tymshft

There is nothing new under the sun…turn, turn, turn

Internal control, 14th century version

In a recent Facebook comment, I noted that I have interests that are derived from my employment in the automated fingerprint identification system (AFIS) industry. Most of you would shake your heads if you saw my Facebook statement – “‘Type 2’ is my life” – but for a relatively small amount of people concerned with AFIS interoperability, my statement makes perfect sense, and leads to other penetrating questions such as “Binary or XML?” It’s not exactly “boxers or briefs,” but it will have to do.

Jim Ulvog doesn’t get excited by Type 2 records. He does get excited by internal controls. He spoke about them in June, and has just returned to the subject. In both cases, he spoke of internal controls that were established long before any accounting standards were established in the United States of America. And as you can see from his most recent post, I’ve looked at the topic myself.

Both of the examples cited – one from the 4th century, and one from before the 1st century – concern religious organizations. (Ulvog advises non-profits on accounting issues.) As I read Jim’s latest post, I began wondering – when did internal accounting controls first appear in what we would consider for-profit businesses?

Well, I don’t know if this is the first instance of business internal controls, but Meril Markley has discussed the presence of internal controls in 14th century power corporations in Toulouse. Back then, power consisted of harnessing the rushing river waters to power mills. After some false starts, the Toulouse capitalists formed joint ownership ventures that functioned as “a legal person separate from its owners” – in other words, the modern corporation. (This concept of a corporation as a person is controversial today, as you can see when you read opinions on campaign financing.)

These joint ventures had shareholders who actually owned the corporation, and people who did the work. This arrangement presented some problems that needed to be solved.

Early on, the shareholders had to confront the fact that none of them were inclined to be involved in the messy day-to-day operation of the mills. They needed a way to delegate authority without losing control. Their solution was to elect from among their ranks an eight-member board to hire professional managers having the technical knowledge to keep the mills running while supervising the employees and serving customers. To prevent board members from getting the upper hand and eclipsing the ultimate authority of all the shareholders, they were elected two at a time to two-year terms with term limits. Mill managers were granted one-year contracts, and their performance was reviewed at the annual general meeting of shareholders. They were personally liable for any shortfalls in the accounts, while their reward for a job well done was another one-year contract.

Now that they had figured out how to run and control the corporation, the next problem to address was the problem of conflicts of interest. In the same way that a church treasurer can potentially be tempted by all the money lying around, the corporate arrangement included possibilities for fraud that had to be confronted.

They instituted rules prohibiting employees and their families from dealing in grain or from buying shares in the company. Neither shareholders nor their families could be employees. All transactions were recorded meticulously using a precursor of the double-entry system of bookkeeping. To police expenditures, the person recording an expense on the general ledger could not be the one who authorized it. Demands by employees for profit-sharing were quashed. Shareholders and employees were forbidden to lend money to the corporation, and vice-versa.

For more details, including the use of independent auditors, read the article.

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