure compliance and limit colonial autonomy. However, these colonies had been relatively autonomous for over a century and taxes were mainly local. Regulations could be obeyed and appropriate custom duties paid; however, colonial merchants were good at evading taxes and regulations (both local and British) and disrupted the new English tax bureaucrats especially when obedience meant economic ruin. For example, the Molasses Act of 1733 required molasses to be exported only to British markets (including Caribbean colonies). However, French Caribbean markets were larger and necessary for profitable New England trade. The result—smuggling on a substantial scale. British regulation of trade started with the Navigation Acts of 1650 to 1750. These Acts basically established the mercantile system. Imports to England were required to be carried only in English ships or those of the exporting country. Major colonial exports (called “enumerated articles”) such as tobacco had to be exported to England. Most manufacturing was discouraged in the colonies. The Sugar Act of 1764 actually reduced the duty on sugar and molasses, but also transferred smuggling cases to vice-admiralty courts and thus designed to eliminate illegal trade with French Caribbean colonies. The Currency Act of 1764 outlawed paper money in the colonies—various colonies printed paper money during the French and Indian War. The Stamp Act of 1765 required a stamp tax on legal documents and various paper products, designed solely to raise revenues. This was a measure to partially fund the British troops in the colonies. In the past, colonial legislatures had exclusive control to levy taxes. In total, these were opposed by the colonies and a boycott was organized on British-manufactured goods. This in turn promoted primitive local industries. Various mob uprisings also took place and British bureaucrats harassed. Colonial leaders started working together across colonies, since they now had common grievances. The Townsend Acts of 1767 added duties on glass, paint, and tea. These were also protested. The Townsend Acts were repealed, except for a small duty on tea. However, the Tea Act of 1773 essentially gave the failing British East India Company a virtual monopoly on tea.

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Boston protesters boarded the Dartmouth in December of 1773 and dumped 342 chests of East India tea into Boston Harbor, the Boston Tea Party. From Parliament’s perspective, this required extreme sanctions. The Coercive (Intolerable) Acts of 1774 were passed to establish firm British control of the colonies, which included closing Boston Harbor. Many colonists considered that the last straw.

Independence The colonial grounds for protest were both economic and political. British regulations and enforcement in the 1770s were harsh by comparison with the lack of enforcement and taxes the previous century and a half. British response to colonial protest could be accommodating or repressive, but became particularly repressive with the Intolerable Acts. Despite the differences in history, economic conditions and religious values, the colonies became united because the regulations considered the most repressive affected all of them. In response to the Intolerable Acts, 12 colonies sent delegates to the First Continental Congress at Carpenter’s Hall in Philadelphia, September 5, 1774. The Congress adopted a declaration of personal rights to life, liberty, and property and sent a petition of grievances to the king. Before adjourning, they called for a second congress to meet in May 1775. Prior to the start of the Second Continental Congress, hostilities in Lexington and Concord started the Revolution in April 1775. The new Congress first met in May 1775 as planned. This became the War Congress and the only colony-wide government authority. Thus, they assumed provisional leadership and most colonial governments (generally under British or loyalist governors) dissolved. What a predicament! There was no executive, no constitutional framework or any governing rules to guide them, no revenue and no mechanism to raise taxes, no cash or banks, no army, and no bureaucratic infrastructure to actually wage war. Even declaring independence had to be debated. Most colonies established new provisional governments, usually with politically active revolutionary supporters and, where possible, existing political institutions. The initial funding method of the war effort proved to be rather easy. Based on prior war efforts, the Continental Congress authorized

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the first printing of paper money in May 1775. The use of the printing press would be the primary mechanism for financing the war by both the Continental Congress and the 13 colonies for the next 5 years. Following the precedent of the French and Indian War, taxes were expected to be raised after the war’s conclusion to retire this paper. The earliest printing (emission) of Continental Currency was $3 million in May 1775, the first federally issued money. The purpose was to fund initial war expenditures, with the currency to be redeemed from taxes levied by the states. Unfortunately, the printing presses didn’t stop. Funding resolutions from the Continental Congress continued and inflation spiraled out of control. Simultaneously, all 13 colonies issued paper currencies with little effort to levy taxes. By 1780 the Continental Congress issued some $241.5 million in paper, to see its value drop to roughly 2½¢ on the dollar; that is, “not worth a Continental.” Robert Morris was appointed superintendent of finance in 1781, the closest to a chief executive the federal government had under the Articles of Confederation. Although Cornwallis’ defeat at Yorktown in October 1781 effectively insured victory, the 3 years of Morris’ tenure as superintendent were difficult. This period was the financial low point for the United States. By the start of Morris’s tenure, the U.S. financial system had essentially collapsed. Paper money would no longer be accepted and domestic credit virtually nonexistent. Soldier morale was low, with no pay and poor supplies. Incompetence and fraud in supply were common. It was up to Morris to fix the system, ensure the Army was maintained in the field, and resurrect the failing financial system. Congress created the position of superintendent in 1781, with broad authority over financial matters. Almost immediately, Morris undertook wide-ranging reforms, under three major categories. First, he instituted specific reforms to keep the army in the field and maintain some level of federal credit. Second, he chartered the Bank of North America, the first commercial bank in the United States. Third, he proposed a federal tariff bill, to be the first direct revenue source under the Continental Congress. However, Rhode Island voted it down. Despite later efforts, the tax plan was dead. The federal government would have to limp on, with state dominance of credit and other financial matters. In frustration, Morris resigned in 1784. The rise of an effective federal government would have

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to wait until a new constitution was approved and a new government put into place. The financing would be dominated by future Treasury Secretary Alexander Hamilton in the 1790s, not Robert Morris. Morris would later be ruined by speculating in western land and spend 3 years in debtors’ prison.

The Constitution and Funding the War Debt The Treaty of Paris in 1783 ended the war, but the economy was in depression with a weak government under a mountain of debt. The Articles of Confederation provided no solutions. After Shays Rebellion of 1786 to 1787 in western Massachusetts over state taxes, a new government was deemed necessary. Virginia politicians proposed delegates from the states to meet at Annapolis to consider trade across states as a first step, then Alexander Hamilton proposed a second convention, used by Hamilton, James Madison, and others promoting a Constitutional Convention which convened in Philadelphia in May of 1787. Madison proposed the “Virginia Plan” with a legislature based on state population (Virginia was the most populous state at the time)4 and a weak executive. The small states wanted a single vote per state (just like the Continental Congress), and William Paterson introduced to “New Jersey Plan.” The “Connecticut Compromise,” introduced by Roger ­Sherman, proposed House members elected based on population and a Senate with two Senators from each state. Given George ­Washington as president of the Convention, a strong executive was expected, although many opposed both a robust central government and a powerful president. Solving this and many other issues took most of the hot, Philadelphia summer, ­finishing on September 17. The slavery issue was the big unsolved issue. Despite the efforts of the many antifederalists, 11 of the 13 state conventions ratified the Constitution by July 1788 (and the 2 remaining ­holdouts eventually ratified it). The Constitution gave the country a republic, established the rule of law, and created a reasonably powerful federal g­ overnment under a strong executive.5 The Elector College unanimously chose George Washington as the first president in March 1789 and he was inaugurated April 30, 1789. Washington and the first Congress established the institutional

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frameworks and procedures for effective governance. Congress approved four cabinet departments (conveniently inherited from the Continental Congress): Foreign Affairs (renamed State), War, Post Office, and Board of Treasury (Treasury Department). The realist Hamilton, the first secretary of the treasury, relying on the “necessary and proper clause,” established a reliable revenue system primarily using customs duties, recommended a central bank (soon to be chartered as the First Bank of the United States), created an effective federal accounting system, and assumed in full the debts of the Continental Congress and states. The Hamiltonian model worked well and many of his reforms continued for decades with only modest changes.

The Rise of American Business American industry followed Britain’s lead, becoming the manufacturing giant of the world by the end of the 19th century. At the start, America was the Jeffersonian ideal of an agrarian society (but ignoring the big plantations requiring slaves), with only a few small manufacturing firms before 1800. That changed as firms started, grew, and prospered. First textiles, then armaments and farm implements, and by mid-century railroads became common. The telegraph provided instantaneous communications. After the Civil War petroleum, steel, and other industries were developed and consolidated, creating America’s big business. Professional management and sophisticated accounting became central to big business success. The most successful entrepreneurs of the 18th century were often general merchants with broad-based activities including wholesaling, shipping (both exporting and importing), with limited banking and insurance exposure. The accounting activities were not much different from Renaissance Italian merchants focusing on mercantile transactions. As economic activity grew and transportation improved, merchandising became more specialized, most successful, and much bigger. Merchant capitalists would fund much of the growing industrialization in America, both as cash-providing partners of inventors and other entrepreneurs, as well as developers of formal capital markets. Early manufacturing in the United States was small-scale and local, relying on a combination of craftspeople, water power, and draft

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animals. As in Britain, the earliest industries included sawmills, textiles, grist mills, breweries, and iron foundries. These operations were simple, with relatively little machinery, and seldom involved selling to customers very far from home. Capital usually came from savings by the entrepreneur and family members; local merchants also provided capital, usually joining as partners. Little accounting expertise was required; consequently, single-entry cash-basis bookkeeping was often considered adequate. Canals, toll roads, gas lighting, and other utilities plus, later, railroads changed the business environment. These required vast infrastructure and capital, out of reach for typical entrepreneurs. Instead, the promoters (a quirky brew of entrepreneurs, engineers, merchants, politicians, and speculators) turned to government and nascent capital markets for funding. Prospective investors wanted reliable interest and dividend payments plus checks and balances to ensure operations remained healthy; that required adequate accounting and monitoring. Simultaneously, many promoters and speculators were interested only in short-term profits. If they had the authority (such as being corporate officers or on the board of directors) they could pilfer from the inside. Despite the corruption of speculators such as Daniel Drew and Jay Gould, most railroads consolidated and eventually turned to professional managers for efficiency and profit. Managers typically were interested in careers, rather than shortterm gain. Engineers and other railroad professionals developed sophisticated accounting systems to monitor and control their widespread operations. Many key financial reporting and cost-accounting issues were first addressed by railroad managers. Industrial firms by the mid-19th century expanded operations using increasingly sophisticated machinery, from textiles and farm machinery to oil and gas, iron and steel, plus a whole host of other industries. The economic boom of the Civil War propelled many of the companies to postbellum dominance. Particularly prominent were John D. ­Rockefeller’s Standard Oil and Andrew Carnegie’s iron and steel works. Both Rockefeller and Carnegie trained in accounting early in their careers and became the premier industrial entrepreneurs of the late-19th century. In the process, they built a couple of industrial giants. Carnegie in particular (based in large part on his experience with the Pennsylvania Railroad)

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concentrated on accounting information to control production costs and dominate the industry as the low-cost leader. Roughly around the turn of the 20th century, a massive merger movement, beginning earlier with the consolidation of railroads, transformed the predominant firms in most industries into giant oligopolies. Near-monopoly power was created, but somewhat limited (and occasionally broken up) by the Sherman Act and other antitrust legislation. The increasing size meant the need for additional accounting information and procedures to collect and analyze the relevant data for planning and control purposes. Major industrial accounting models that propelled large manufacturing companies in much of the 20th century were developed by Du Pont and expanded at General Motors (GM). Du Pont developed a number of sophisticated accounting tools including return on investment (ROI). Du Pont made a fortune from munitions during World War I and used much of the retained earnings to expand into other areas, including the automobile industry by taking a large share in GM. When GM foundered during the 1920 recession, Pierre Du Pont took charge and transferred Du Pont accounting experts such as Donaldson Brown to GM. GM under the leadership of Alfred Sloan would use this accounting data to obtain necessary information on the various subsidiaries and develop an information or control system to effectively run an immense decentralized industrial operation. By the mid-20th century, GM would be the dominant manufacturing firm in America and the GM system the model for structuring big decentralized corporations. GM and other manufacturing giants led the country to global industrial dominance, producing half of the world’s manufactured goods.

