Financial Management for Business

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Cambridge University Press
978-0-521-76290-8 - Financial Management for Business: Cracking the Hidden Code
Robert Bittlestone
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Part 1
A dream of future
wealth
The aim of ‘A dream of future wealth’ is to provide the reader
with an intuitive understanding of the rules of business financial
management. ‘Do you know how to play chess?’ is the question
that mirrors our subject, whereas the rather more demanding
challenge ‘Do you know how to play chess well?’ is tackled in
Part 2, ‘The hidden art of management’.
But before you skip directly to Part 2, let us remember that we
cannot play chess well until we know how to play chess.

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Cambridge University Press
978-0-521-76290-8 - Financial Management for Business: Cracking the Hidden Code
Robert Bittlestone
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1

Income and outcome
Few have heard of Father Luca Pacioli, the inventor of double-entry bookkeeping; but he has probably had much more influence on human life than has
Dante, or Michelangelo.
Herbert Muller1
13 March 1500. Two men are walking across the great square of San
Marco in Venice. The monk is from Borgo San Sepulcro: he is a
mathematician, 53 years old, and he has been travelling for the last
few weeks with a 47-year-old artist from Anchiano.2 They have
recently left Milan where they were the guests of Ludovico il Moro
at his colossal Castello Sforzesco, but on 6 October 1499 the French
army invaded Milan and Ludovico was forced to flee.
Almost a century will pass before Shakespeare writes The Merchant
of Venice, but the monk’s mathematical skills turn out to be of great
practical assistance to merchants: initially in Italy, but later worldwide. The artist is also destined for immortality: a few years later he
will create the most famous painting in the world.
So what did Leonardo da Vinci, artist and designer of flying
machines, find so compelling about the mind of Luca Pacioli, mathematician and ambassador of accountancy?3 And what made the
1
2

3

Muller 1952, p. 257.
Luca Pacioli met Leonardo da Vinci in Milan after arriving there in 1497. They
collaborated on various projects and Pacioli also taught da Vinci mathematics. They
lived in the city until 1499 and moved to Venice in March 1500. A letter from a
Venetian friend of Pacioli’s dated 13 March 1500 refers to da Vinci’s visit to his
musical instrument works some days earlier and to seeing his charcoal portrait of
Isabelle d’Este. These and further details of Pacioli’s work and his relationship with da
Vinci can be found in Michael White’s Leonardo: The First Scientist (2000), in Peter
Bernstein’s Against the Gods: The Remarkable Story of Risk (1996) and in Alfred Crosby’s
The Measure of Reality: Quantification and Western Society, 1250–1600 (1997).
Pacioli (sometimes written Paccioli) was the ambassador rather than the inventor of
accountancy in the Summa (Pacioli 1494). As Bernstein points out: ‘this was not
Paccioli’s invention, though his treatment of it was the most extensive to date.
The notion of double-entry book-keeping was apparent in Fibonacci’s Liber Abaci
and had shown up in a book published about 1305 by the London branch of an
Italian firm’ (Bernstein 1996, p. 42). There is also clear evidence that the Dubrovnik
writer Benedikt Kotruljevic´ (Benedetto Cotrugli) described double-entry accounting

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Cambridge University Press
978-0-521-76290-8 - Financial Management for Business: Cracking the Hidden Code
Robert Bittlestone
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4

FINANCIAL MANAGEMENT FOR BUSINESS: CRACKING THE HIDDEN CODE

Figure 1.1

Leonardo da Vinci and

Luca Pacioli

Figure 1.2

Pacioli’s Summa in the
Castello Sforzesco
Photographed by the author with
the kind permission of the Biblioteca
Trivulziana. Copyright Comune di
Milano. All rights reserved.

author of the critically acclaimed 1494 opus Summa de Arithmetica,
Geometria, Proportioni et Proportionalita so interested in the relationship
between mathematics and art? Was this the first and last time that
the words ‘creative’ and ‘accountancy’ were combined in a context
untarnished by suspicion? Can we put ourselves in their shoes and
pinpoint the problem they were trying to solve and the nature of the
solution that emerged?
Luca Pacioli clearly understood the hidden code of accountancy.
He taught Leonardo da Vinci mathematics and da Vinci illustrated
Pacioli’s Summa, so the great artist had many opportunities to decipher the code himself. But what is the Pacioli financial code about,
and why is it hidden?
Few of the tourists who visit the Castello Sforzesco enter its
Trivulziana Library, but if you do so, you will find on its shelves one
of the original printed copies of Pacioli’s book. Turn to page 201 and
you will see something quite remarkable (Figure 1.2).
in his 1458 Libro de l’Arte de la Mercatura. See Yamey 1994, pp. 43–50; and also Stipetic´
2000, p. 32.

