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Q. What do a 500-year-old math textbook and sophisticated software for modern asset managers have in common?
A. They both rely on a seminal business concept that’s been unchanged in over five centuries: Double Entry Bookkeeping (DEB).
DEB is a method of recording and reporting on business activities that was first described in 1494 by Italian mathematician and “Father of Accounting” Luca Pacioli. Centuries later, the idea is still used basically as it was first conceived by Pacioli. Under DEB, every financial transaction has an equal and opposite effect; that is, a debit in one account offsets a credit in another. A “journal entry” is created from a business transaction; within each journal entry, a set of balancing journals that describe outcomes from the transaction (e.g., wrote down inventory, received cash, recorded a gain/loss) are posted to a financial ledger. Financial ledgers are in turn rolled up into income statements, balance sheets, and other views that allow businesses to assess financial health.
Why has DEB had such remarkable staying power, and how does it apply to the investment accounting world? It’s a fundamental business premise that can be explained through a clean, intuitive model. In building the industry cloud platform for investment management, Ridgeline recognizes the importance of having a powerful, intuitive model driving one of our customers’ most critical business functions: investment accounting. While the model still conforms to Luca’s time-tested approach, it has been extended to apply to the market’s modern-day investment accounting challenges.
However, on any given day for an asset management firm, there may be hundreds or thousands of accounts and millions of transactions to accurately record, process, and understand. This sheer volume of data makes for a lot of complexity — and a lot of room for errors to sneak into a system.
To address the complexities inherent in building a next-generation investment accounting engine, Ridgeline has two high-level goals: 1) apply the proven, age-old DEB model to a software architecture at scale, and 2) enhance the architecture by extending the use of DEB to tackle the complexities specific to the asset management industry in a better way.
AN IMPORTANT DISTINCTION ABOUT INVESTMENT ACCOUNTING
Before jumping into a key example of what makes investment accounting so challenging for today’s investment managers, let’s quickly distinguish it from its calculating cousin: traditional or “corporate” accounting.
Put simply, traditional accounting systems record outcomes. Typically, they serve as repositories of business transactions resulting from various manufacturing processes that drive quality and efficiency (i.e., revenues, costs of production, R&D, inventory). Unlike traditional accounting systems, investment accounting is not just for recording. As asset managers know, these systems are interwoven into the day-to-day operations of a firm — to the extent that an investment accounting system itself is the primary manufacturing process for an investment firm.
Consider a manufacturer that uses various complex systems to manufacture widgets. While these systems (cost accounting, inventory and parts management, etc.) may communicate with the corporate accounting system, the systems’ functions play a bigger role in driving profitability and controlling costs than does the corporate accounting itself. In investment management, on the other hand, the end product being “manufactured” is accounting views, not widgets. This means investment accounting is not just for record keeping but is a critical business driver in and of itself. The following diagram illustrates this critical difference.
CONTRASTING ACCOUNTING SYSTEMS FUNCTIONS
In the diagram above, someone may wonder why investment returns would be considered a “variable” determinant rather than part of the manufacturing process. Investment returns can be influenced by the quality and timeliness of information received, but ultimately human interaction — rather than systematic factors — drives the “production” of investment returns. And these returns can vary greatly.
Given its manufacturing-like role, investment accounting systems can contribute significantly to reducing a business’s overall costs through an efficient use of resources and increasing the quality of information disseminated by various audiences. Those gains tend to remain permanent once the system is in place.
But, unsurprisingly, anything that can drive that much business value can’t be an easy fix. Sure enough, investment accounting is a challenging function to implement and automate. This is typically due to the volume of data, the imperative for accuracy, and the problems that arise when inaccuracies inevitably seep in during the rapid pace of business. The concept of “temporality” helps to illustrate the magnitude of the problem to be solved as well as the huge benefit for the asset management community in having a next-generation software platform that addresses it and other key challenges.
Temporality
Temporality in accounting involves the ability to process and report information based on various time dimensions, primarily “as of” and “as on” views of accounting data. The ability to provide these dimensional views in an automated setting is dependent on the ability to tackle four major software challenges as described below.