Banking and Capital Markets America’s first bank was the Bank of North American, chartered by the Continental Congress in 1781 about the time of Cornwallis’ surrender at Yorktown. Robert Morris’ Philadelphia bank was a typical commercial bank of the time, taking in deposits and making short-term commercial loans to well-to-do merchants. The bank also provided central banking functions, serving as a fiscal agent, receiving government deposits,

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and making short-term loans to a cash-strapped Continental Congress. A few other commercial banks were founded in the major cities following Morris’ example, including Alexander Hamilton’s Bank of New York. As Treasury Secretary, Hamilton created the First Bank of the United States in 1791 as a central bank (and the first corporation to get a federal charter) to establish a strong financial structure for the nation. The bank was chartered for 20 years, with 20 percent owned (temporarily) by the government and the remaining in private hands. A major function of the bank was providing short-term loans to the cash-strapped government. Under Thomas Jefferson’s presidency, the bank was little used and the charter was not renewed in 1811. Interestingly, Canada adopted the banking structure of the First Bank (and the related 18th-century American banks), creating a relatively stable banking structure that still exists in modified form. Canada managed to avoid the financial collapses and chaos that proved common in the United States. Eighteenth-century banks were conservative and stable. That changed in the 19th century particularly after the War of 1812 as states experimented with bank chartering, from conservative with considerable regulatory oversight to nearly anything goes. Banks issued their own banknotes, meaning that money supply could expand exponentially in poorly regulated states, which proved a major cause of booms, followed by inflation, panics, and depressions. Promoters of various canals and later railroads got initial funding from some of these state banks. Rural banks, more common in the South and West, often took big risks and got the reputation as “wildcat” banks. With regulations typically allowing lower reserves in specie (gold and silver), greater loan volume using banknotes (that is, the bank loan would be paid out in that bank’s paper currency), plus various techniques making specie redemptions more difficult—meaning bank owners could make (and lose) more money. Failure proved to be common and shady promoters could leave town in the middle of the night to set up a new bank in another state. This unstable system allowed the promoters and then farmers to buy lands in (at the time) the western states and develop them. Cities, transportation systems, and relatively more stable government would follow. Infrastructure projects like street lighting, canals and later railroads needed substantial capital, which required “creative” funding: bankers,

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merchants, governments, and various passive investors. These big capital projects needed state charters, with connections and cash “contributions” to the powers that they typically needed. Construction often involved difficult work before civil engineering became a profession, mostly done exclusively by hand, livestock, and the dangerous use of gunpowder. Public works and transportation system were part of the rise of investment banking, which had its beginnings in the major coastal cities selling stocks and bonds to the public. Brokers initially traded securities in coffee houses and on the streets. The Philadelphia Stock Exchange started in 1790 as the Board of Brokers meeting in the Merchants Coffee House. The 1792 Buttonwood Agreement created what became the New York Stock Exchange (NYSE) as a private partnership (it remained private until 2006). Initially brokers traded government bonds and bank stocks.6 Utilities and canal company securities were added, including the successful Erie Canal. By 1835, some 80 commercial firms traded, including mainly banks and insurance companies, plus about 10 railroads, canals, and gas utilities. The NYSE continued to expand, but became the world’s largest stock exchange only in the 1920s. The biggest objective of commercial firms became keeping up interest and dividend payments. Because stocks were considered risky, dividends were expected to be much higher than bond interest, often 7 to 8 percent of par value (if the company wanted its stock to remain at par, usually $100 a share) or above. Corporate income was often overstated, because no standard accounting requirement existed and it proved difficult to account for wear and tear of plant and equipment (depreciation was not well understood and often ignored). This left little cash for capital projects or even standard maintenance.7 Cash shortages meant expanding operations usually requiring new stock or bond issues rather than accumulated earnings.

The First 50 Years of American Business By 1790 Americans had won a Revolution, survived a depression, written a constitution, and elected the first federal government. As Secretary of the Treasury under George Washington, Alexander Hamilton created a viable financial system, with revenues generated mainly from customs duties and the Bank of the United States established as a central bank.

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Attempts at nonpartisan government would soon end, replaced by a contentious political party system and increasing corruption. Business adjusted to the evolving government environment and learned to pay off or “capture” politicians and government agencies as they were created. Business would thrive under a strong federal government with relatively weak control of business. Textiles The first industry to develop a factory system on a large scale was textiles, concentrated in New England—home of poor soil and long, cold winters. Prior to industrialization, textile production was carried out by individuals and priced at piece rates. That changed with Samuel Slater, an English textile superintendent working at Arkwright’s factory in Cromwell, England. Slater immigrated to America in the late-1780s. Hired by Merchant Moses Brown to build a textile factory in Rhode Island, Slater succeeded and by the end of 1790 the partnership Almy, Brown and Slater produced the first factory-made yarn; this is usually considered the first factory in America. Initially, local consumers preferred British yarn, but a little Congressional lobbying by Brown and a letter sent to A ­ lexander Hamilton encouraging American business produced higher duties on imported yarn. Hamilton issued his own “Report on Manufacturers” in 1791, which led to customs duties to protect “infant industries.” Slater’s yarn started selling and the factory had continued success. Late in his life, Slater built an integrated textile company (that is, integrating all the production processes to produce cloth within a single mill) using steam. Despite an explosion of new competitors across New England, Slater’s company remained a leading textile manufacturer at the time of his death in 1835. By 1812, 11 steam engines were operating in America, although water remained the primary source of power. With factories came large numbers of salaried workers, multiple products, overhead and the shift from mercantile to industrial accounting. Cost records of U.S. textile firms go back to early 19th century New England companies showing increasingly detailed systems. The accounting records varied widely by both place and time. McLane Report published in 1832 a list of 88 large textile companies

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(identified as those with assets over $100,000) out of a total 106 American manufacturing firms.8 In the early 19th century, Boston merchants established joint stock companies run by fulltime managers. The first integrated textile mill was built in 1814 by Francis Cabot Lowell at Waltham, Massachusetts. Its success led to more competitors, with 10 companies operating about 30 mills in Lowell (with interlocking ownership and family networks). Accounting control became necessary as operations were managed by nonowner superintendents or agents. Some became relatively sophisticated. For example, Tyson states: The most outstanding feature of the cost accounting reports from the Lowell mills is the detail of comparative cost reporting. Historical records reveal that cost comparisons were conducted between different time periods, individual products and product lines, and different mills.9 Attempts were made to deal with depreciation issues by the 1830s, such as a 7.5 percent charge for “tear and wear” as part of an earnings calculation.10 At Lyman Mills (by mid-century) materials-costing included freight and insurance, calculated on a first in-first out basis;11 payroll records were kept daily by employee hours for each process; overhead (“arbitrary allocations of limited utility”)12 was distributed to mill accounts based on multiple criteria (such as floor space or number of materials) and generally treated as period costs.13 Unit costs were calculated for pricing decisions, initially with only prime costs (materials plus labor), later including limited measures of overhead. Eli Whitney, the Springfield Armory, and Standardized Parts Eli Whitney made of couple of major contributions to the early economic growth of 19th-century America. After his invention of the cotton gin, cotton became the staple of Southern planters. His 1793 patent became one of the most famous early patents, partly because of litigation. Whitney’s gin was simple; consequently, others made illegal copies and

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Whitney spent 15 years defending his rights in court. He finally gave up, moving north to begin manufacturing firearms. This time, Whitney made a fortune as a government firearms contractor. He started the process in America of making weapons using interchangeable parts, a system initially begun in France. Congress established the Springfield Armory in 1794, which produced 1,000 muskets by 1797. This was basically the entire domestic production. In 1798 Congress appropriated $800,000 for arms purchases, but with no prospects of identifying American manufacturers. Whitney wrote fellow Yale alumnus Oliver Wolcott, conveniently Secretary of the Treasury at the time, offering to produce 10 to 15,000 rifles using mass production techniques. Whitney’s offer was accepted (although he had no experience at manufacturing arms) and he was advanced $5,000 to begin. With few existing tools to create mass-production machinery, only the firing mechanism approached the concept of interchangeability—a process he demonstrated in Washington in 1802. Using limited mechanization (but more than anyone else before him), Whitney fulfilled the contract in 10 years.14 With improving tools and experience, the use of interchangeable parts and mass production soon became a common reality in firearms (literally manufacturing lock, stock and barrel) and beyond. It was the Army’s Springfield Armory that produced the most complete factory process in the early 19th century, while simultaneously developing a sophisticated manufacturing process. “Modern factory management had its genesis in the United States in the Springfield Armory.”15 The Springfield Armory was first established in 1777 by George Washington as an arsenal during the American Revolution in Springfield, Massachusetts. It became a primary manufacturer of military firearms beginning in 1794, including the famous Springfield rifle. Many technical innovations were developed or improved here, including interchangeable parts, assembly line production, quality control, and cost accounting for wages, production time, and materials. It was here that breech-loading rifles were introduced in 1865, Enfield Rifles during World War I, the M1 (Garand rifle) in the 1920s, and the M-14 after World War II. After closing in 1968, the armory was turned into the Springfield Armory National Historic Site.

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Colonel Russell Lee became superintendent in 1815 and served until 1833. He reorganized the operation around the centralized authority of the superintendent’s office. His improved accounting system increased costing accuracy and was used for control and monitoring. Production and quality control were maintained first by careful inspections and second by accounting controls, with records maintained for each transaction. As stated by Alfred Chandler: The master armorer and each foreman had a day book in which he entered the amount and value of wood, coal, and supplies (cutting steel, files, emery, and the like), which the workers had received. These amounts were transcribed monthly into a ledger or “abstract book,” the debit side of which listed the total of items received and the credit side the parts produced, materials still on hand, and scrap. The foreman, in turn, had similar books for each worker under his control. In his monthly abstract, the foreman credited each worker with units completed, units on hand, scrap, waste, and tools returned as worn out. … These accounts were consolidated monthly in tabular form for each shop or other operating unit by its foremen, and for the armory as a whole by the master armorer.16 Chandler considered these records the most sophisticated used by any American business before 1840.

