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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Marine Insurance, General Average, Mesopotamia, Genoa, Middle Class, Capitalism, London Coffeehouses and Lloyd’s of London

Posted by PITHOCRATES - April 3rd, 2012

History 101

It was in Genoa that Marine Insurance became a Standalone Industry

Risk management dates back to the dawn of civilization.  Perhaps the earliest device we used was fire.  Fire lit up the caves we moved into.  And scared the predators out.  As we transitioned from hunting and gathering to farming we gathered and stored food surpluses to help us through less bountiful times.  To avoid famine.  As artisans rose up and created a prosperous middle class we also created defensive military forces.  To protect that prosperous middle class from outsiders looking to plunder it.

As we put valuable cargoes on ships and sent them long distances over the water we encountered a new kind of risk.  The risk that these cargoes wouldn’t make it to their destinations.  So we created marine insurance.  Including something called ‘general average’.  An agreement where the several shippers shared the cost of any loss of cargo.  If they had to jettison some cargo overboard to save the rest of the cargo or to save the ship.  Some of the proceeds from the cargo they delivered paid for the cargo they didn’t deliver.  Some merchants who borrowed money to finance a shipment paid a little extra.  A risk ‘premium’.  Should the shipment not reach its destination the lender would forgive the loan.

So how long has marine insurance been around?  A long time.  Some of these practices were noted in the Code of Hammurabi (circa 1755 B.C.).  For ancient Mesopotamia was a trading civilization.  That shipped on the Tigris and Euphrates and their tributaries.  Out into the Arabian sea.  And beyond.  Following the coasts until advances in navigation and sail power took them farther from land.  The Greeks and Romans insured their valuable cargoes, too.  As did the Italian city-states that followed them.  Who ruled Mediterranean trade.  And it was in Genoa that marine insurance became a standalone industry.  No longer bundled with other contracts for an additional fee.

As the British Maritime Industry took off so did Lloyd’s of London

But the cargoes got larger.  And the voyages went farther.  Until they were crossing the great oceans.  Increasing the chances that this cargo wasn’t going to make it to its destination.  And when they didn’t the financial losses were larger than ever before.  Because the ships were larger than ever before.  So as the center of shipping moved from the Mediterranean to the ocean trade routes plied by the Europeans (Portugal, Spain, France, the Netherlands and England) the insurance industry followed.  And took the concept of risk management to new levels.

With trade came a prosperous middle class.  Where wealth was no longer the privilege of landholders.  Capitalism transferred that wealth to manufacturers, bankers, merchants, ship owners and, of course, insurers.  You didn’t have to own land anymore to be rich.  All you needed was skill, ability and drive.  It was a brave new world.  And these new capitalists gathered together in London coffeehouses to discuss business.  Including one owned by Edward Lloyd.  On Tower Street.  Where those particularly interested in shipping came to learn the latest in this industry.  And it was where shippers and merchants came to find underwriters to insure their ships and cargoes.

This was the birth of Lloyd’s of London.  And as the British maritime industry took off so did Lloyd’s of London.  As the British Empire spread across the globe international trade grew to new heights.  The Royal Navy protected the sea lanes for that trade.  The British Army protected their far-flung empire.  And Lloyd’s of London insured that valuable cargo.  It was a very symbiotic relationship.  All together they made the British Empire rich.  To show their appreciation of the Royal Navy making this possible Lloyd’s set up a fund to provide for those wounded in the service of their county following Lord Nelson’s victory over the combined French and Spanish fleets at the Battle of Trafalgar.  They continue to provide support for veterans today.  In short, Lloyd’s of London was the place to go to meet your global insurance needs.  From marine insurance they branched into providing ‘inland marine’ insurance needs.  Providing risk management to property beyond ships plying the world’s oceans. 

The Purpose of Insurance is to Let Life Go On after Unexpected and Catastrophic Events

Cuthbert Heath led Lloyd’s in the development of the non-marine insurance business.  Underwriting policies for among other things earthquake and hurricane insurance coverage.   And Lloyd’s helped to rebuild San Francisco after the 1906 earthquake.  With Heath ordering that they pay all of their policies in full irrespective of their policy terms.  They could do that because they were profitable.  Which is a good thing.  Insurers need to be profitable to pay these large claims without being forced out of business.  Which is why when the Titanic sunk in 1912 they were able to pay all policies in full.  And to continue on insuring the shippers and merchants that followed Titanic.  To allow life to proceed after these great tragedies.  And they would do it time and again.  Following 9/11.  And Hurricane Katrina.

This is the purpose of insurance.  Risk management.  So unexpected and catastrophic events don’t end life as we know it.  But, instead, it allows us to carry on.  Even after some of the worst disasters.  Because life must go on.  And that’s what insurance does.  Even people who rely on a particular body part for their livelihood have gone to Lloyd’s to buy insurance.  Perhaps the most famous being Betty Grable.  Who insured her legs for $1 million in 1940.  Pittsburgh Steeler Troy Polamalu has a lucrative endorsement with a shampoo company.  And insured his long hair for $1 million.  Rolling Stones guitarist Keith Richards insured his hands for $1.6 million.  America Ferrera (Ugly Betty) has an endorsement deal with a toothpaste company.  And they insured her smile for $10 million.  Even ‘the Boss’ Bruce Springsteen insured his voice for $6 million. 