“As On,” “As Of,” and Error Correction
Back in Luca’s day, accounting was primarily focused on recording entries as they were received (“as on”). If prior errors were discovered that had a “dependency chain” (i.e., subsequent accounting entries were impacted by the fix), adjusting entries were figured — perhaps with the help of the 15th-century calculator known as an abacus — and then posted as “correcting entries” today instead of when the original activity and its downstream consequences should have been recorded. If one wanted to review what a general ledger should have looked like based on the day the error should have been fixed, barring a superhuman effort from a scribe with an endless supply of quills, this information was lost! The ability to review ledgers based on when entries should have been recorded is commonly called “as of” views.
Closed Period
In Luca’s world, an exchange of data was performed on foot, horse, or mule. If a period was undergoing a “closing process,” that period’s books would remain open for a certain time interval so that late entries coming from afar could be recorded (after all, mules need their rest too). Keeping periods open is something that still exists today, except in a digital world, it is delivered in a more timely manner.
Temporality in the Asset Management World
The asset management market requires a myriad of temporal views and processes that have historically stressed investment accounting systems. The operational effort, cost, and risk associated with having to manually intervene to produce many of these views is significant; as one moves up market to larger and more complex asset management firms, the challenges grow from significant to staggering.
It is easy to understand the magnitude of the challenge with an example. Let’s assume that a EUR-denominated bond purchase was made in a USD base currency fund/portfolio two weeks ago. Two days ago, it was discovered the trade carried a yield from which to derive price from that was incorrect, and a cancel/rebook was performed on the trade. Then one day ago, the trader realized that yet again, the yield quoted on the corrected ticket was wrong, so it was cancelled and rebooked with yet another new yield. What was the impact from these activities?
These seemingly simple trade corrections spawned multiple temporal views that an asset management firm must have visibility into. These views can be logically broken down into two primary categories, each with specific types:
- External
- Client
- Regulatory
- Other (e.g. performance measurement to pension fund consultants)
2. Internal
- Managerial
- Operational
- Fund accounting-specific
The illustration below depicts the activities triggered by multiple corrections of the same past event.
IMPACT FROM A SINGLE TRADE WITH TWO CORRECTIONS
The cascading effect of these competing “corrections” quickly becomes a multi-pronged headache for firms, including the following challenges:
- Error corrections — Each trade correction triggered a series of adjusting entries. In this simple example, dozens of journal adjustments resulted.
- Many temporal views are now required.
- Managerial — “Show me the history based on ‘today’s knowledge” (e.g. show trade adjustment #2, positions, balances, and all activities on the dates they should have been posted as if the trade had been booked correctly to begin with).
- Client — “You sent me an appraisal two days ago and one day ago. Show me why my appraisal changed.” In this case you need to start with the balances as they appeared “as on” two days ago, then trade adjustment #1 and its corresponding activities/adjustments, followed by closing balances as they appeared “as on” one day ago.
- Performance Consultant — Same as Client, just pick two “as on” dates and the activities between the two dates.
- Fund Accounting — “Show me balances from yesterday’s NAV close (“as on” yesterday), today’s corresponding activities/adjustments, followed by real-time (“today’s knowledge”) balances.
- Many, many more…
From the Model to the Real World
In the real world, this situation is many orders of magnitude greater than the example above, as asset management firms have hundreds or thousands of funds and portfolios, each of which holds hundreds or thousands of investment tax lots. The example doesn’t include complex corporate actions (e.g., reorganizations), wide securities coverage, additional sets of books (e.g., tax), jurisdictions, multi-basis, multi-currency, and a host of other challenges that make building investment accounting systems the ultimate challenge for the market. Whew.
Financial institutions of all shapes and sizes are profoundly impacted by software issues related to temporality. Significantly increased operating costs result from the headcount increases that are necessary to deliver many of these views via Excel or other less productive means. Costs to reconcile can include hiring hundreds or thousands of employees. Equally as important are the operating and regulatory risks that come with a fragmented temporal environment.
THE OPPORTUNITY
Ridgeline is both humbled and excited about the challenges we face as we transition investment accounting from its over-burdened current state into a single, integrated, industry-specific solution that includes other critical functions like trading, portfolio management, compliance, reporting, and client engagement. Our 250+ person team of engineers, technologists, and industry experts spends each day taking on these big hurdles to deliver the investment management industry a better alternative to what legacy technology has offered.
If you’d like to know more about how Ridgeline is helping to give asset management firms a competitive advantage with a purpose-built, cloud-native platform, please drop us a line at hello@ridgelineapps.com.
