Double Entry Bookkeeping, Trial Balance, Financial Statements, Financial Ratios, Italian City-States and Capitalism

Posted by PITHOCRATES - January 8th, 2013

History 101

The Government Finances are a Train Wreck because they have the Power to Tax and to Print Money

President Obama averaged a deficit of $1.3 trillion for each of his first 4 years in office.  Bringing the national debt up to $16.4 trillion at the end of 2012.  And there will be another drop-down, drag-out fight to raise the debt limit in a couple of months.  Why does the government spend this kind of money?  Because they can.  And because they can they can buy a lot of votes by giving stuff away.  Stuff paid for with all of that spending.

When the government implemented Social Security and Medicare there was still an expanding birthrate.  More people were entering the workforce than were leaving it.  Providing an ever expanding tax base.  And a rising level of tax revenue.  Without ever having to increase tax rates.  And the smart government planners thought the good times would just keep rolling.  But they didn’t.  Thanks to birth control and abortion.  Which reversed the equation.  The population growth rate slowed down.  Fewer people entered the workforce than left it.  Resulting in a declining tax base.  And falling tax revenue.  Pushing Social Security and Medicare to the brink of bankruptcy.

The government finances are a train wreck.  And they keep digging their hole deeper.  Because they can.  For they have the power to tax.  And to print money.  Something private businesses can’t do.  Which is why few corporations’ finances are train wrecks.  Except those with unionized workforces with defined-benefit pension plans.  Something long discontinued by most in the private sector.  As it’s a failed economic model.  Just like Social Security.  And Medicare.  Over time more people move from being contributors to being beneficiaries.  Pushing defined-benefit pension plans, too, to the brink of bankruptcy.

At the End of each Accounting Period they run a Trial Balance to Verify the Total of Debits Equals the Total of Credits

The difference between private sector businesses and the federal government is that private sector businesses have to be responsible while the federal government does not.  The federal government focuses on what’s politically expedient.  While private sector businesses must focus on the bottom line.  Spending only the money they have.  Because they can’t tax or print money to fix their messes.  Like the government can.  And does.  A lot.  So they have to avoid making messes in the first place.  They can’t kick the can down the road.  Because in the private sector there is accountability.  And that accountability begins with getting their hands around their business numbers.  So they can understand what their businesses are doing.  And when it’s time to take appropriate actions.  To prevent a financial train wreck.  And it all begins with double-entry bookkeeping.

Double-entry bookkeeping includes debits and credits.  Each transaction is posted to the accounting records with at least one debit and at least one credit.  The dollar amount of debits equals the dollar amounts of credits.  If they don’t equal after recording a transaction they were posted incorrectly.  For example, when someone pays cash for something at a retail store there are two debits and two credits to post.  First we debit cash $20 and credit sales revenue $20.  Then we debit cost of goods sold $18 (the cost of the item sold) and credit inventory $18 (the cost of the item in inventory).   If posted correctly the total debits equal $38.  And the total credits equal $38.  If, for example, someone debited sales revenue instead of crediting sales revenue the total debits would equal $58 while the total credits would equal $18.  Because they don’t balance we know something was posted incorrectly.  And can go back, find the error and correct it.

A business accounts for every penny that flows through their business.  Each accounting period will have thousands of such entries.  And at the end of each accounting period they will run a trial balance to verify that the total of debits equals the total of credits.  When they do they can be pretty sure that the financial information they recorded fairly represent the financial activity of the business at the end of that accounting period.  Then they prepare the financial statements (the income statement, the balance sheet, the statement of cash flows and the statement of retained earnings and stockholders’ equity).  Businesses study these statements to assess the health of their businesses.  They calculate financial ratios to assess the liquidity, long-term debt-paying ability and profitability of the business.  As well as calculate ratios for investor analysis.  To make sure they are satisfying the owners of the company.  The stockholders.