CHAPTER 5

The Railroads By 1869 thirty-eight railroads, with $350,000,000 in capital stock were listed on the New York Stock Exchange. Railroads and their financing were the center of attention in the capital markets. —Gary Previts and Barbara Merino Transportation proved to be the single most important factor in the development of 19th-century industry. With poor or nonexistent roads, most goods that went any significant distance traveled by water. Early inland waterways primarily meant rivers, such as the vast Mississippi. Generally, markets stayed local, usually adequately served by local artisans and smallscale firms. An expanding industrial base required better transportation. For all points not on existing water, shipping alternatives had to be developed. Coaches and wagons proved slow and expensive. Canals became the first effective alternative. Funding and engineering were the major hurdles. The promoters and builders persisted and figured out the building process. Funding was problematic and promoters looked to government, city merchants and bankers, speculators, and even European investors. Many canals were planned, fewer were built, and a modest number proved highly successful. The most famous, the Erie Canal, ran from Buffalo on Lake Erie to Albany on the Hudson River. The Canal tied New York City to the heartland and allowed New York to become the largest and most economically dominant city in the nation. Promoting the Canal was a political or speculative act, combining New York City Mayor (and later New York State Governor) De Witt Clinton to land speculators in western New York. Although cost overruns resulted in total expenditures of $8.4 million, some 50 percent over initial budget projections, the Canal still became successful and vast quantities of goods traveled west (and settlers east), generating substantial tolls. Wall Street proved a major beneficiary as Erie Canal securities became

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investment favorites (European investors eventually owned a majority of the shares). In addition, the movement of goods turned New York City into the major port in the nation. The railroad enabled shipments of large quantities of manufactured goods at relatively low cost to anywhere a company was willing to lay tracks. For standardized (“commodified”) products, handcrafts were effectively doomed. As railroads crisscrossed the country, economies of scale became essential to manufacturing as industries expanded exponentially. Chandler identified three major benefits of railroads on economic growth: First, it has lowered internal transport costs, brought new areas and products into commercial markets and, in general, performed the Smithian [named for economist Adam Smith] function of widening the market. Second, it has been a prerequisite in many cases to the development of a major new and rapidly enlarging export sector which, in turn, has served to generate capital for internal development, as, for example, the American railroads before 1914. Third, and perhaps most important for the take-off itself, the development of railways has led on to the development of modern coal, iron and engineering industries.1 Initial railroads were primitive, slow, unsafe, and usually traveled short distances, say from a port town to a nearby inland city. No standardization existed. A shipper could not easily unload a shipment in one location and reload it nearby. By 1830 only 23 miles of railroad track were completed. By 1840 track mileage increases to 2,810 compared to 3,300 miles of canals. Steamboat entrepreneur (and later railroad tycoon) Cornelius Vanderbilt initially bought into railroads to interconnect with his shipping routes, as did his competitors. For example, the 43-mile Boston and Providence Railroad built in the 1830s met the New York Transportation Company ships at India Point in Providence and thus connected to Long Island Sound. From here steamboats owned by Vanderbilt and others could move the goods to New York City and beyond. It would be decades before giant trunk lines would connect New York and the other East Coast port cities to the Midwest and beyond.

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The Development of the Big Four Railroads Four major railroads took shape as trunk lines between large commercial centers and became major competitors before the start of the Civil War: the Baltimore and Ohio (B&O) connecting Baltimore to the Ohio River and beyond; both the Erie and New York Central connecting New York City to the Great Lakes; and the Pennsylvania Railroad from Philadelphia to Pittsburg and into the Midwest. These four provided many of the techniques associated with professional management and industrial accounting, as well as tales of manipulation and widespread corruption. Not considered corruption at the time were the poor working conditions of employees, resulting in thousands of deaths and injuries for which neither the railroad nor state took any responsibility. The Pennsylvania became a leader in professional management, while Erie speculators focused on looting—both the railroad and fellow investors. Maryland chartered the Baltimore and Ohio Railroad Company, the first successful major commercial American railroad, in 1827. The merchants founding the B&O expected a track from Baltimore to the Potomac, and then on to the Ohio River, some 300 miles. They hoped to capture the trade from the upper Potomac and Virginia’s Shenandoah Valley. Long term they wanted to open up the West to Baltimore merchants and stay competitive with New York’s Erie Canal and, later, the other major railroads. The budgeted cost to the Ohio River was a relatively modest $5 million, to be completed over 10 years of construction. The B&O reached the Ohio as expected, but only after 25 years and costing $15 million. The B&O nearly went bankrupt at least twice before completing the line to Wheeling (on the Ohio River) in 1853. The Erie Railroad was something of a political compromise for the building of the Erie Canal. The Canal was built in the northern part of the state and the “Southern Tier” politicians close to the ­Pennsylvania border wanted a railroad as their own avenue west. Thus was born the Erie Railroad, chartered in 1832 (the Canal had been completed in 1825). However, they did not have the clout to run from New York City to Buffalo; instead the line was established to run from Dunkirk (near Buffalo) to Piedmont (close to New York and the New Jersey border). It was, thus, a railroad running roughly from nowhere to nowhere, but at the time the longest railroad in the world at 451 miles. After emerging

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from bankruptcy, it had a complicated capital structure that included bonds convertible into stock (and back again) which made it a speculator’s dream. Daniel Drew and, later, James Fisk and Jay Gould would achieve their reputations as speculators and Robber Barons mainly from Erie shenanigans.2 The New York Central Railroad was a merger of several relatively unsuccessful New York roads in 1853, and the combined enterprise roughly followed the route of the Erie Canal from Albany to Buffalo. Because rail traffic was increasingly going large distances, railroad consolidation increased scale and efficiencies. Successful steamboat entrepreneur Cornelius Vanderbilt took effective control of the New York Central in 1867. He was the major shareholder in the Harlem Railroad which ran into the middle of Manhattan Island and moved on to dominate Harlem competitor Hudson River Railroad. Both railroads connected to the New York Central and thus provided railroad access from New York City to Buffalo. Vanderbilt was an investor rather than a railroad manager, although he hired competent engineers and other managers. The railroad ran with reasonable efficiency, but did not create innovative management or accounting controls. The Pennsylvania Railroad (“Pennsy”), founded in 1846, initially connected Harrisburg and Pittsburg. By 1865 it was the largest private business in the world, with 3,500 miles of track and 30,000 employees. The Pennsy developed the first professional management system, run by engineers rather than financiers or speculators. Engineer J. Edgar Thomson became President in 1852, assisted by Vice President (and later President) Thomas Scott; the pair transformed the railroad’s management into a line-and-staff structure and improved the accounting and financial system to provide the necessary controls to manage a giant corporation. Following the Pennsy example, railroad managers trained as engineers and focused on lifetime careers in railroad operations. The Pennsy remained the largest railroad in the nation during much of the 20th century, controlling 10,000 miles of track after hundreds of acquisitions.

Railroad Sophistication and Regulation The large railroads developed top-down management approaches. Historian Harold Livesay claimed: “modern bureaucratic management

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structures [were created] because they had no choice. Their size and complexity precluded the use of traditional methods of finance and management.”3 The basic approach was to move maximum traffic at the lowest possible cost. Part of the needed control structure involved sophisticated accounting. According to Alfred Chandler: “to meet the needs of managing the first modern business enterprise, managers of large American railroads during the 1850s and 1860s invented nearly all of the basic techniques of modern accounting.”4 Management and Accounting Innovations Early attempts at improved management and reporting started in the 1830s. The B&O published financial statements that included income statements by 1832, a balance sheet in “T account” format by 1840, and various useful tables. Major George Whistler, engineer in charge of construction of the Western Railroad issued a “Report on Avoiding Collisions and Governing Employees” in 1844 as part of four-member commission that defined responsibilities and lines of authority for each operation of administration, maintenance and communications.5 Soon after that, the B&O developed a manual, Organization of the Service of the Baltimore & Ohio Railroad that departmentalized “the road into the working of the road and collection and distribution of revenues.”6 Under this system, financial responsibility was centralized under the Treasurer. The general superintendent became the chief administrator. Thomas Messler of the Pittsburg, Fort Wayne and Chicago developed a system of accounts in the 1840s and established an accounting department to combine bookkeeping and auditing. Despite the speculative bent of owners and board members, the Erie had a number of innovative (if frustrated) managers, including Daniel McCallum. McCallum as general superintendent of the Erie defined the duties of the executives and administrators needed as the organization grew in size. McCallum’s perspective was that a large railroad must be run by a management system based on manageable geographic divisions, resulting in lines of authority—which developed into the first organization chart in American business. Control would be maintained by detailed reports to headquarters. In his 1855 Superintendent’s Report,

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McCallum listed the information to be collected and developed into control measures, including the average load carried in each car, the number of miles run, and costs per ton mile of the major expense categories.7 After the Erie was taken over by Daniel Drew and other speculators not interested in efficient operations, he left the Erie to found the McCallum Bridge Company in 1858 and was appointed military director of the Union railroads during the Civil War. The Pennsylvania invented a decentralized form of management (initiated with legal changes) dividing the system into three interlocking corporations in the 1870s: (1) the Pittsburg, Cincinnati & St. Louis; (2) the Pennsylvania Company; and (3) the Pennsylvania Railroad Company, each with a separate management structure under a general manager. The president of the Pennsylvania Railroad—J. Edgar Thomson until his death in 1874—was also president of the other two. Essentially, they were “east,” “west,” and “south” semiautonomous systems. The accounting system tied the three corporations together. Strategic planning also was maintained at the central office. As stressed by Chandler: “Thomson was indeed one of the most brilliant organizational innovators in American history.”8 Thomson created a uniform set of accounts and reporting system. In addition, much of the purchasing was done at the central office to achieve economies of scale. The Pennsy used and integrated 144 sets of records related to financial, capital, and cost accounting. Thomson used the operating ratio (operating revenues divided by operating expenses) as a standard way to measure performance by volume. Civil Engineer Albert Fink trained on the B&O and became general supervisor of the Louisville and Nashville where he developed the ton mile as the basic measure of unit cost. To accomplish this, he had to recategorize the accounts based on the nature of the costs rather than by department. Fink created four categories: (1) those that did not vary with the volume of traffic, including overhead and maintenance; (2) costs that varied with volume of freight but not miles carried, such as station expenses; (3) movement expenses which varied by the number of trains run such as fuel; and (4) interest charges based only on debt levels.9 It was the ton mile calculation (and the similar cost per passenger mile), in particular, that was used for rate making and to control the work of subordinates.

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A continuing problem was how to treat wear and tear and obsolescence of capital assets. A basic approach was a contingency fund or a surplus account (analogous to retained earnings). Plant assets could be written down in value or repairs and renewals could be charged as operating costs.10 Fink was a proponent of “betterment accounting,” for railroad track where initial costs were capitalized but not depreciated (remaining on the books at cost until retired). The costs of replacing track were expensed, unless the track was improved (a “betterment”), which would be capitalized. Railroad Consolidations Railroads became the first industry where firms got gigantic through consolidation. Competition meant volatile pricing and potential rate wars, often with relatively inefficient operations. Professionals saw the need to improve efficiency in size. Rather than loading and unloading passengers and goods every few hundred miles, consolidated routes could continue almost nonstop across country. Standardization of track, signaling, accounting, and labor practices brought cost savings. If competition could be reduced, higher rates could be charged, to the detriment of passengers and shippers (although large shippers such as Standard Oil could still demand favorable rates). Investors saw the potential for greater dividends and rising stock prices; speculators the chance to bet on prospective mergers and, those with substantial funds, to control railroad empires. The initial consolidation of small struggling railroads formed Cornelius Vanderbilt’s expanded New York Central in the 1860s. After his victory in the Erie wars, Jay Gould acquired and leased various railroads related to the Erie mainly for short-term gain. Gould’s acquisitions spurred Thomson and Scott of the Pennsylvania to expand their own lines westward to remain competitive. The Pennsy vertically integrated into steel and mining companies, as well as rail-related companies such as Pullman Palace Car Company. The B&O also expanded west. Gould was not successful with the Erie expansion, but tried again in 1880 with the Union Pacific (UP), only to sell out in 1882 and attempt to create a major western railroad by acquiring multiple small lines. In addition