People hate insurance companies.  Because they don’t understand how insurance works.  For they only know that they pay a lot in premiums and never receive anything in return.  But this is the way risk management is supposed to work.  And we need risk management.  We need insurance companies.  And we need insurance companies to be profitable.  Meaning that most of us will never see anything in return for all of our premium payments.  So these companies can pay for the large losses of the few who sadly do see something in return for all of their payments.  For insurance companies protect our wealth.  And earning potential.  So life can go on.  Whether we’re raising a family and planning for our children’s future.  Or taking precautions for some unforeseen accident to one of our body parts that may limit our future earning potential.

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Spice Trade, Arab Traders, Italian City-States, European Colonialism, Dutch East India Company and Dutch Banking

Posted by PITHOCRATES - January 10th, 2012

History 101

Venice and Genoa became the Ultimate Middlemen for those Delicious Asian Spices

The next time you cook a meal don’t use any spices.  Note how less delicious your meal is.  How much less you enjoy eating it.  And how little you eat.  Keep doing this and you’ll probably lose a lot of weight.  And be healthier.  Because your food will taste so terrible that you’ll eat less.  Which can be a good thing.  As eating less can cure cardiovascular disease and diabetes in many people.  But your food will be so bland that life itself will become bland.  And less enjoyable.  Then go out with some friends and eat some buffalo wings and nachos.  Note the difference.  Then go pay homage to the spice aisle at your grocery store.

Variety is the spice of life.  And a variety of spices to make your food taste better makes that life even better.  The ancient Egyptians knew this.  And they developed some of the earliest trade routes to Indian spice markets.  The Greeks and Romans knew it, too.  Who continued this spice trade.  Buying the spices that travelled along the Silk Road from China and the Spice Islands.  Into Constantinople.  Capital of the Eastern Roman Empire.  Which became the great Byzantine Empire.  Until this overland trade was interrupted by the Arabs.  Who took over the spice trade.  Especially those coveted spices from the Spice Islands.

Meanwhile in the West the Roman Empire fell.  And ushered in the European Dark Ages.  Where life became rather bland.  Until the Italian Renaissance.  Sparked by the rise of the great Italian city-states.  Such as Venice.  And Genoa.  Who developed international banking.  And merchant trade in the Mediterranean.  Based largely on that lucrative spice trade.  Where the mighty trade empires of Venice and Genoa became the ultimate middlemen for those delicious Asian spices.  A trade now dominated by the Arabs.  Who brought it to Mediterranean ports.  Where it boarded ships bound for the great Italian city-states.  The gateway to Europe.

The Quest for Asian Spices ushered in the Era of European Colonialism

Europeans tasted their food spiced with pepper.  Nutmeg.  And other spices.  They discovered a new word.  Delicious.  There was no going back to the bland days of the Middle Ages.  They wanted more.  And did not like the stranglehold the Arabs and the Italian city-states had on this trade.  They decided to do something about it.  And set their minds to finding the source of these great spices themselves.  And find a sea route directly to that source.

The Portuguese were first.  Vasco da Gama sailed around Africa and into the Indian Ocean in 1497.  Opening the first direct sea route from Europe to India for the Portuguese Crown.  While trying to find a western sea route for the Spanish Crown Christopher Columbus discovered The Bahamas in 1492.  In 1500, Portuguese Pedro Álvares Cabral accidentally discovered Brazil trying to follow the Vasco da Gama route.  He sailed a little too far west.  Which is why they speak Portuguese in Brazil today.  Ferdinand Magellan succeeded for the Spanish where Columbus failed.  He found that western route to the Spice Islands after sailing around that new continent that Columbus and Cabral bumped into.  South America.  Through the Straits of Magellan.  And back to Spain in 1522.  Well, not Magellan.  Or 4 of his 5 ships that originally sailed.  But one ship survived this voyage.  And it was full of spices.

The quest for Asian spices ushered in the era of European colonialism.  For there was big money in this spice trade.  So much that others wanted in, too.  Two of which came up with novel ways to fund this trade.  By selling stock in trading companies.  The two big ones were the British East India Company.  And the Dutch East India Company.  And it was the Dutch who showed the world what real banking was all about.  They blew away those great Italian city-states.  They were able to put greater fleets to sea.  And finance far greater trade than the Genoese or the Venetians ever dreamed.

Dutch Banking helped the Americans gain Legitimacy in the World of Nations

These trading companies did more than trade.  They settled colonies.  Negotiated international treaties.  Coined money.  Even waged war.  The Dutch and the British went to war in many places over their new colonies and the wealthy trade they produced.  In the Spice Islands.  China.  India.  Africa.  Even in the New World.  Where the Dutch traded Manhattan to the British for Run, another of the Spice Islands so the Dutch could corner the nutmeg market.