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Cambridge University Press
978-0-521-76290-8 - Financial Management for Business: Cracking the Hidden Code
Robert Bittlestone
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INCOME AND OUTCOME

5

Figure 1.3

Luca Pacioli’s hidden code
L. Pacioli, ‘Summa de Arithmetica, Geometria, Proportioni et Proportionalita’, Pt 1,
Section 9, Treatise 11: Particularis de Computis et Scripturis in J. B. Geijsbeek, Ancient
Double-Entry Bookkeeping (Denver, CO: J. B. Geijsbeek, 1914), pp. 44–45.

Pacioli’s code is concealed within this extract from his book at
Figure 1.3. Although he was not the first to invent it, he deserves great
credit for explaining it and his publication has been of incalculable
influence ever since. It contains the circuit diagram of capitalism: it
sets out the financial plumbing that makes it possible for a business
to attract investors, to borrow money from banks, to conduct trade,
to pay its workforce and its suppliers, to collect money from its
customers, to remit taxes and to reward its shareholders. Without
it, business as we know it would simply not exist.
But it is not at all straightforward for today’s students of financial
management to glance at this extract and to understand immediately
why it is of such fundamental importance. In fact the effort involved
has made the subject so unpopular that Pacioli’s hidden code is now
felt by some practitioners and academics to be a purely mechanical
procedure that no longer warrants a place on the business curriculum.4
4

See, for example, this comment from a Professor of Accounting: ‘To the casual
observer, accounting would appear to be being taught in a vacuum, with little
reference to either its past or to its future. It appears to lag behind the real world
and to focus upon teaching students about accounting as it was practised in the precomputer age of the 1970s, with the sole acknowledgement of progress being an
emphasis on accounting standards in all accounting degrees, presumably on the basis
that knowledge of the latest pronouncements of the IASB and FASB are all the up-todate information that is needed for a graduate to enter the profession. In addition,
anecdotal evidence suggests that double entry – the first real development of

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Cambridge University Press
978-0-521-76290-8 - Financial Management for Business: Cracking the Hidden Code
Robert Bittlestone
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6

FINANCIAL MANAGEMENT FOR BUSINESS: CRACKING THE HIDDEN CODE

When I started my career in 1973 I was unaware of this historical
context. I found myself working for a company called Roneo Vickers as
a trainee in a department called Financial Evaluation and Planning,
since this was felt to be the closest match for the skills of a recently
graduated economist. The fact that I had no knowledge of the financial
techniques that the department was supposed to apply was not seen as
any specific disadvantage: ignorance was indeed bliss in those days.
In fact it took me an embarrassingly long time to work out what
was going on. But it is now more than thirty-five years later and large
volumes of water have passed beneath the bridge. Some of my children have embarked upon their own business careers and it seems
wasteful for them and others to reinvent this particular wheel. So let
me share with you this story.
The Vickers Group was at that time a classically unfocused conglomerate, with business activities such as shipbuilding, office equipment, baby incubators and military tanks (perhaps unwitting
originators of the phrase ‘from cradle to grave’). Roneo Vickers was
the office equipment subsidiary, with annual sales in the region of
£100 million, a substantial business in those days. Furniture manufacture took place at Dartford in Kent and office machinery was
produced at Romford in Essex; there was a paper production facility
in Yorkshire and some overseas production as well. These products
were sold throughout the UK via a direct sales force and also exported
to the European subsidiaries.
One of my first tasks there was to design and implement a userfriendly management reporting system. The goal of our project was
simple: to create a set of paper forms which would identify clearly
the performance of each subsidiary. Every month about thirty of
these subsidiaries would be required to fill in these forms with key
numbers reflecting the month’s results and to send them in to the
centre. Our project design therefore had to adhere to established
financial rules and I was trying to find out about these laws of
accountancy from the Group Chief Accountant, because I didn’t
understand them at all.
I was staring at three financial schedules. One of them was called
the ‘Profit and Loss Account’, another was called the ‘Balance Sheet’
and the third one was called the ‘Cash Flow’. The original documents
had various additional rows and columns but I have reproduced at
Figure 1.4 the essence of these three forms.
My main problems were with the Balance Sheet and Cash Flow,
but I did have a few questions to ask about the Profit and Loss
Account, so I went to find my accounting colleague, hoping he was
in a supportive frame of mind, and we had a conversation along the
following lines.
‘David, do you have a moment to help me with some of these schedules
from the management reporting project?’
accounting into the discipline as we know it today – is no longer considered to be a
necessary tool of an accounting graduate’ (Sangster 2010, pp. 23–39).

