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Understanding investment in 50 objects: A balancing act

Understanding investment in 50 objects: A balancing act
July 22, 2016
Understanding investment in 50 objects: A balancing act

This object is a mystery; or certainly mystery and speculation swirl around its meaning – the figures in the painting, the symbols pictured and the intriguing contrast between the brilliance of some parts of the painting and the merely workmanlike quality elsewhere. And it’s not even certain who the artist was.

What is known is that the painting – oil on poplar – hangs in the Capodimonti Museum in Naples where it is the property of the Italian state, bought out of public funds in 1903 to prevent it being sold to England. It is also certain who is the main figure in the painting – that’s Luca Pacioli, an Italian friar and mathematician of the 15th century, who, for a while, worked with Leonardo da Vinci (it’s even suggested that Leonardo painted the superior bits of the work).

To historians of art and of commerce, Pacioli is a well-known figure. That’s partly because of the renown – and the enigma – of the painting, but also because Pacioli is caricatured as “the father of accounting”. Not for nothing was the portrait used on the box of an early piece of accountancy software called Pacioli 2000. After all, Pacioli is credited with the first published description of double-entry bookkeeping, which was – and is – at the core of all accountancy. It is not too much of a stretch to say that without double-entry bookkeeping, the world today would not be as we know it.

True, it flatters Pacioli to attribute this system of accounting solely to him. He explained double-entry bookkeeping in his book, Summa di Arithmetica, Geometrica, which was published in Venice in 1494. However, earlier manuscripts describe the system; then there are ledgers from 13th century Florence showing double-entry bookkeeping in use, and a form of the double-entry method was used in the Persian empire and described by Al-Khawarizmi, the mathematician whose Latinised name gave us ‘algorithm’.

So what is double-entry bookkeeping and why is it so important? Let’s tackle the second part first. It’s important because any business needs accurate information, especially if that concerns its financial dealings – its capital, its cash, its creditors (what it owes) and its debtors (what it is owed). Double-entry bookkeeping achieves this in a comparatively simple format that readily shows whether errors have been made in totting up accounts and, with a bit of refinement, provides a way to spot and to trace those mistakes.

It does this via the principle of double entry. That is, wherever there is a transaction that gives rise to a debit, there must be an equal and opposite transaction that gives rise to a credit. For example, imagine I am setting up my online publishing company. The first thing I need is some equity capital to fund bits of equipment and give me ready cash to meet day-to-day expenses. So, by various means, I find that capital and that gives rise to a credit transaction appearing on the right-hand side of my balance sheet, probably under the label, ‘equity capital’. Simultaneously, that generates an equal and opposite transaction on the other side of my balance sheet where my cash account rises by the amount of the equity capital raised (technically, that’s a ‘debit’ transaction).

Soon I am doing some business and eventually Financial Times UK will pay me for this wonderful article I’m writing now. When that happens, I will receive a cash payment. That will cause an increase in my cash account (again, technically a debit transaction) and simultaneously my accounts-receivable column (my debtors) will fall by the same amount.

Meanwhile, I can keep a check on all transactions by giving each one a date and a code and I will attach the same date and code to both the debit and credit transactions. Should my accounts fail to balance, then I have an audit trail that will help me find the error.

True, there is more to it than that. My little publishing venture won’t make many transactions, so it will only need one set of books. For a bigger business, there will be a system of ‘day books’ (from which we get the word ‘journal’) that feed into the double-entry system. Day books will be a schedule of individual transactions for, say, sales invoices, cash sales, invoices received. As such, they don’t need to balance, even though the overall accounts do.

Always, the key word is ‘balance’. Income and expenditure balance; cash in and cash out balance; assets and liabilities balance. Except, in a way, they don’t. If income and expenditure always balanced, then a business would never make a profit and that wouldn’t be good. The point is they can be made to balance and, from the point of view of monitoring a firm, that’s a sensible adjustment.

Thus, for example, the excess of income over expenditure will be contained in a balancing item, such as a rise in accounts receivable, which, in effect, reduces income. Cash in and cash out can always be balanced by adjusting the level of a firm’s debt. Ultimately, assets and liabilities will be in balance thanks to the function of equity, which is a sort of liability that never has to be met. Thus equity rises if a firm is successful so that its assets swell far beyond its liabilities. Alternatively, equity can shrink to less than nothing if liabilities somehow become much greater than assets. There is always a balance of sorts.