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to professional managers and speculators, investment banks including J.P. Morgan and Kuhn Loeb consolidated railroads during this period. The railroads became overextended because of massive building (borrowing to fund both construction and acquisitions), creating huge debt payments. Despite obvious corruption and speculation, investors, including many overseas buyers, bought up available railroad stocks and bonds, encouraging the overleverage. The high fixed costs of railroad operations plus large interest and principal payments left little margin for error even during boom periods. The trunk lines remained competitive on major routes, but maintained monopoly control and pricing on lines to lesser destinations. The Panic of 1893 drove 150 railroads into bankruptcy, including the B&O, Erie, and UP. This became a buying opportunity to the banks and Morgan, for example, created Northern Securities as a holding company controlling the Northern Pacific, Great Northern and other railroads over 17 states. Railroad Regulation Massachusetts started requiring railroad annual reports in 1836, followed by New York in 1842. New Hampshire created the first railroad commission in 1844, followed by Connecticut (1853), Vermont (1855), Maine (1858), Ohio (1867), Massachusetts (1869), 11 states in the 1870s, and 9 in the 1880s. The Massachusetts Board of Railroad Commissioners included Charles Francis Adams, Jr., grandson of John Quincy Adams. Adams became chairman in 1872. In 1876 railroad accounts were placed under the Commission, with authority to establish a uniform set of accounts and power to audit the accounts. As the railroads expanded into other states, the commissioners met with railroads and other regulators in Saratoga, New York in 1879 to establish a uniform accounting system. This proved a difficult process, although Adams came up with a “classification of railroad expenses.” It would take almost another three decades before a national uniform railroad account system was finalized under the Hepburn Act of 1906. Railroads monopoly pricing on lines with no competition led to unrest by farmers and other shippers subject to overcharging. States passed antitrust and other regulations, many of which prohibited

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discriminatory pricing or even established specific rates. Unfortunately, the 1886 Supreme Court case, Wabash versus Illinois, ruled that the federal government had exclusive control of interstate commerce, thus ruling the state laws unconstitutional. That decision led to federal legislation the following year. The Interstate Commerce Commission (ICC) Act of 1887 monitored the railroad industry, in part to ensure rates were “reasonable and just.” The demands that brought the first permanent regulatory commission to the United States resulted directly from the railroads’ discriminatory pricing policies. Farmers, merchants, and small manufacturers whose livelihood was so intimately related to the costs of transporting their products to market spearheaded the protest against discriminatory rates. They were quickly joined by many who, like Charles Francis Adams, were outraged by the exploitative and speculative practices of Wall Street and disturbed by the alliances between railroads and politicians.11 The bill prohibited rebates, discriminatory pricing, pooling (dividing traffic in competitive routes), financial reports, and began hearings and investigations. The railroads were somewhat cooperative, especially to end cutthroat competition on high traffic routes. Simultaneously, they filed lawsuits to avoid more onerous rules. The cases made their way through the court system and before the end of the century the Supreme Court curtailed most of the power of the ICC including mandating rates. The rate-setting powers were reestablished with the Hepburn Act of 1906. Railroads started consolidating and established pools12 relatively early, but were joined by other companies attempting to eliminate intense competition. Standard Oil introduced the trust agreement in the 1870s and the state of New Jersey liberalized incorporation laws to facilitate legal consolidations across state lines. As with railroads, the Wall Street banks (later called the “Money Trust”) facilitated or created concentrated holdings across dozens of industries. Both political parties campaigned on the need for antitrust legislation and in 1890 John Sherman, Republican Chairman of the Senate Finance Committee, introduced a short bill, which became the Sherman Antitrust

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Act. The Act stated: “every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce … is declared to be illegal.” Relatively few cases were filed under the Sherman Act, but victories were achieved and companies had to contemplate “acceptable levels” of concentration. One of the successful antitrust prosecutions was a Morgan’s railroad holding company, the aforementioned Northern Securities in 1901.

CHAPTER 6

Industrialization and Professional Management The modern industrial enterprise—the archetype of today’s giant corporation—resulted from the integration of the processes of mass production with those of mass distribution within a single business firm. … Almost nonexistent at the end of the 1870s, these integrated enterprises came to dominate many of the nation’s most vital industries within less than three decades. —Alfred Chandler Mass transportation moved raw materials and finished goods large ­distances efficiently, allowing industrial entrepreneurs to produce for mass (and expanding) markets. Institutional characteristics, including a mainly hands-off government allowing the development of monopoly power and low taxes, contributed to successful businesses becoming really big business. Of the thousands of examples of manufacturing success, s­ everal names stand out, partly because of their use of accounting for d ­ eveloping long-term business strategies. Among these were Andrew C ­ arnegie, John D. Rockefeller, the Du Ponts, Alfred Sloan, and others at General Motors (GM).

Andrew Carnegie Transfers Railroad Accounting to Steel Andrew Carnegie created the gigantic Carnegie Steel, applying the railroad training to manufacturing: “he made his own company so efficient that his competitors were forced to emulate him.”1 While still a teenager he became secretary and personal telegrapher to Thomas Scott of the Pennsylvania. The Pennsy was the largest railroad in the world in

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1865, probably the largest private corporation. This was achieved from a professional management structure with much of the control the result of a sophisticated accounting system, including detailed statistical analyses of tonnage, mileage, and costs. Carnegie learned how to run a railroad profitably, knowledge he transferred to manufacturing. Carnegie speculated in stocks and invested in several partnerships and other ownership interests (which often included Scott), usually in firms selling products to railroads, such as bridges, iron, telegraphy, and oil. He knew relatively little about the various businesses, but relied on his managerial skills and accounting expertise, plus he hired experts when needed. Carnegie viewed accounting as a major information source to maintain efficient operations. In his autobiography he states: “One of the chief sources of success in manufacturing is the introduction and strict maintenance of a perfect system of accounting.” His focus was on cost data detailing labor and materials used per unit of output. Carnegie inspected Bessemer plants in England and he organized a partnership in 1872 to manufacture Bessemer steel that would dominate the industry. A major reason for success was the demand for steel rail by the Pennsy and other railroads. He built the massive Edgar Thomson works (named after the Pennsy president) in 1875 as the most modern steel plant of the time, with the intent of being the low-cost producer. Like his competitors, he considered labor as a production cost to be controlled (the 12-hour day, 7 days a week was standard). Carnegie’s accounting system was the best in the industry. A voucher system, similar to that of the Pennsylvania Railroad, accumulated materials and labor costs through each department and was used to prepare monthly cost reports. The cost reports included the raw materials in process and were used to evaluate process improvements and pricing decisions. Even during a recession, he could price products below competitor’s costs, operate near capacity, and maintain some level of profitability (in part because wages were normally based on steel selling prices). Carnegie sold out to J.P. Morgan in 1902 when Morgan offered him $480 million, considerably more than the book value of C ­ arnegie Steel (Morgan’s valuation was based on profit potential rather than book value.). With Carnegie Steel added to his other 200 acquisitions, Morgan put together U.S. Steel with over 80 percent of steel capacity of the nation. Carnegie Steel was the largest acquisition at the time, and Morgan created



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the first billion-dollar corporation, the U.S. Steel initial public offer in 1901 (capitalized at $1.4 billion).

Merger Movement and Big Business at the Start of the 20th Century Industries with relatively homogeneous products but complex manufacturing enjoyed economies of scale, barriers to entry, and incentives to control markets. The industrial barons preached stable markets, while critics cried exorbitant monopoly pricing. Survival required efficient operations, acquisition (or destruction) of competitors, and the ability to survive recessions. In an era of little regulation, the major players probably seldom broke the law.2 By 1900 big business meant consolidating activities: horizontal integration to eliminate direct competitors, plus vertical integration to take advantage of all profitable opportunities of reducing costs and increasing scale. Accounting activities continued to be essential for setting prices, reducing costs, and controlling activities through a central office coordinating diverse internal operations. Many huge firms became vertically integrated, which could extend from mining raw materials to distributing complex finished goods. Big business would have a centralized headquarters, headed by a Rockefeller, Du Pont, Ford, or a Morgan partner. Dozens of plants around the country would produce various oil, steel, automobile, or chemical products, some previously run by competitors not long before. Standard products were mass produced for a large domestic market, with increasing export possibilities. Management control was provided through manufacturing simplification, specialization of jobs, and a management hierarchy. Coordinating performance used timely cost accounting reports developed over the decades and perfected with the assistance of scientific management engineers. The Legal Process of Consolidation Emerging big industries like oil and steel faced overcapacity and, from their perspective, cutthroat competition. Too many sellers meant prices could fall below production costs. Marginal competitors might produce defective products, detrimental to the entire industry. The emerging

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leaders started consolidating, either by (1) pooling agreements to regulate selling prices and limit regional sales levels, or (2) buying out (or ruining) competitors. Each approach had problems, both implementation and legal, especially when dealing over large distances and across states. Corporations were chartered by states, with little consideration for operating across state lines. Standard Oil’s Ohio charter did not allow the corporation to own companies outside the state. In 1879 lawyer Samuel Dodd created the first trust agreement for Standard Oil, the dominant player in that industry, and an improved version in 1882. Separate charters were received from each state where Standard had a major interest, and used trust agreements that essentially created a gigantic stock swap (of stockholders, not corporations). This worked, given the legal status of corporations at the time. Under Dodd’s scheme, stockholders exchanged their shares for trust certificates. The trustees, based in New York City, became the directors of all the companies. However, legal challenges especially at the state level proved problematic. Each state attempted to protect its perceived sovereignty and collect its fair share of taxes. A preferred alternative proved to be the accommodating liberalization of state incorporation laws, led by New Jersey (“the traitor state” according to the trust-busters). Each state had its own version of incorporation provisions from extremely tight to extremely lenient. New Jersey lowered the barrier to be as unrestrictive as possible, then changed the provisions even more favorably as companies lobbied for “improvements.” New J­ersey’s justification was the need to generate new revenues to pay off massive debts. As Mitchell described it: “New Jersey presided over the degradation of corporate integrity from 1889 to 1913. … It is how New Jersey changed the face of American corporate capitalism.”3 Large consolidations became legal using the holding company. When John Moody studied holding companies in 1904 he found 170 out of 318 (53.5 ­percent) were chartered as New Jersey corporations. Scientific Management Much of modern cost accounting was developed after 1880. Many of these innovations came from the scientific management movement of



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mass production. Complex machinery such as reapers, sewing machines, and typewriters required complicated engineering and the efficient use of workers to perform specialized tasks. Standard costs4 were calculated as efficiency measures. Mechanical engineer Frederick Taylor looked for the best way to use materials and labor and standards were determined to minimize waste. Later, actual costs were compared to standard costs as performance measures and the variances were analyzed for potential corrective actions. The long depression resulting from the Panic of 1873 caused many industrialists to focus on operating efficiency and cost reduction. Based on his experience with the Springfield Armory, Captain Henry Metcalfe in the 1880s thought the major issues were coordination and control, including the “wasteful delay in the process of manufacturing.”5 Metcalfe developed a shop-order system of accounting which helped control the flow of goods and provide better costing data. Routing slips identified when and where the materials went by department, with foremen adding time, wages and machines used. From this information, Metcalfe made a calculation of overhead (he called these costs “indirect expenses”) allocated to department based on the department’s contribution to work done. Frederick Taylor of the Midvale Steel Company claimed to be using principles similar to Metcalfe, although he favored specialized clerks filling out the routing slips.6 Taylor sought to improve industrial efficiency. He presented his first paper in 1895, describing what he called scientific management. Much of his analysis was based on time and motion studies and a detailed analysis of specific jobs. It was Taylor’s thesis that worker efficiency could be improved by (1) analyzing in detail the movements required to perform a job, (2) carrying on experiments to determine the optimum size and weight of tools and optimum lifts, and (3) offering incentives for topnotch performance. From such considerations Taylor went on to develop certain principles of proper physical layout of a shop or factory, correct routing of work, and accurate scheduling of the production of orders.7 Taylor’s system, however, failed to identify responsibility for specific tasks and maintaining efficiency.