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Cambridge University Press
978-0-521-76290-8 - Financial Management for Business: Cracking the Hidden Code
Robert Bittlestone
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INCOME AND OUTCOME

7

Figure 1.4

The three primary
financial schedules

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Robert Bittlestone
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8

FINANCIAL MANAGEMENT FOR BUSINESS: CRACKING THE HIDDEN CODE

‘Yes, but what’s the problem – they look pretty straightforward to me?’
‘Well I’d first like to make sure that I’ve understood the Profit and
Loss Account properly, so let me explain what I think it means and please
correct me if I’m wrong. Let’s start with the top line. Sales presumably
means the amount that we have sold to our customers, the things that
they have bought from us and paid us for?’
‘Not at all. The Sales line does correspond to what we have sold to our
customers, but they don’t pay for their purchases immediately. We let
them buy from us on account and settle their bill later. The amount they
owe us is listed in the Balance Sheet under Debtors, which is called
Accounts Receivable in the USA.’

I wasn’t entirely confident about the implications of what he had
just said, but it didn’t seem to matter very much, so I moved on to the
next line.
‘The Cost of Sales is presumably what it costs us to sell the things that the
customers have bought?’
‘Absolutely not: the Cost of Sales has nothing to do with the cost of
selling, it’s the cost of manufacturing the product or buying it in from a
supplier.’
‘Really? Why don’t we call it the Cost of Manufacturing then?’
‘We just don’t. I’m sure everybody knows that the cost of sales refers
only to the costs of the things that we sell, not the costs of selling them.’
‘What happens to the selling costs then?’
‘They get included further down the Profit and Loss Account, in the
Expenses line.’
‘David, I’ll have to come back to you later for some more advice about
the Cost of Sales, but let’s stick to the schedule for now. The next line is
Gross Profit and this looks to me to be simply the difference between
Sales and Cost of Sales – am I right?’
‘Yes,’ said David, with just a hint of irritation.
‘So now we come onto Expenses, which I presume include the selling
costs you spoke about just now and also the costs of developing the
products in the first place and managing the company generally?’
‘Not at all. Our research and development costs are capitalised and end
up in the Balance Sheet as fixed assets, so they are not included in Expenses.’
‘I’m a bit confused here. How can the research and development costs
for our copiers become an asset in the Balance Sheet?’

David looked at me as if I were completely mad.
‘All sorts of costs end up as assets in the Balance Sheet,’ he said. ‘The cost
of motor vehicles, the cost of building the factory in the first place, the
cost of buying the land, the cost of installing a telephone system – they’re
all in the Balance Sheet as assets.’
‘What about the cost of selling then? Is that in the Balance Sheet too?’
‘No, because the criterion that we generally use for categorising a
cost as an asset is that the item concerned should have a productive life of
longer than a year, which is true for motor cars, but not for selling costs.’
‘But what happens if our selling costs include advertising to build up
the Roneo Vickers brand in the long term, over a period much longer than
a year – shouldn’t this advertising then be classed as an asset as well?’
‘Maybe from a theoretical perspective, but in practice if companies
were allowed to do this then the framework would be wide open to

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Robert Bittlestone
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INCOME AND OUTCOME

9

abuse, with any kind of miscellaneous publicity costs being treated as an
asset. There is a clear set of financial rules about things like this and part
of my job is to ensure that we comply with these rules.’
‘But coming back to the research and development expenditure for a
moment, doesn’t this mean that if for example we happened to have an
R&D team that was half as effective as that of a competitor such as
Gestetner, so that it took us twice as long and cost us twice as much to
develop our copiers, then your accounting rules would mean that our
Balance Sheet would list an asset of twice the value of theirs?’
‘Yes.’
‘But that means that anyone reading our Balance Sheet would get a
completely distorted view of the worth of our company?’
‘Yes.’
‘David, why are you grinning?’
‘Well, that’s their problem really, isn’t it? As long as we comply with
the rules and the auditors approve our annual statements, we can’t be
held responsible for how people interpret the results.’