An interesting turn of events goes back to that Dutch banking.  After the United States won their independence from Britain one of the first loans the Americans secured to help pay their massive war debt was the one John Adams negotiated with the Dutch.  So Manhattan went from the Dutch to the British to the Americans.  And thanks to the Dutch it would stay American.  As the Americans were able to get their finances in order.  And gain legitimacy in the world of nations.  Not to mention becoming home of some of the finest restaurants in the world.  Serving some of the tastiest foods ever to grace a palate.

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The Line of Diocletian, the Byzantine Empire, Italian City-States, Banking, Usury and the Protestant Reformation

Posted by PITHOCRATES - January 3rd, 2012

History 101

Europe began to Awake from its Slumber of the Dark Ages in about 1300 Italy

Once upon a time the only lending was to help someone in need.  Such as someone with a poor harvest to survive the winter.  We did it out of the goodness of our hearts to help others in need.  So to charge interest for a loan like this would have been cruel.  Taking advantage of someone’s misfortune wasn’t the Christian thing to do.  Or the Jewish.  Or the Muslim.  That’s why no one then charged interest for loaning money.  You just didn’t kick a person when he or she was down.  And if you did you could expect some swift justice from the religious authorities.  As well as the state.

Rome was once the center of the civilized world.  All roads led to Rome, after all.  Then Diocletian split the Empire into two in 285.  Along the Line of Diocletian.  Into East (Greek) and West (Latin). The West included Rome and fell around 486, ushering in the European Dark Ages.  Meanwhile the Eastern half, the Byzantine Empire, carried on.  And skipped the Dark Ages.  Its capital was Constantinople (named in 330) .  Formerly Byzantium.  Modern day Istanbul.  Where all Asian overland trade routes led to.  This city of Emperor Constantine.  His city.  Who reunited East and West.  And adopted Christianity as the Empire’s new religion (381).  Located at the crossroads between Europe and Asia, trade flourished and made the Byzantine Empire rich.  And long lasting.  Until weakened by the Venetian-financed Fourth Crusade (1202–1204).  (The Latin Christians’ attack on the Greek Christians was fallout from the Great Schism of 1054 where Christianity split between Latin Catholic and Greek Orthodox).  And then falling to the Ottomans in 1453.

Europe began to awake from its slumber in about 1300 Italy.  Great city-states arose.  Genoa.  Pisa.  And Venice.  Like those early Greek city-states.  Great ports of international trade.  Rising into trade empires with the decline of the Byzantine Empire.  Where these Italian merchants bought and sold all of those Asian goods.  Putting great commercial fleets to sea to bring those Asian goods into Genoa, Pisa and Venice.  Getting rich.  But to make money they had to have money.  Because in the international trade game you had to first buy what you sold.  Which included the cost of those great merchant fleets.  And how did they pay for all of this?  They borrowed money from a new institution called banking.

That Europe that Slumbered during the Dark Ages Arose to Rule International Trade

Modern finance was born in Italy.  Everything that makes the commercial economy work today goes back to these Italian city-states.  From international banking and foreign exchange markets to insurance to the very bookkeeping that kept track of profits and losses.  It is here we see the first joint-stock company to finance and diversify the risk of commercial shipping.  London would use the joint-stock company to later finance the British East India Company.  And Amsterdam the Dutch East India company.  Where the Dutch and the English sent ships across oceans in search of trade.  Thanks to their mastery of celestial navigation.  And brought back a fortune in trade.  Putting the great Italian city-states out of business.  For their direct sea routes were far more profitable than the overland routes.  Because the holds of their ships could hold far more than any overland caravan could.

The Catholic opposition to usury (charging interest to borrow money) opened the new banking industry to the oppressed Jews in the European/Christian cities.  For it was one of the few things the Christian rulers let the Jews do.  Which they did.  Even though it was technically against their religion.  And they did it well.  For they had an early monopoly.  Thanks to that same Catholic Church.  Then came another schism in the Christian church.  The Protestant Reformation.  Where, among other things, Protestants said the Old Testament did not bind them to all rules that the Jews had to follow.  Then John Calvin took it a step further and said commercial loans could charge interest.  And, well, the rest is banking history.

Europe was then the dominant region of the world.  That region that slumbered during the Dark Ages arose to rule international trade.  Thanks to their navigational abilities.  And their banking centers.  Which financed their trade.  And the great things to come.

The Enlightenment led to the Modern World, Limited Government, the Industrial Revolution and Beyond

With the fall of the Byzantine Empire and the rise of the Italian city-states, Greek thinkers left the Byzantine Empire and went West.  To those rich Italian city-states.  Bringing with them great books of Greek knowledge.  The intellectual remnants of the Roman Empire.  Translated them.  And massed produced them on the new printing press.  And kicked off the Enlightenment.  Which then spread throughout Europe.

The Enlightenment led to the modern world.  From limited government.  To the Industrial Revolution.  And beyond.  All thanks to those Italian city-states.  International trade.  And banking.

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