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Somewhat related to scientific management were the factory accounting innovations made around the turn of the 20th century by Alexander Church and others. Much of this involved the allocation of “factory burden” and other measures of overhead costs. Engineer Henry Gannt, a collaborator with Taylor, used standard costs based on a standard volume measure (usually some percent of capacity). A key point for accountants was using standard costing to determine value for inventory—not an interest of the engineers, but useful to distinguish cost of goods sold from ending inventory. Church was interested in management accounting techniques to highlight efficiencies that would show increased profit, especially based on “full product costing” to individual products. This included prime costs (material and direct labor), indirect shop or factory costs, and other overhead charges.8

Du Pont Du Pont started as a gun powder company in 1802, which, after 100 years, became antiquated—equipment, management, and accounting. The Gunpowder Trade Association, effectively a cartel, ensured no real competition. Du Pont Powder Company was a 1903 buyout and reorganization by three young Du Pont cousins—with Pierre Du Pont the builder of what proved to be a modern diversified global enterprise focusing in research and development as well as production and management. As summarized by Johnson and Kaplan they reorganized the American explosives industry, including an organizational structure including “best practices.”9 Pierre learned the techniques of management and accounting used by Carnegie and competitors through a relative’s steel rail company and “learned the virtues of cost accounting as a management tool and the perils of insufficient working capital.”10 In the buyout, the elder Du Pont received $12 million in bonds in exchange for stock; the cousins took stock—which would not have much value unless they substantially increased firm profitability. This they did, after creating a centralized, departmentalized operation controlled largely through an innovative cost accounting system. When the cousins took over, the company had 40 manufacturing mills, with mill superintendents responsible for operating efficiency of each plant. Monthly reports



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were maintained by the home office. Information was primarily associated with materials and labor, not particularly effective in evaluating overhead. This made make-or-buy decisions, pricing, and product development difficult. Du Pont proceeded to buy out the major competitors, usually exchanging stock for Du Pont bonds, achieving about 60 percent of the explosives market. The goal became to increase efficiency and, like Carnegie, become the low-cost producer. They (mainly Pierre) created a hierarchical management structure, with both line and staff jurisdictions. Cost sheets were developed to analyze relative costs and determine which plants were effective and which had to be reorganized or shut down. A development department was created to keep up with technology, with three divisions: Competitive Products, Raw Materials, and Experimental. Vertical integration was used, in part, to keep costs down and ensure supply, buying, for example, nitrate mines and acid manufacturers. By 1904 Du Pont had 200 employees in the financial offices, which included the treasurer, accounting, auditing, credit, and collections. The accounts, with the acquisitions, had to be consolidated and standardized. This could be the point where industrial accounting matured, integrating cost, capital, and financial accounting—a process completed by 1910. The integration process was considered necessary to get a handle on overhead costs, including indirect labor (e.g., foremen, inspectors) and materials (e.g., maintenance, depreciation, taxes, and power), plus allocating central administrative costs. Separate analyses were made of selling costs and purchasing costs. Monthly cost sheets were made for all costs for each of the 13 products produced.11 The Treasurer’s Office provided information based on standardized measures, collecting accounting data from the various subsidiaries based an established chart of accounts. The Treasurer’s Office was divided into three units: Accounting, Auditing, and the Treasurer’s Office. The auditor was responsible for determining internal performance as well as external economic and financial conditions. Accounting involved routine transactions analysis including cost data for sales, production, research and development, construction, and other operations. By World War I, the Treasurer also was responsible for credit and collection, salaries, forecasts, and analysis.12

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Du Pont developed an extensive fixed asset accounting system, at a time when plant and equipment normally were expensed quickly and few records maintained. Since expansion was financed largely from retained earnings, short-term forecasting of earnings and cash flows was a necessity. Future cost estimates were relatively accurate, but accurate forecasts of prices proved more elusive. Knowledge of demand was critical to pricing decisions, but problematic to predict. One interesting point was that the firm used Hollerith tabulating machines in the early 1900s to prepare daily sales sheets and other reports.13 Long-range planning focused on new investment in fixed assets, using a return on investment (ROI) calculation made possible with their fixed asset accounting records. Du Pont used a form of ROI soon after the reorganization and continued to improve the technique. Financial Executive Donaldson Brown completed the technique by incorporating the importance of volume (called turnover by Du Pont). The higher the volume, the greater the ROI and vice versa: Earnings as a percent of sales is multiplied by turnover (sales divided by total investment). ROI remained the cornerstone of Du Pont and, later GM and much of the rest of industrial America, determining investment decisions. “The ROI measure was used to evaluate new proposals for building manufacturing facilities and thereby facilitating the allocation of funds among competing product lines; capital was allocated to those products and mills that were earning the highest returns.”14 Du Pont was labeled the “Powder Trust” in 1906, making it difficult to maintain the military as the major customer. Prior to gobbling up much of the competition, Du Pont was part of the Gun Powder Trade Association, a cartel to set prices and output quotas. The company remained relatively small, with capital of no more than $63 million (compared with U.S. Steel’s billions dollar capitalization). Despite the small size, an antitrust suit was launched and the company was forced to divest itself of significant holdings to create two new competitors, completed in 1913. With World War I just around the corner, enormous profits were coming even after the divestiture. Over the 4 years of war, Du Pont had sales over a billion dollars. Net income was $238 million, largely because of substantial profits built into contracts with Allied Countries. Pierre expected to charge equivalent amounts to the U.S. military, but was persuaded to



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settle for a more “reasonable return”—prompted by an unfavorable public reaction (“war profiteering” considered despicable) and persuasion by the War Department. During World War I, Du Pont looked for possible by-products for gunpowder and developed new products including synthetic fibers, paint additives, and plastics. With the massive profits and cash from World War I, Du Pont began to stress diversification using ROI calculations as an important component of acquisition decisions. Arlington Company, which produced celluloid was a 1915 acquisition and resulted in a huge range of new products after the war was over—celluloid, dyes, paints, varnishes, and so on. Another investment was GM, which proved to be lucrative only after a near-bankruptcy in 1920 and bailout by Du Pont— more on this in the next section.15

General Motors No firm better illustrates the rise and dominance of American industry (and later fall), including cost accounting, than GM. This includes the American industrial approach to production, market strategy, and control. Much of the innovation in production and control techniques using cost accounting came from the auto industry, building on the earlier innovations from railroads, Carnegie Steel, scientific management, and Du Pont. Initially, dozens of competitors handcrafted cars for the wealthy. Auto workers were artisans. Henry Ford changed the rules, inventing the moving production line and pricing cars for the average consumer. The new labor force was largely unskilled and low paid. Ford emphasized low cost, mass markets, and a single design: the black Model T. Over 15 million cars were sold. The Model T’s market share hit 48 percent, but declined as Chevrolet produced more innovative cars in the 1920s. Ford detested accountants and fired the lot of them every so often—Ford was a production, not a cost accounting, innovator. The Ford Motor Co. would hover near bankruptcy during the Great Depression and World War II—showing that production costs cannot be easily controlled or pricing determined without effective cost accounting. William (Billy) Durant was basically a salesman. He bought a patent related to manufacture cars and set up a business to build carriages.

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Contracting out the manufacturing, he concentrated on selling to a national market. Seeing the potential of automobiles at the turn of the century he bought the failed Buick Motor Co. in 1904 and created a marketing force to sell autos as well as parts and accessories. From this he formed GM in 1908, buying investment interests in Olds, Cadillac, and other auto-related companies. Relying on leverage without a cash reserve, a recession in 1910 forced him out as president although he remained a director. Durant created Chevrolet, then returned to GM as president with backing from Du Pont and J.P. Morgan. A buying spree made GM big but without coordination as each subsidiary was essentially on its own. A great organizer, Durant was a poor administrator and GM failure looked likely in the short but deep depression of 1920. Durant was out and Pierre Du Pont became president of the near bankrupt company in 1921, saved primarily by Du Pont money. The driving force behind a reorganized GM was Alfred Sloan, who moved up the executive ladder and became GM president in 1923. Not a car guy (his ball bearing company was acquired by Durant), Sloan had a vision of a decentralized corporate structure around a single coordinated company with a domestic market of economic niches from Chevy to Caddy. Each division acted as a separate entity, under top management coordination and control, including uniform accounting procedures. This included annual model changes, multiple products ,and raising (or lowering) prices based on accurate costing and sales predictions. Americans aspired to upscale cars, eventually to a Cadillac traded in every year for a new one. Sloan was a system guy, with organization charts and accounting reports on every facet of the company. Electrical Engineer Donaldson Brown became treasurer at Du Pont and was brought over to GM as financial vice president to develop the accounting system and statistical data needed to run this diverse, vertically integrated industrial giant profitably. “The builder of many of Du Pont’s basic financial and statistical controls, Brown in 1921 was probably as well versed as anyone in the United States in the development and use of these new administrative tools.”16 The accounting system developed at Du Pont by Brown and others included many of today’s classic arsenal of cost-accounting techniques, described by Brown as “centralized



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control with decentralized responsibility.” Du Pont’s ROI was expanded by Brown to analyze product turnover and return on sales. At GM, financial planning was based on an annual 20 percent ROI, influencing selling and wholesale prices, expected volume, and production decisions. ROI became a top management standard that allowed the evaluation of the various divisions based on corporate goals. What is now called flexible budgeting was another GM innovation, where budgets could be compared to actual results at any production or sales level. Sales were forecast for the upcoming model year and retail prices set. Operations were estimated based on expected volume. Standard price and volume data were used to coordinate division operation plans. The division manager would forecast revenue (based on selling price and expected sales volume), costs, and ROI. Forecasts were based on past data, adjusted for expected changes in costs and production efficiency. Calculations included both variable and fixed costs, although fixed costs were more difficult to analyze. Standard volume was set at 80 percent of plant capacity, but actual volume was volatile in the short run—varying by business cycle events and many other factors. Consequently, actual sales reports were submitted by dealers every 10 days (after overproduction in 1924 produced a financial crisis, caused by production schedules not adjusted for actual sales). Under the flexible budget, costs and profits could be forecast for any level of output. ROI calculations, integrated with flexible budgeting, would be adjusted short term for volume, with the focus on long-term ROI. The complete system was operating at GM by 1925.17 Sloan’s vision for GM and the American Dream were put on hold during the Great Depression and World War II. Management accounting procedures from GM and other firms spread and were refined, entered the college accounting curriculum, and many cost accounting procedures were codified as part of generally accepted accounting principles (GAAP) and tax accounting. Brown’s cost accounting was in wide use at mid-century. By mid-century the United States was an economic colossus, with half the world’s wealth and productivity and nearly two-thirds of the machinery. Pundits were describing the American Century, with mass production and high productivity. Big Labor, backed by federal regulation

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(Big Government), became a partner with Big Business in sharing the economic wealth and promoting a rising middle class. GM had half the domestic auto market and American producers 99 percent. The United States led the world in exports. Detroit would maintain a net export surplus until the late-1960s. The American production system and market strategy were alive and well and seemed destined for perpetual success. The system still considered labor a commodity to be hired and fired (but with the substantial power of unions, an increasingly expensive commodity), big inventories were needed to reduce production bottlenecks, and quality was maintained by checking and reworking. These features would come to haunt American business when the United States became overwhelmed with imports, still a couple of decades away. But in 1950 the GM system was the model, not the problem. As stated by GM Chief Executive Officer (CEO) Charles (“Engine Charlie”) Wilson in 1953: “What was good for the country was good for General Motors, and vice versa.”