With the benefit of hindsight I can attest that even in 1973 this
conspiratorial attitude was unusual, but I didn’t know that at the
time and the project deadline was looming, so I continued with my
naive questions.
‘What is this word “Depreciation”?’
‘Well, most of our assets wear out over time, except for land of
course, so if we are to form a realistic view of our overall costs, we need to
include some allowance for our use of these assets. In most cases we
calculate the monthly depreciation by dividing the original cost of the
asset by its expected lifetime, although for factory machinery we usually
divide it by the expected production hours rather than the calendar
lifetime. But then again you need to remember that the factory depreciation becomes part of the cost of sales rather than the expenses’
‘I get the general idea, but it does sound somewhat arbitrary to me.
Supposing you make a mistake when you estimate the productive lifetime of the asset – doesn’t that mean that all of your historic depreciation
charges were wrong?’
‘Yes, but in practice we stick to the same depreciation period for the
same type of asset, so at least we’re consistent.’
‘You mean at least we’re consistently wrong?’

David looked piqued.
‘There are always judgments involved in accountancy – it’s rarely black
and white. My task is to ensure that the accounting rules are correctly
applied and to stop our managers from trying to influence these judgments purely to present an over-optimistic outcome.’
‘Let’s move on to the Operating Profit. These numbers suggest that
this is simply the Gross Profit minus the expenses – is that right?’
‘Yes.’
‘Then we have to subtract the interest … then there’s the tax.
Presumably this is what we owe to the taxman?’
‘Absolutely not. Each month we calculate the tax that we think will
be due on the profit we have made, using an estimated tax rate, and then
we correct it once the annual tax bill is actually determined. The amount
we owe to the taxman appears in the Balance Sheet.’

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978-0-521-76290-8 - Financial Management for Business: Cracking the Hidden Code
Robert Bittlestone
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Figure 1.5

Visualising Pacioli’s hidden code: how the accounts work Copyright Robert Bittlestone 1977, 2010.

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978-0-521-76290-8 - Financial Management for Business: Cracking the Hidden Code
Robert Bittlestone
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INCOME AND OUTCOME

11

I found myself becoming increasingly uneasy with David’s effortless
cross-references to the Balance Sheet and so I thought it might be
wise to inquire about it.
‘I think I understand the Profit after Tax bottom line of the Profit and Loss
Account, so shall we switch to the Balance Sheet now? There’s a line
there called Undistributed Profits – can you explain what that means?’
‘Our Undistributed Profits, also called Retained Earnings or Reserves,
are recorded in the Balance Sheet as a record of all the profit we have ever
made that we have not yet paid to our shareholders as a dividend. In
effect it’s the surplus that the business owes to its shareholders, but has
not yet distributed to them.’
‘But why does Profit appear in the Balance Sheet as well as in the
Profit and Loss Account? In fact I see that it also appears in the Cash Flow
statement that we haven’t even discussed yet. Why is it in all three of
these statements? And if we owe all this money to the shareholders, why
don’t we pay it to them? Presumably we have to pay other people that we
owe money to, such as our suppliers and the bank?’
‘Yes we do, but the nature of the contract we have with our suppliers
and the bank is rather different to our implied contract with our shareholders. Our shareholders wish to maximise the return they make from
investing in our business over a reasonable period of time. If the management of the company decides that it would be better to retain some of
the profits to help grow the company for the shareholders – perhaps by
acquisition or a major R&D programme – then it may be appropriate to
hold back from paying out a dividend today so that the company can
become more valuable in the future.’
‘So these reserves of profit are the same as the cash in our bank
balance?’
‘Absolutely not,’ said David, exhibiting signs of considerable
frustration.
‘David, I was going to ask you a whole lot more about the Balance
Sheet and the Cash Flow statements, but that was when I thought that
my questions about the Profit and Loss Account would only take about
five minutes. I think it might be better if we catch a late lunch and pick
up on the rest another day.’
‘Agreed.’

So we had our lunch, but I didn’t really enjoy it: I was already the
victim of some serious intellectual indigestion. Before our conversation I had assumed that the Profit and Loss Account was simply
a categorisation of money coming in and money going out,
rather like my own bank statement, but I was clearly quite wrong
about this.
What was worrying me was that when David made statements
like ‘All sorts of costs end up as assets in the Balance Sheet’, he
was referring to some form of interconnection between the Profit
and Loss Account and the Balance Sheet that I hadn’t anticipated
at all. Worse still, as I looked over these three schedules, I could
see that the Bank Account figure appeared in both the Cash Flow
and the Balance Sheet tables, while I had already observed that the
Profit figure appeared in all three statements, but in curiously
different ways.

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