The First Use of Double-Entry Bookkeeping dates back to the Italian City-States of Florence, Genoa and Venice

This is a lot of valuable information.  Courtesy of that double-entry bookkeeping.  Something that can be so mundane and mind-numbing at the data entry point.  Especially if you’re trying to figure out why your trial balance doesn’t balance.  But when it does balance.  And the financial information is fairly represented.  Business owners and managers can make informed decisions to avoid doing what our federal government does.  Including making the hard decisions that permit these businesses stay in business for a decade or more.  Even a century or more.  Thanks to merchant banking.  And the Italian city-states.

For those of you who hate bookkeeping blame the Italians.  Some of the Florentines were using it as early as the 13th century.  The Genoese were using it shortly thereafter.  Soon Florence, Genoa and Venice were using double-entry bookkeeping.  This mastering of economic data made these city-states the dominant economic powers of the Mediterranean.  Making them masters of trade.  And merchant banking.  To manage that trade.  This system of accounting even made it into textbooks in the late 1400s.  Helping to spread good business practices.  Where they were picked up by other great traders.  The Europeans.

With double-entry bookkeeping businesses were able to grow.  First with the help of government.  Mercantilism.  Then without.  Free market capitalism.  Which created the British Empire.  And gave us the Industrial Revolution.  Then the United States came into their own in the late 19th century.  And surpassed the British Empire.  Economic activity exploded in the United States.  Because they were able to get their hands around all of those financial numbers.  And thanks to free market capitalism they focused on the bottom line.  And made the necessary decisions.  No matter how painful they were.  Something that the federal government just can’t do.  Because those decisions aren’t politically expedient.

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The State of the Union Address Ignores the 800 Pound Gorilla in the Room: Old People.

Posted by PITHOCRATES - January 26th, 2011

Old People:  God Love them but they’re Killing Us

The State of the Union Address was very similar to the one last year.  And a lot of Obama’s campaign speeches.  He still wants to invest (i.e., spend).  Even though record spending to date hasn’t helped anything.  We have record debt.  And deficits.  The nation is broke.  And yet he still wants to spend.  I mean, ‘invest’.

But we can’t ‘invest’ anymore.  We don’t have the money.  We can’t borrow anymore.  Or print anymore.  Without creating problems we can’t walk away from.  We have to reduce the deficit.  For real.  Can’t just talk about it.  And we can’t keep raising taxes.  Because that would stall the economic recovery.  If there was any economic recovery to stall.  No, we can’t indulge in these fantasies anymore (see How Obama’s speech muddied the budget debate by Robert J. Samuelson posted 1/27/2011 on The Washington Post).

What we got were empty platitudes. We won’t be “buried under a mountain of debt,” Obama declared. Heck, we’re already buried. We will “win the future.” Not by deluding ourselves, we won’t. Americans think deficits are someone else’s problem that can be cured by taxing the rich (say liberals) or ending wasteful spending (conservatives). Obama indulged these fantasies.

If deficits stemmed mainly from the recession, this wouldn’t matter. They would shrink as the economy recovered; tax collections would rise and spending (on unemployment insurance, food stamps) would fall. Unfortunately, this isn’t the case. In fiscal 2010, the deficit – the gap between government spending and revenue – was $1.3 trillion. Of that, about $725 billion was a “structural” deficit, says Mark Zandi of Moody’s Analytics. That is, it would exist even if the economy were at full employment (5.75 percent by Zandi’s estimate).

Ouch.  Even Reagan’s tax cuts of the Eighties couldn’t fix this.  There’s a problem on the spending side.  A huge problem.  We have to address this problem.  If we don’t, nothing we do on the revenue side will amount to a hill of beans.

The real issue isn’t the deficit. It’s the exploding spending on the elderly – for Social Security, Medicare and Medicaid – which automatically expands the size of government. If we ended deficits with tax increases, we would simply exchange one problem (high deficits) for another (high taxes). Either would weaken the economy, and sharply higher taxes would represent an undesirable transfer to retirees from younger taxpayers.

And there it is.  Old people.  God love them but they’re killing us. 

So How do we Reduce the Deficit and Care for the Elderly?