SUPPLEMENT D

Panic Attack: All Those Pesky Bubbles and Crashes The monetary history of the last four hundred years has been replete with financial crises. The pattern was that investor optimism increased as economies expanded, the rate of growth of credit increased and economic growth accelerated, and an increasing number of individuals began to invest for short-term capital gains rather than for the returns associated with the productivity of the assets they were acquiring. —Charles Kindleberger and Robert Aliber Bubbles, panics and depressions seemed a recurring theme of American economics (and much of the world) particularly since the 19th century.1 Basic structural problems included an out-of-control state banking system where banks could issue large amount of bank currency (legal tender at the time), speculators bought and sold large amounts of land, financial markets were openly rigged, and government regulation was close to zero. From the founding, major panics happened pretty much like clockwork about every 20 years, each with a unique cause but similar characteristics. Despite the limited amount of foreign trade, panics started in the United States pulled down economies in Europe and beyond and vice versa. Major panics followed by depressions happened in 1819, 1837, 1857, 1873, 1893, and 1907 (plus minor panics in between). The one most remembered today was the Crash of 1929 followed by the Great Depression of the 1930s, which affected the entire world. Thanks to the New Deal and a restructured Federal Reserve, the federal government became more proactive. Downturns since then have continued but were typically shorter and less severe—recessions rather than depressions (12 post-World War II recessions and counting). The Great Recession of 2007–09 was the most severe and seemingly unnecessary.

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The National Bureau of Economic Research (NBER) tracks business cycles, the economic phases of booms and busts. Many economic theories of business cycles exist, including Joseph Schumpeter who focuses on industrial innovation leading to creative destruction. Hyman Minsky’s theory is based on supply of credit where speculative and Ponzi financing result in inflated asset pricing and an inevitable collapse. According to Roubini and Mihm: Crises—unsustainable boom followed by calamitous busts have always been with us … The very things that give capitalism its vitality—its power of innovation and its tolerance for risk—can also set the stage for asset and credit bubbles and eventually catastrophic meltdowns whose ill effects reverberate long afterward.2 When George Washington was sworn in as president, farming dominated the economy, falling to about half the economy by 1900 as manufacturing increased in importance. Panics were most likely to happen in late spring or fall as crops were sent to market and gold went from eastern banks to pay for the western crops. With low reserves, banks had less specie (gold and silver) to ride out economic chaos. The major (and more minor) panics had overextended banks and asset price rises in land or stocks or both based on speculation. The United States in the 19th century had 5 major panics roughly 20 years apart, beginning in 1819. Common features included overextended bank lending using the banks’ currency, speculation in either or both land and stock, related massive increases in asset prices causing bubbles, the aforementioned agriculture cycle, and various forms of inept government action. Railroad overbuilding and collapse played an increasing role in the second half of the 19th century. Even with perpetual downturns, the American economy grew on a real (inflation-adjusted) per capita basis since the country was formed. The change in gross domestic product (GDP) indicates cycles that roughly parallel the recurring panics and depressions. The Census Bureau data show that real GDP rose from $6.7 billion in 1800 to $319.9 billion in 1900 (based on 1996 dollars); on a per capita basis, real GDP increased from $1,259 to $4,204 (or 333.9 percent).



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The War of 1812 caused severe inflation as massive amounts of paper money were issued and conversion to specie abandoned. The Second Bank of the United States (serving many functions of a central bank) was chartered in 1816, but, with key positions filled by patronage, was corrupt and incompetent. The gold standard was resumed. In 1819 a $4-million gold payment was required on the Louisiana Purchase borrowing from 1803. The Second Bank called in state bank notes demanding gold which decimated the money supply. Credit essentially stopped, while both speculators and banks failed. The result was the Panic of 1819 and the inevitable depression which lasted until 1823. The Second Bank of the United States took much of the blame. After that land speculation resumed as did overborrowing based on individual bank paper banknotes, and asset price rises. Andrew Jackson opposed the rechartering of the Second Bank of the United States in 1836 and removed federal funds before that. The federal government moved to require specie payments—including land purchases. The combination of the loss of the Second Bank and the “hard money” policy of Jackson led to the Panic of 1837. By this time, Jackson was out of office and new President Martin Van Buren took the blame. The California gold discoveries in 1848 resulted in a big increase in gold supply and therefore, an increase in money supply although the gold standard was in effect. As expected inflation, speculation, and asset price rises happened—made worse by Wall Street manipulation. What made this one different was the excess leverage and overextension of railroad construction. The Ohio Life Insurance and Trust Company went bust, precipitating a panic resulting in the failures of brokers, banks, and railroads. Railroads were central to the Panic of 1873, the major post-Civil War crash caused specifically by the failure of Jay Cooke (Cooke had depended on German and Austrian funding which collapsed with the failure of the Vienna Stock Exchange), a major investment bank attempting to build the Northern Pacific Railroad, soon joined by other overextended banks, railroads, and brokers, plus the temporary closing of the New York Stock Exchange. Possibly the worst downturn was the depressions after the Panic of 1893, following the boom decade of the 1880s (the gold standard had resumed in 1879). Railroads conducted massive overbuilding with

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resulting excess capacity. The gold supply fell as a financial collapse gripped first London, then Europe followed by the United States. Panic hit America with the failure of the Philadelphia and Reading Railroad and the National Cordage Co. Speculators sold stock and bought gold, resulting in a stock crash in May, 1893. Major railroad failures included the Union Pacific, Erie, Northern Pacific, and Baltimore and Ohio. Also failing were some 500 banks and 15,000 sundry businesses. Labor strikes added to the economic woes. Treasury Department gold dropped from the necessary $100 million to almost nothing and the government, in desperation, turned to Money Trust head J.P. Morgan for help. Morgan raised about $100 million in European gold using Treasury gold bonds and the government gold supply was restored. The depression was still on, but financial collapse avoided. The last major panic before the Great Depression was in 1907, a complex mess involving the usual speculation, manipulation, and a stock crash. The broker Otto Heinze collapsed after a failed attempt to corner United Copper Co., setting off a panic and stock market collapse. Particularly at risk were New York trust companies, supplying brokers (then set to fail at an alarming rate) with margin loans. J.P. Morgan once again stepped in to save many of them, uttering “this is the place to stop the trouble.” In a reversal of public policy Morgan had to persuade Treasury to move millions of dollars into New York banks. The liquidity was enough to stop the bank runs and provide financial stability. However, First Tennessee Coal, Iron and Railroad Company approached bankruptcy, putting New York’s largest broker, Moore & Schley in jeopardy. Morgan again stepped in, working out a deal for U.S. Steel to buy Tennessee Coal—a potential violation of antitrust laws. Morgan somehow persuaded President Theodore Roosevelt to allow the deal. Then New York City turned up insolvent, requiring the Money Trust to finance a $30 million bond deal for the city. Despite the role of Morgan, many banks, trust companies, and industrial firms failed during the depression that followed. Morgan appeared to save the day, but Congress was not amused. The Pujo Hearings and legislation led to the Federal Reserve as the third attempt at central bank in 1914—some 80 years after to demise of the Second Bank of the United States. After that, the federal government took a more decisive and growing role in bank and corporate regulation.

Conclusions Over millions of years of evolution, humans developed big brains, hand dexterity, and language. Technology advances included fire and stone tolls of increasing complexity and sophistication. Before agriculture, humans may have started trade, baked bread, and brewed beer—the divine taste of beer may explain settling down to farm wheat and other grains. Farming developed, villages and then cities followed, as did accumulating wealth and the need to account for that wealth, initially using tokens. Civilizations started and cultures flourished. Technology improved, wealth increased and accountants turned inventory control into symbols and eventually writing, and developed the abstract concepts of numbers. Cultures developed in Mesopotamia, Egypt, Persia, and elsewhere, then shifted to the Europe of the Greeks and Romans. Romans mastered engineering, conquered much of the known world, and proved to be pretty good accountants. Rome still fell, turning Europe dark for a thousand years. Italian city-states emerged to create merchant wealth whose success depended on the innovation of double-entry bookkeeping and the valuable information created—the Renaissance was born. Mercantile success traveled north, as did double entry, in part because of the development of the printing press. The Enlightenment in Europe brought science and technology in systematic form and enhanced forms of banking, manufacturing, and merchant trade—almost literally around the world. Unique circumstances in England (including Common Law and property rights protections) made this small country the original host to the Industrial Revolution. ­Industrial productivity exploded.1 Along the way, accounting sophistication rose as entrepreneurs discovered the need for enhanced information to survive, especially because of fairly regular economic downturns. The story shifts to America where 13 diverse colonies joined to fight what they considered a common enemy, Britain (or, more specifically, George III). The American Revolution was won, a new Constitution established republican principles, and business went from relatively

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unsophisticated agriculture to world industrial dominance in a bit over 100 years. Accounting continued as part of the story, as accounting and financial reporting sophistication had to match business growth and complexity. In about 150 years American industrial accounting went from the equivalent of the Medieval Italian merchant system to sophisticated accounting and control techniques capable of providing the necessary information to run giant diversified manufacturing firms effectively. As stated by Johnson and Kaplan in Relevance Lost: “By 1925, American industrial firms had developed virtually every management accounting procedure known today.”2 Essentially, that meant all the features integrated and developed by Donaldson Brown at General Motors. At the founding of the country under a republic created by the American Constitution in 1788, manufacturing was local and predominantly hand crafted. Machinery and the factory system began in New England textile mills and spread into other industries. Nascent financial and transportation companies provided improved capital and distribution systems allowing for expanded markets and greater industrialization. Accounting systems, primarily focusing on basic material and labor costs, provided rudimentary information for control and planning. Railroads were the first really big businesses, financed by capital markets and governments. These were complex system and the need for control grew as railroad systems expanded. Professional management at major railroads created innovative accounting and control systems to keep the trains running profitably. Improvements continued and many of the fundamental accounting and control systems were perfected here. Andrew Carnegie and other industrialists used railroad experience to adapt the railroad accounting systems to steel and other categories of manufacturing to control costs and ensure that operations were run efficiently. For a variety of reasons industries were consolidated around the turn of the 20th century and the need for effective accounting control became imperative. Du Pont proved to be the most effective innovator during the early 20th century and this knowledge was absorbed and expanded at General Motors. Donaldson Brown can be given credit for consolidating available insights and adding his own innovations to create the accounting and control system that dominated the middle of the 20th century when America was at its height of economic dominance.

Notes Introduction 1. Huntington (1996, pp. 40–41). 2. Huntington (1996, pp. 69–72). 3. Huntington (1996) compared the rise of western civilization versus all the rest (e.g., China, Japan, and other Southeast Asian countries, Muslim countries, Sub-Saharan Africa, Latin America); then the later relative decline of the West and the rise of some of the others (particularly Southeast Asia), especially after the collapse of communism around 1990.