Maybe that’s what Luca Pacioli is pointing to in that enigmatic portrait – balance. At the very least, mathematical investigations of the work show that it is all about symmetry, where one side equals the other – just like double-entry bookkeeping. Philip Ryland

 

21: A Salvador Dalí sketch: the importance of cashflow

After paintings of dripping clocks, Salvador Dalí is probably best remembered for his grandiose behaviour and anarchic publicity stunts. He once drove to Paris in a Rolls-Royce filled with cauliflower. A pet ocelot was frequently with him whenever he went for brunch. In 1936, he gave a lecture at the International Surrealist Exhibition wearing a deep-sea diving suit, holding a billiard cue and accompanied by two Russian wolfhounds.

The Spanish artist also frequently paid for lavish meals by sketching on the back of the bills he was presented with. However, unlike his usual eccentricity, this was a highly calculated act that provides us with an important investment lesson. The logic was simple: Dalí assumed that the restaurant would value his mini work of art more than the cash it would have received for the meal, so he ended up buying his dinner without spending anything. Meanwhile, the restaurant calculated that a Dalí sketch would ultimately come to represent a sum worth many times the value of the meal.

According to Dr Edmund Klein, a researcher at the University of Buffalo who cared for Dalí when he was diagnosed with skin cancer in 1972, the surrealist painter also used a variation of the technique to pay for medical treatments. Indeed, the trick was used repeatedly, and was not just confined to dining out and hospital appointments. Throughout his life, Dalí refused to pay his secretaries in a regular salary, instead gifting them commissions that several cashed in for millions of dollars years later.

The connection to investment should not be taken too literally; after all, most businesses do not accept surrealist art in lieu of payment. But Dalí’s treatment of bills offers useful lessons, nonetheless. Chief among them is the importance of cash flow to a company. If – as Dalí would have hoped – a restaurant that accepted a doodled invoice decided to lock it in the safe, the liquidity of the payment would have diminished considerably. As a result, cash flow would have been hurt – the restaurant would be without the hard cash to replace the bottles of champagne now absent from its cellar. To the restaurant, a bill signed by Dalí essentially functioned as an IOU, a promise of payment, albeit possibly far into the future, and not by the man himself.

In practical terms, poor cash flow can be a problem for companies that can collect cash only after they have supplied their goods or services; for example, companies engaged in long-term construction projects whose progress payments fail to meet costs, or those – such as in the UK food industry – whose customers are more powerful than they are. Such companies build up debtors in their balance sheet, but struggle to turn the debtors into cash.

That plays to the adage that “revenue is vanity, profit is sanity, cash is reality”. A company with negligible or erratic cash flows may well struggle to make its own payments, settle liabilities and provide sufficient headroom for dividends. As several Kurdistan-based oil companies have found to their cost in the past two years, delayed payments from the regional government have placed enormous strains on business operations. In the case of one such, Gulf Keystone (GKP), the cash crunch, multiplied by debt issues, could ultimately prove ruinous.

Dalí’s preferred payment method is also a useful reminder that investors should always check a company’s method of revenue recognition. If our notional restaurant had a particularly aggressive accountant, the revenue for Dalí’s meal might be recognised the day it was served. But as no cash was received, the meal can only be accounted for as ‘accrued revenue’. And because Dalí paid with a piece of art (of indeterminate value) it may be some time before the cash finds its way into the business. That can be a red flag for would-be investors examining young technology companies eager to prove they have a product to sell.

The other lesson extends to the balance sheet, and the valuation of a company. How would our restaurant hope to value a hastily-sketched piece of art against the value of a meal? Were Dalí to have fallen out of vogue, or if wine was spilled over the doodle, would the sketch even be worth enough to cover the cost of the meal?

As it is, these sketches now fetch many thousands of dollars at auction, although it’s difficult to say whether that exceeds the value of the meal after adjusting for inflation. If our restaurant’s sketch was to be recognised on the balance sheet – perhaps as a financial investment, under property or as an intangible asset – what is the proper way of accounting for the appreciation or depreciation in the value of the asset?

Like many parts of every business, the true value is only what the market would be prepared to pay for it. Fortunately for any restaurant that accepted one of Dalí’s sketches, there is no shortage of art dealers out there. Other assets can be a lot harder to shake out – think of the unprofitable projects sitting on the balance sheets of natural-resources companies, or the enormous books of bad loans held by the banks after the financial crisis. The genius of Dalí’s ruse was that both sides were happy – he benefited from having the gall to pay without cash, the restaurant was confident that the non-cash payment would be worth more in the long run. It’s not always that easy. Alex Newman