Where do the financial statements come from?

Most people know from their own experience that finance is considered a difficult and confusing subject, especially for those who do not work with it every day. Few people know that the first balance sheet was created during the late Middle Ages with the income statement coming along a few years later (the cash statement only became required in the late 1980s). How can something so old and critical to understanding and managing business still be so broadly misunderstood? Let’s take a brief look at where the statements come from to see if it sheds any light on the topic.

A brief history of accounting…

As you may be aware, the earliest business transactions took place through barter and trade (e.g., I give you three chickens for one goat). This form of transacting was originated and settled on the spot, thus, tracking transactions was not necessary. However, much of the transactions that occur in business today take place on credit (usually 30 days on account), introducing the need to track what you have and what you owe.

The earliest known tracking of goods took place in Mesopotamia in cities along the Tigris Euphrates river valley, some 10,000 years ago, where active trading took place between towns and cities up and down the rivers. Many of the same problems that businesses face today existed for merchants at this time. Trade involved shipping goods up and down the rivers, requiring merchants to trust a boatman with their goods. As you might imagine, disagreements were common about what was shipped and what was received on the other end. So merchants decided they needed a way to track the goods shipped. All of this, however, took place before writing and numbers were even invented (and you thought accounting was confusing today!).

In place of writing and math, merchants made clay tokens in various shapes with different markings to identify their products. Before sending the goods, a token for each item would be encased in a ball of clay, which would then be dried in the sun and given to the boatman. The boatman would then deliver the clay ball to the buyer on the other end of the transaction, who would match the tokens with the items in the delivery and verify that everything was accounted for. Fortunately, for us, writing and numbers were invented, but I’m not so sure their invention made accounting any easier for us to understand!

Modern-day accounting and the primary financial statements

Various forms of bookkeeping or account tracking have been traced throughout history, with the earliest known official account book dating back to 1211. However, around the time the explorers were setting sail for the Americas, a new form of accounting was invented. Although a man named Benedikt Kotruljevic is credited as the original inventor of (or earliest to document the principals of) double-entry accounting, it was Luca Pacioli, whose manifesto was widely reprinted, that is regarded as the leader of this technique and is considered the “father of accounting.” During this time period, there was a growing acceptance of commercial activity leading to a greater need to efficiently track commercial proceedings. Such account documents were needed for legal security, employee control and to remember the transactions that occurred.

Take, for example the exploration of Christopher Columbus or other adventurous sailors that set sail to exploit the riches of the new world. Investors in these explorations wanted ways to track their investment. It was through this kind of activity, where accounts were not immediately settled, that the balance sheet was derived. The intention was (and still is) to provide a snap shot of what a business has and what it owes at a moment in time.

The balance sheet, however, does not provide the details that explain exactly how profits were generated. So, investors wanted to know how much income their business ventures created relative to their expense. The desire to better understand profitability lead to the invention of the income statement.

Modern accounting still follows the principles of these systems some 500 years later.

So what about the cash statement?

The cash statement, not required by US GAAP until 1988, was first introduced in 1863 by managers of the Dowlais Iron Company to provide more details on the source and use of funds. The company had recovered from a business slump, and despite generating a profit, had no cash to invest in new equipment. To explain why no funds were available to invest, managers created a new financial statement that showed where the company’s cash was tied up (it so happens that it was tied up in excess inventory). Such was the genesis of the cash flow statement.

In the early 80s companies started operating with increasing amounts of debt, greatly accelerating the risk of bankruptcy. Investors became increasingly concerned that the accrual method of accounting was resulting in net income that was significantly different from the actual cash flows of the firm. This led to stakeholders wanting a clearer picture of where cash was coming from (cash flow is considered more reliable as an indicator of a firm’s earning power). Thus, the cash flow statement became a requirement.

All these years later, the statements are still used for the same purpose – as tools to evaluate performance.