Chapter 1 1. A case can be made that accounting preceded agriculture and civilization by thousands of years. Notched bones from sites long before the Fertile Crescent’s agriculture revolution have been found, suggesting a primitive inventory system. Accumulated pebbles likely were used for inventory and control, precursors to the famous clay tokens. 2. I possibly missed the date by 10,000 or more years. A recent archaeological dig in Israel suggests farming started some 23,000 years ago. 3. Diamond (1997). 4. Matt Ridley has a different view, arguing that traders started tens of thousands of years ago. The result was the “collective brain,” where trade encouraged specialization and the accumulation of knowledge. Before trade, innovations were quickly lost. See Ridley (2010). 5. As Ridley stated: “Cities exist for trade. They are places where people come to divide their labor, to specialize and exchange. They grow when trade expands” (Ridley 2010, p. 158). 6. Schmandt-Besserat (1996). 7. Schmandt-Besserat (1986, p. 34). 8. The 16 types identified by Schmandt-Besserat were cones, spheres, disks, cylinders, tetrehedrons, ovoids, quadrangles, triangles, biconoids, paraboloids, bent coils, ovals/rhomboids, vessels, tools, animals, and miscellaneous. She studied 8,162 tokens, of which 3,354 were spheres and 1,457 cones. A few sites had large quantities: Jarmo 2,022, Uruk 812, and Susa 783; 30 sites had fewer than 10 tokens each (1996, pp. 15–20). She identified 108 sites, which included Jericho but not Catal Huyuk (26–7). Five sites had tokens

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from around 8,000 BC, all small villages. Complex tokens came only from later cities with monumental buildings, such as Uruk and Susa. 9. Mattessich (1987). 10. The Code was discovered in 1901 in Iran, but now is in the Louvre. It could be considered a primitive constitution. 11. Littleton (1988).

Chapter 2 1. But not according to Thomas Hobbes, the 17th century English philosopher who started social contract theory (and also claimed life was nasty, brutish, and short). In Leviathan he proclaimed that individuals “contracted” for an absolute monarch in exchange for safety. 2. The Anglo-Saxon Chronicle is a set of manuscripts started in the 9th century (until the early 12th century) written by monastic scribes at various locations and times, not particularly impressed with Norman invaders. The quote is from Wood (1986, p. 18). 3. Fukuyama (2011, p. 252). 4. Wood (1986, p. 198) suggests that this emphasis on individual property rights institutionalized this perspective (“possessive individualism”) rather than social needs and responsibilities, which continued from this protocapitalist system to today. 5. European civil law, used by most European and many other countries, was based on Roman law as codified by the 6th century Code of Justinian, but including influences of the Catholic Church, Napoleonic Code, and other factors. 6. Domesday records made it clear how extensive the land shift from Saxon to Norman had been. 7. German sociologist Max Weber attributed much of the impetus for capitalism to the Protestant work ethic important to the entrepreneurs responsible for the Industrial Revolution (more generally, the cultural influences of religion). 8. Mills (1994). 9. See Antoni (1977). for a more extensive analysis of the Pisan Document. 10. Lee, G. (1984a) The Development of Double Entry: Selected Essays, edited by Christopher Nobes (1984) is particularly useful describing the various accounting fragments from the 13th to the 15th century. 11. Lee, G. (1984b). See Geoffrey Lee (1984) for a more thorough analysis of the Farolfi ledger.

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12. Charlemagne established the livre as the currency of his Empire in 781 (equal to one pound of silver). The Livre remained the currency of France until the French Revolution. 13. Lee, G. (1977, p. 94). 14. Lee (1977). 15. Soll (2014, p. 30). 16. Pacioli, L. (1494, reprinted 2010). My English translation version is called The Rules of Double-entry Bookkeeping, reprinted by IICPA Publication in 2010. It has 36 chapters in 88 pages. 17. Lee (1977). 18. Pacioli (1494, reprint 2010, p. 18). 19. Pacioli (1494, reprint 2010, p. 29). 20. Pacioli (1494, reprint 2010, p. 67). 21. The copyright effectively extended only for Venice and areas controlled by Venice. See Alan Sangster (2007) for additional information on the printing of Pacioli’s Summa. 22. Soll (2014, p. 60). 23. Standard & Poor’s issues bond ratings, with AAA bonds the most credit worthy. 24. Reported in Soll (2014, p. 78). 25. Soll (2014, p. 52). 26. Fouquet served as Superintendent of Finance in the mid-17th century and flaunted his corrupt wealth, including the magnificent chateau Vaux-­leVicomte. He was arrested by order of envious King Louis XIV and imprisoned for life. 27. Brucker (1971, p. 74). 28. Pacioli (1494, p. 67). 29. Derivatives are financial instruments usually based on other financial instruments or contracts. Forwards at the time were the buying and selling of commodities, and options gave the holder to right (but not the obligation) to buy or sell commodities. Derivatives expanded greatly since introduced by the Dutch.

Supplement B 1. According to A. C. Littleton, 1927. 2. Modern accounts also show a cash flow statement to provide additional information on the importance of cash and liquidity. The cash flow statement shows the changes in cash and where they came from:

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Cash Flow Statement, Farolfi & Co., Salon Operating Cash Flows Cash Inflows From Revenues 1,200 ducats Cash Outflows For Expenses (500) Change in Other Current Net Assets (300) Net Cash From Operations 400 ducats Investing Cash Flows 0 Financing Cash Flows Cash From Owner Investments 1,000 ducats Increase in Cash 1,400 ducats Cash for the period went from zero to 1,400 ducats, from operations and owner investments.

Chapter 3 1. 2. 3. 4. 5.

Kennedy (1987, p. 81). Fukuyama (2011), Chapter 17. Keay (1991, p. 114). Keay (1991, p. 170). Almost simultaneously with the South Sea Bubble was the Mississippi Bubble. The Mississippi Company was a French financial scheme created by Scottish economist John Law in 1717. The concept was to colonize and create a trading empire in Louisiana Territory as a reform scheme for the failing finance system in France with a huge national debt and a poor tax system. Law’s reform had multiple components, including creation of a national bank, replacing gold with paper currency, and commerce reforms. Like the South Sea Company, speculation drove the Mississippi’s stock price up and up, despite no obvious way for making profits even with monopoly rights in a big New World territory. In 1720 speculators sold and the stock price collapsed; simultaneously, the national bank (Banque Royale) did not have the gold for redemptions and went bankrupt. Law was dismissed, the company taken over by the state, taxes were raised, and instead of reform, France resumed its march toward the French Revolution. 6. Walpole, a Whig, earlier served seven months in the Tower of London when Tories were in power. 7. Ahamed (2009, p. 77). 8. Kennedy (1987). 9. Adam Smith was the father of classical economics based on The Wealth of Nations (1776) and, to a lesser extent, The Theory of Moral Sentiments (1759). Smith used the example of manufacturing pins based on several specialized steps to illustrate the factory system. 10. Musson (1978, p. 82).

Notes 115

11. Boulton produced small products like buttons and buckles that used many workmen with specialized functions but not sophisticated machinery— similar to Adam Smith’s description of pin-making. 12. There were about 1,200 steam engines running by the end of the 18th century, suggesting Watt and Bolton produced about 40% (Musson 1978, p. 112). 13. The Rocket was later donated to the Patent Office Museum and is now on display at the Science Museum in London. 14. Brunel was famous for many engineering projects including the Clifton Suspension Bridge and the Thames Tunnel. 15. Fleischman and Parker (1991).

Supplement C 1. Capitalists have a habit of proclaiming the great opportunities of laissez faire unless individual benefits of subsidies, monopoly rights or tax relief exist. 2. Kocka points out these were “islands of capitalism” within rigid Feudal structures, 2014, Chapter 2. 3. Kocka (2014), especially Chapters 2–3. 4. Kocka (2014, p. 97). 5. Thomas Piketty’s Capital in the Twenty-First Century (2014) takes a modern view, particularly on income inequality. His analysis includes data going back to the French Revolution to the current period, suggesting that extreme income inequality causes economic instability and potential revolution. His findings suggest that income inequality, which dropped precipitously after catastrophic events such as World War I, is now in America similar to France just before the Industrial Revolution. 6. The Soviet system showed that industrialization could exist without capitalism. 7. Sombart’s 1902 Modern Capitalism became a classic on the history of capitalism. 8. Both Sombart’s focus on Jewish business people and Weber’s “Protestant ethic” were subject to criticism by later scholars mainly on empirical grounds. See Kocka (2014, pp. 11–14). 9. Kocka (2014, p. 21). 10. See Fukuyama (2011) and (2014) for a historical analysis of political order. 11. The Big Four were Mitsubishi, Mitsui, Sumitomo, and Yasuda. 12. Studwell (2013, p. 267). It should be noted that this perspective differs from standard neo-classical economics which values market efficiency, not government intervention. 13. Bremmer (2010, pp. 4–5).

116 Notes

14. An important consideration of these factors is social responsibility that recognized all corporate stakeholders and a commitment to maximize longterm earnings with these additional considerations.

Chapter 4 1. Previts and Merino (1998). 2. Miller (1994). 3. Miller (1994). 4. Assuming slaves are counted; otherwise, Pennsylvania was the most populous. 5. As pointed out by Hogeland (2012), the founding fathers were elites designing a governing system for their benefit. They owned most of the government debt and often considered democracy the “rule of the mob.” 6. Government debt was most actively traded. The temporary federal capitol was initially located in New York City (March 1789–August 1790), then moved to Philadelphia until May 1800, when Washington, DC became the permanent capitol. 7. Cash shortages especially in economic downturns often meant workers’ salaries were reduced to maintain dividend levels. This led to labor strikes such as the 1894 Pullman strike, as workers had little appreciation for investor interests (and vice versa). 8. Chandler (1977, p. 60). 9. Tyson (1990, p. 11). 10. Tyson (1990, p. 94). 11. First-in first-out or FIFO means cost of production follow the earliest items produced. Say the first 60 goods cost $4 each to produce, followed by 70 costing $5 each. If 100 goods are sold, the cost of goods sold would be 60 @ $4 plus, 40 @ $5, or $440 total ($240 + $200). Remaining inventory would be 30 @ $5 or $150. 12. According to Hoskins and Macved (1986). 13. Period costs are accumulated for the accounting period such as the fiscal year. Product costs follow the specific goods produced. Cost of goods sold are product costs. 14. Livesay (2007), Chapter 2. 15. Chandler (1977, p. 75). 16. Chandler (1977, p. 74).

Chapter 5 1. Chandler (1977, p. 40). 2. See John Steele Gordon’s The Scarlett Woman of Wall Street (1988).

Notes 117

3. Livesay (2000, p. 29). 4. Chandler (1977, p. 109). 5. Chandler (1977, p. 97). 6. Chandler (1977, p. 99). 7. McCullum (1856, p. 106). 8. Chandler quoted a Pennsy executive: “Thomson was great in everythingoperating, traffic, motive power, finance; but most important of all in organization” (Chandler 1977, p. 179). 9. Chandler (1977, p. 116). 10. During the 20th century, depreciation of property, plant, and equipment became the standard approach for wear and tear. Straight-line depreciation (the most common technique) somewhat arbitrarily determines a useful life and an ending salvage value to calculate an annual depreciation expense. For example, a machine costing $11,000 with a useful life of five years and an ending value of $1,000 would have a depreciation expense of $2,000 a year ($10,000/5 years). 11. Chandler (1965, p. 185). 12. Pooling involves agreements to manage rates and routes to achieve nearmonopoly power among nominally competitive railroads or other ­industries.