Old people are killing us.  There’s no getting around that.  But we just can’t abandon them in their retirement.  But we have to do something with Social Security and Medicare before they bankrupt the country.

The first thing we need to do is the easiest thing.  Repeal Obamacare.  If we don’t, it’s just going to be Medicare writ large.  We haven’t suckered anyone into dependence yet.  So just end it.  Before we do.  This will eliminate a future problem.  So we can address the current ones.

Defined benefit pension plans are a thing of the past.  They’re chronically underfunded.  And mismanaged.  Just look at our biggest cities.  Those public sector pension plans are bankrupting them.  Meanwhile, most businesses have moved away from them.  Instead, they use 401(k) plans.  Or other plans where the employee is in charge.  Not the employer.  Best thing about these?  They’re portable.  You contribute.  And the money is yours.  No matter how long you work at a company.  The government needs to move in this direction.  They need to make a transition from a defined benefit pension plan (i.e., Social Security) to a personal retirement plan (i.e., a 401(k), an IRA, etc.).  The oldest people will be more in the Social Security system as we know it.  The younger people will be in a personal retirement plan.  And don’t start bitching about the risk of putting our retirement money into the stock market.  First of all, stocks are cyclical.  They usually climb after they fall.  Second, Social Security is going belly up.  Once it does, you ain’t getting anything out of it anyway.  So it’s a moot point.  At least with the stock market, we have a chance to retire.

The government has to get out of health care.  It’s a very complex thing.  And the most unqualified people shouldn’t run complex things.  Like pensions, we need to put people in charge of their health care.  We need to transition to private health insurance.  And remove the obstacles in the health insurance industry (restriction of competing across state lines, tort reform, etc.).  We have to move away from Medicare.  People need to buy their own private health insurance policies.  The oldest people in the system can get vouchers to help them.  The younger ones just need to learn NOW that they will have to take care of themselves.  The best thing about this?  Your health insurance will be portable.  You’ll never have to work again at a place you hate because of their health insurance benefit.  You can do whatever the hell you want to.  Because you will be paying for your own health insurance.  And you’ll take the same insurance with you no matter how many times you change your job.  Your days of bitching about a change in your prescription coverage will be over.  Because you will be getting exactly what you choose to buy.

Now, doing the above is going to cost.  Because there is no such thing as a Social Security trust fund.  Or Medicare insurance.  It’s all pay as you go.  Today’s taxes pay for today’s beneficiaries.  So when the young transfer out of the existing systems, there will be a huge funding shortfall for these systems.  We will have to borrow to cover this transition period.  But we will have to show that this borrowing is a temporary thing.  So that our creditors won’t fear that we’ll be dancing with default.  And how do we do that?  By making huge tax cuts. And by making sweeping rollbacks in regulation.  You make the United States so business friendly that jobs come running back to this country.  Because business owners will see that if you want to be profitable in business, you have to locate your business in the United States.  Sure, there will be some revenue shortfalls in the beginning of the transition.  But in the long run, the economic expansion will shower Washington in tax revenue.  Even at lower tax rates.  And because businesses are being so profitable, they’ll be bidding up labor rates to get the best employees.  Because they’ll have to.  You see, in a bustling economy with portable retirement and health insurance plans, no one will have to work where they don’t want to.  Everybody wins.  Employers.  Employees.  Even government.  Because they will finally escape the huge costs of Social Security and Medicare.

Getting back to the Founding Fathers

So there you have it.  A simple and doable plan.  In bullet form, the plan is:

  • Repeal Obamacare
  • Privatize Social Security
  • Privatize Medicare
  • Cut taxes and rollback regulation
  • Live happily ever after

Simple.  And the transition pains will hurt far less than bankruptcy.  Of course, there is a downside to this simple plan.  At least for Big Government liberals.  Because this plan gives us limited government.  Like the Founding Fathers wanted.  Which isn’t all that bad for liberals.  Because in this plan they’ll lose their jobs in a booming economy where there will be other jobs available for them.  Unlike being laid off when the Great Recession turns into another Great Depression.

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