The Pacioli-Fritz accounting system: bringing intangibles to light

| December 24, 2010

Since the so-called father of accounting, Luca Pacioli published his book Summa de arithmetica, geometria, proportioni et proportionalitain Venice in 1494, in which he describes the method of bookkeeping that Venetian merchants were using, known as the double-entry accounting system, much has happened in the world of commerce and economics.

Relatively speaking, not much has happened in the double-entry accounting system.

The Pacioli world was a mercantile one, dealing mainly in tangible products with definable risk profiles, and strict rules of depreciation. With the advent of intellectual assets the world has changed dramatically. Yet we remain driven by the mercantile concepts that pertain to accounting assets. We only account for so-called tangible assets. We must update our thinking, and recognise the change in the world, and also account for intellectual, so-called intangible assets.

The value of nothing

Let me illustrate the point with reference to the mining industry. Up until the 1960s there was only one way to assess mining exploration – successful or unsuccessful. If it was successful, we had found a valuable mineral deposit and we could assess the value of that deposit. On the other hand, if our drilling program found nothing, that work was worthless.

The developments in accounting in the 1960s meant we could create a risk profile for exploration, even when exploration did not produce a result. We were able to value finding nothing. If you don’t find anything in a certain spot, you won’t come back and drill. But it also indicated where and perhaps when there might be mineralization. That knowledge itself is valuable. And that became a driver for what followed, the mining boom.

We need to extend this thinking further into other areas of commerce and economic activity.

Uncover hidden worth

In Pacioli’s time and much of the time after, the majority of money spent in a business related to the acquisition of tangible assets. In the last 40 years, the bulk of money used by a business for value creation relates to the acquisition of intangibles.

That is best seen in that more than 70 per cent of expenditure by a company goes in salaries and commissions. Bundled in a single expense line item called “salaries” we acquire knowledge, patents, we create brand names and we create knowledge. But all of these things are accounted for as intangibles, and therefore not part of the assets of the company. These assets are expensed in the profit and loss account as salaries, as costs to the business. This in my view is where we have failed.

Yet the solution to our conundrum of how to account for intangibles is staring us in the face.

A simple breakdown

The disaggregation of the expense called salary is the answer. Here we are spending money on acquiring assets. Some of that money is of course cost. But much of it is acquiring tangible, resalable goods in the form of knowledge, or knowledge-based products or processes. It increases the value of the individual to the business. It appreciates the person, and appreciates what the persons output is. By valuing the particular levels of money spent on particular things, we should be able to get a risk profile for the investment.

Think about it this way. An employee is worth more today to the business than they were on the day they arrived. The money spent on bringing an employee into a business should be capitalized, it should not be expensed. We should be able to break that salary line item up into different categories, as to what is capital expenditure and what is actually expense, which we will not recover. By doing so we move from an expenditure, cost-based accounting model to a tangible, asset acquisition process and accounting approach.

Pacioli was not wrong. We have just not moved with the times. By updating our accounting conventions and developing risk profiles for our expenditure and investment in people, we will bring accounting from the dark ages into the modern enlightened age.