Chapter 6 1. Livesay (2000, p. 29). 2. The post-Civil War period may have been the most corrupt period in ­American history. Probably the most common category of corruption was bribery of political officials. However, political machines became adept at various types of “consultive services” that were more or less legal. Cash “contributions” were categorically illegal but seldom prosecuted. Businesses could treat employees with little regard and decimate the environment with impunity. Caveat emptor (let the buyer beware) was the plight of the customer. 3. Mitchell (2007, p. 31). 4. “Expected cost” rather than actual cost. The difference between actual and standard, called a variance, can be analyzed as a measure of relative efficiency. 5. Quoted in Chandler (1977, p. 273). 6. Chandler (1977). 7. Robertson (1973, p. 341). 8. See especially Johnson and Kaplan (1991), Chapter 3. 9. Johnson and Kaplan (1991), Chapter 4. 10. Livesay (2007, p. 175). 11. Chandler (1977, p. 445). 12. Chandler (1962, pp. 60–61).

118 Notes

13. The tabulating machine was used by the Census Bureau for the 1890 census. Extensive data were entered on punch cards which allowed flexibility when evaluating vast amounts of data. The same benefits became available to Du Pont and other large industrials to evaluate sales, purchases and production information on a daily basis, including by product, region, or type of customer. See Johnson and Kaplan (1991), pp. 76–78. 14. Kaplan (1984, p. 414). 15. Chandler (1977, p. 290): “Other industries developing in somewhat similar style at the time (that is, consolidating and adopting advanced manufacturing, management, and accounting techniques) included cigarettes, matches, cereal, canning, soap, meat, beer, sewing machines, farm machinery, office equipment, and electric machinery.” See especially Chandler (1977) Chapter 9 for a summary history of these industries. 16. Chandler (1977, p. 145). 17. Sloan (1963).

Supplement D 1. Bubbles are substantial increases in asset prices in real estate and stocks, along with euphoric expectations, exceeding their fundamental values, usually based on speculation. Panics are economic disruptions such as institutional failures or bank runs, usually resulting in economic downturns. Depressions are long-term economic downturns, often defined as declines in GDP of at least 10%. 2. Roubini and Mihn (2010, p. 4).

Conclusions 1. Granted, at about 2% economic growth a year it took decades to see much impact, but this compares to millennia without much if any measurable growth in economic productivity. 2. Johnson and Kaplan (1991).

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Index Abstract markings, 17 Accountants American central banking, 4 audit failure, 7 bankruptcy proceedings, 4 certified public accountant (CPA), 6 federal regulation, 7–8 American industrialism banking and capital markets Bank of North American, 75–76 cash shortages, 77 corporate income, 77 Hamilton’s Bank of New York, 76 infrastructure projects, 76–77 public works and transportation system, 77 rural banks, 76 British merchants, 68 broad-based activities, 73 Carnegie’s accounting system, 74–75, 93–95 colonial grievances, 68–70 constitution and funding, 72–73 Continental Congress, 70–71 costing accuracy, 81 Du Pont gun powder company cost sheets, 99 exchange for stock, 98–99 fixed asset accounting system, 100 return on investment, 100 Treasurer’s Office, 99 World War I, 100–101 economic falls, 105–108 farmers, 67–68 general motor model, 75 general motors Brown’s cost accounting, 102–103 failure, 102

flexible budgeting, 103 Ford Motor Co., 101 Model T’s market, 101 Sloan’s vision, 103 Intolerable Acts, 70 Jeffersonian ideal, 73 joint stock company, 67 legal process of consolidation, 95–96 massive merger movement, 75 merchant capitalists, 73 Morris’s tenure, 71–72 plymouth colony, 67 profit-making, 67 promoters and speculators, 74 railroads Baltimore and Ohio Railroad Company, 85 consolidations, 89–90 economic growth benefits, 84 Erie Railroad, 85–86 management and accounting innovations, 87–89 New York Central Railroad, 86 Pennsylvania Railroad, 86 regulation, 90–92 scientific management movement, 96–98 Springfield Armory, 80 textile production, 78–79 War Congress, 70 Whitney’s offer, 79–80 Arab empires, 20 Arabic numerals, 28 Arkwright, S., 53–54 Banking and capital markets, 36–37 Bank of England, 49–50 Bessemer, H., 55 Bolton, M., 56 Bookkeeping, 2 Domenico Manzoni’s, 31

130 Index

double-entry (see Double-entry bookkeeping) Britain and industrial revolution Bank of England, 49–50 cognitive revolution, 44 East India Company, 45–47 experimental locomotives, 58 gross national product, 51 Hayek’s libertarian perspective, 44–45 Henry’s financial problems, 44 income taxes, 44 industrialization, 50–51 iron and steel, 54–55 mercantilist system, 43 modern cost accounting, 58–60 railroads, 57 South Sea Company, 47–49 steam engines, 55–56 steamship, 57 textile industry Arkwright’s spinning frame, 53–54 Cartwright’s power loom, 54 cotton, 52–53 Crompton’s spinning mule, 54 Kay’s flying shuttle, 53 spinning and weaving, 52 “top-down” process, 44 Tudor rule, 43 Buttonwood Agreement, 77 Capitalism characteristics, 61 definition, 61, 64 developments of trade, 61 economic and sociological concepts, 63–64 industrial capitalism, 62–63 merchant capitalism, 61–62 Western civilization, economic growth China, 66 global trade, 65 Japanese model, 65 Russia, 66 social consequences, 66 United Kingdom, 65

Capital markets, 36–37 Carnegie’s accounting system, 93–95 Carron’s innovations, 60 Cartwright, E., 54 Cash book, 20 Certified public accountant (CPA), 6 Chandler, A., 81, 87 Civilization in Mesopotamia Fertile Crescent, 10 food storage, 10–11 industrial innovation, 3–4 opportunistic inventions, 11 permanent settlements, 11–12 primitive irrigation, 1 record-keeping bills of exchange, 2 bookkeeping, 2 capital markets, 4, 5 cuneiform, 2 diary of financial transactions, 2 engineering marvels, 2 laissez faire economic system, 3 professional management, 5–6 Sumerians, 14–15 trade, 11 Clay tablets and writing system abstract markings, 17 Cuneiform writing, 16–17 summary documents, 16 Code of Hammurabi, 17–18 Coercive (Intolerable) Acts of 1774, 70 Coinage, 18 Colbert, J.-B., 34 Complex tokens disks, 16 shapes and markings, 16 temple tax system, 16 vs. plain token, 15–16 Crompton, S., 54 Cuneiform writing, 16–17 Currency Act of 1764, 69 Dodd’s scheme, 96 Double-entry bookkeeping example, 39–41 Lee’s components, 27 Manucci’s books, 26–28

Index 131

Medici family, 27–28 medieval business, 25 parchment fragments, 26 partnerships, 25–26 Pisan Document, 26 Envelopes, 14 Financial Accounting Standards Board (FASB), 7 financial records, 20 Fink, A., 89 Gannt, H., 98 Generally accepted accounting principles (GAAP), 7 Glass-Steagall Act, 6–7 Greek alphabet, 17 Greek civilization Athens and Corinth, 18–19 Greece, 18 Myceneans, 18 Guilds, 35–36 Hamiltonian model, 73 Hargreaves, J., 53 Hayek’s libertarian perspective, 44–45 Hepburn Act of 1906, 90 Industrial capitalism, 62–63 Interstate Commerce Commission (ICC) Act of 1887, 5, 91 Italian bookkeeping method, 2–3 Italian merchant, 23–25. See also Double-entry bookkeeping Jericho settlement, 11–12 Laissez faire economic system, 3 Massachusetts Board of Railroad Commissioners, 90 McCallum, D., 87, 88 Merchant capitalism, 61–62 Metcalfe, H., 97 Molasses Act of 1733, 69

National Bureau of Economic Research (NBER), 106 Nation-states Dutch, 33–34 France, 34 holy Roman Emperors, 32–33 Ottoman Empire, 33 Navigation Acts of 1650, 69 New Jersey’s justification, 96 New York Stock Exchange (NYSE), 77 New York Transportation Company, 84 Pacioli, L., Arabic numerals, 28 De divina proportione, 29 double entry, 2–3 Franciscan monk’s robes, 29 Gutenberg’s printing press, 29 Summa, 29–30 Permanent settlements, 11–12 Philadelphia Stock Exchange, 77 Phoenician script, 17 Plain tokens, 12–13 Record-keeping bills of exchange, 2 bookkeeping, 2 capital markets, 4, 5 cuneiform, 2 diary of financial transactions, 2 laissez faire economic system, 3 professional management, 5–6 Roman accounting, 20 Roman empire annual revenues, 33 banking and capital markets, 36–37 bookkeeping, 20 cash book, 20 contract and legal rulings, 23 day book, 20 early manufacturing, 35–36 engineering marvels, 19 English bureaucracy, 23 income and expense accounts, 22 medieval economies, 21–22 monetary system, 19–20

132 Index

Ottoman Empire, 33 professional army, 19 public receipts and disbursements, 20 tax source, 22–23 Schmandt-Besserat hypothesis, 13 Schumpeter, J., 64 Semitic scripts, 17 Sherman Antitrust Act, 91–92 Simple tokens, 14 Smith, A., 63 Sombart, W., 63–64 Stamp Act of 1765, 69 State capitalism, 66 Steamboats, 84 Stephenson, G., 58 Sugar Act of 1764, 69 Sumerian civilization, 14–15 clay tablets and writing system abstract markings, 17 Cuneiform writing, 16–17 summary documents, 16 complex tokens disks, 16

shapes and markings, 16 temple tax system, 16 vs. plain token, 15–16 pottery wheel innovation, 15 Uruk life, 15–16 writing system, 16 written legal codes, 15 Taylor, F., 97 Tea Act of 1773, 69–70 The Dark Ages to the Enlightenment, 21–23 Tokens animal domestication, 13 clay balls, 12–13 complex, 15–16 Schmandt-Besserat hypothesis, 13 simple, 14 Sumerian civilization, 14–15 symbolic representation, 13 transactions, 13 Townsend Acts of 1767, 69 Wedgwood, J., 58, 59 Wilkinson, J., 56

OTHER TITLES IN OUR FINANCIAL ACCOUNTING AND AUDITING COLLECTION Scott Showalter, North Carolina State University and Jan Williams, Dean Emeritus of the College of Business and Professor Emeritus of the University of Tennessee, Editors • Executive Compensation: Accounting and Economic Issues by Gary Giroux • Using Accounting and Financial Information: Analyzing, Forecasting, and Decision-Making by Mark Bettner • Pick a Number: Internationalizing U.S. Accounting by Roger Hussey and Audra Ong • International Auditing Standards in the United States: Comparing and Understanding Standards for ISA and PCAOB by Asokan Anandarajan and Gary Kleinman • Accounting for People Who Think They Hate Accounting by Anurag Singal • Accounting for Fun and Profit: A Guide to Understanding Financial Statements by Lawrence Weiss • Audit Committee Formation in the Aftermath of the 2007–2009 Global Financial Crisis, Volume I: Structure and Roles by Zabihollah Rezaee • Audit Committee Formation in the Aftermath of the 2007–2009 Global Financial Crisis, Volume II: Responsibilities and Sustainability by Zabihollah Rezaee • Audit Committee Formation in the Aftermath of the 2007–2009 Global Financial Crisis, Volume III: Emerging Issues by Zabihollah Rezaee

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