Professor Adams' Lecture Materials

LO2-01: Understand routine economic events - transactions - and determine their effects on a company's financial position and on specific accounts.

Economic event

An economic event is an event, such as the sale of a company's product or service, that causes a change in the financial position of the company.

1. External event: An economic event that occurs between a company and some other entity.
2. Internal event: No exchange, but something occurs inside of the company that changes the financial position of the company.

Accounting equation

Simplest form

- Assets = Liabilities + shareholders' equity

We can rewrite shareholders' equity

- Assets = Liabilities + (paid in capital + retained earnings)

We can rewrite retained earnings

- Assets = Liabilities + {paid in capital + (revenues + gains - expenses - losses - dividends)} [01]

Important features of the accounting equation

1. Balance: For every economic event recorded, the accounting equation (regardless of how you write it) must balance.
2. Double entry: We achieve balance through double entry bookkeeping. Every entry made to one side of this equation must be balanced by an equal entry made to the opposite side of the equation.
3. T-accounts: We keep track of the accounting equation using something called t-accounts (see below).
  - Debit: the left-hand-side of the t-account.
  - Credit: the right-hand-side of the t-account.

General ledger

A general ledger is a collection of T accounts used to keep track of increases, decreases, and balances of financial statement accounts. Below is an image of what ledgers used to look like before computers. [02]

Natural balances

- Assets have a natural debit balance.
- Liabilities have a natural credit balance.
- Shareholders' equity accounts have a natural credit balance.
  - Sales revenue and gains increase equity, so entries to these accounts are primarily recorded as credits.
  - Expenses and losses decrease equity, so entries to these accounts are primarily recorded as debits.

Strengths of double entry bookkeeping

1. Because everything has to balance, the system has a built in mistake checking mechanism. If the equation doesn't balance, there's a mistake somewhere.
2. By carefully tracking economic transactions, firms can make better decisions.
  - Example: you own a pizza shop and you carefully track costs. This allows you to set an appropriate price for your pizzas.

Footnotes

[01] We'll see this later, but (revenues + gains - expenses - losses - dividends) is cumulative for the purposes of this equation. In other words, it's all revenues, all gains, all expenses, all losses, and all dividends since the inception of the business.[02] Image source: https://en.wikipedia.org/wiki/Ledger#/media/File:Ledger.png.

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