The Modern Mixed Economy

A. The Market Mechanism

1. In an economy like the United States, most economic decisions are made in markets, which are mechanisms through which buyers and sellers meet to trade and to determine prices and quantities for goods and services. Adam Smith proclaimed that the invisible hand of markets would lead to the optimal economic outcome as individuals pursue their own self-interest. And while markets are far from perfect, they have proved remarkably effective at solving the problems of how, what, and for whom.


2. The market mechanism works as follows to determine the what and the how: The dollar votes of people affect prices of goods; these prices serve as guides for the amounts of the different goods to be produced. When people demand more of a good, its price will increase and businesses can profit by expanding production of that good. Under perfect competition, a business must find the cheapest method of production, efficiently using labor, land, and other factors; otherwise, it will incur losses and be eliminated from the market.


3. At the same time that the what and how problems are being resolved by prices, so is the problem of for whom. The distribution of income is determined by the ownership of factors of production (land, labor, and capital) and by factor prices. People possessing fertile land or the ability to hit home runs will earn many dollar votes to buy consumer goods. Those without property or with skills, color, or sex that the market undervalues will receive low incomes.

The Central Concepts of Economics

A. Why Study Economics?

1. What is economics? Economics is the study of how societies choose to use scarce productive resources that have alternative uses, to produce commodities of various kinds, and to distribute them among different groups. We study economics to understand not only the world we live in but also the many potential worlds that reformers are constantly proposing to us.



2. Goods are scarce because people desire much more than the economy can produce. Economic goods are scarce, not free, and society must choose among the limited goods that can be produced with its available resources.



3. Microeconomics is concerned with the behavior of individual entities such as markets, firms, and households. Macroeconomics views the performance of the economy as a whole. Through all economics, beware of the fallacy of composition and the post hoc fallacy, and remember to keep other things constant.

Glossary Financial Accounting Terms

account payable an amount due for payment to a supplier of goods or services, also described as a trade creditor.

account receivable an amount due from a customer, also described as a trade debtor.

accountancy firm A business partnership (or possibly a limited company) in which the partners are qualified accountants. The firm undertakes work for clients in respect of audit, accounts preparation, tax and similar activities.

accountancy profession The collective body of persons qualified in accounting, and working in accounting-related areas. Usually they are members of a professional body, membership of which is attained by passing examinations.

accounting The process of identifying, measuring and communicating financial information about an entity to permit informed judgements and decisions by users of the information.

accounting equation The relationship between assets, liabilities and ownership interest.

accounting period Time period for which financial statements are prepared (e.g. month, quarter, year).

accounting policies Accounting methods which have been judged by business enterprises to be most appropriate to their circumstances and adopted by them for the purpose of preparing their financial statements.

accounting standards Definitive statements of best practice issued by a body having suitable authority.

Accounting Standards Board The authority in the UK which issues definitive statements of best accounting practice.

accruals basis The effects of transactions and other events are recognised when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate (see also matching).

accumulated depreciation Total depreciation of a non-current (fixed) asset, deducted from original cost to give net book value.

acid test The ratio of liquid assets to current liabilities.

Financial Accounting Standards

Accounting standards are needed so that financial statements will fairly and consistently describe financial performance. Without standards, users of financial statements would need to learn the accounting rules of each company, and comparisons between companies would be difficult.
Accounting standards used today are referred to as Generally Accepted Accounting Principles (GAAP). These principles are "generally accepted" because an authoritative body has set them or the accounting profession widely accepts them as appropriate.

Securities and Exchange Commission (SEC)
The Securities and Exchange Commission is a U.S. regulatory agency that has the authority to establish accounting standards for
publicly traded companies.
The Securities Act of 1933 and the Securities Exchange Act of 1934 require certain reports to be filed with the SEC.
For example, Forms 10-Q and 10-K must be filed quarterly and annually, respectively.
The head of the SEC is appointed by the President of the United States.

When the SEC was formed there was no standards-issuing body.
However, rather than set standards, the SEC encouraged the private sector to set them.
The SEC has stated that FASB standards are considered to have authoritative support.

Committee on Accounting Procedure (CAP)

In 1939, encouraged by the SEC, the American Institute of Certified Public Accountants (AICPA) formed the Committee on Accounting Procedure (CAP).
From 1939 to 1959, CAP issued 51 Accounting Research Bulletins that dealt with issues as they arose.

Closing Entries | Closing Procedure

Closing entries are journal entries used to empty temporary accounts at the end of a reporting period and transfer their balances into permanent accounts. The use of closing entries resets the temporary accounts to begin accumulating new transactions in the next period. Otherwise, the balances in these accounts would be incorrectly included in the totals for the following reporting period.

The basic sequence of closing entries is:

1. Debit all revenue accounts and credit the income summary account, thereby clearing out the balances in the revenue accounts.
2. Credit all expense accounts and debit the income summary account, thereby clearing out the balances in all expense accounts.
3. Close the income summary account to the retained earnings account. If there was a profit in the period, then this entry is a debit to the income summary account and a credit to the retained earnings account. If there was a loss in the period, then this entry is a credit to the income summary account and a debit to the retained earnings account.

The net result of these activities is to move the net profit or loss for the period into the retained earnings account, which appears in the stockholders' equity section of the balance sheet.

Adjusting Entries

In the accounting process, there may be economic events that do not immediately trigger the recording of the transaction. These are addressed via adjusting entries, which serve to match expenses to revenues in the accounting period in which they occur. There are two general classes of adjustments:

• Accruals - revenues or expenses that have accrued but have not yet been recorded. An example of an accrual is interest revenue that has been earned in one period even though the actual cash payment will not be received until early in the next period. An adjusting entry is made to recognize the revenue in the period in which it was earned.
• Deferrals - revenues or expenses that have been recorded but need to be deferred to a later date. An example of a deferral is an insurance premium that was paid at the end of one accounting period for insurance coverage in the next period. A deferred entry is made to show the insurance expense in the period in which the insurance coverage is in effect.

The Trial Balance

A basic rule of double-entry accounting is that for every credit there must be an equal debit amount. From this concept, one can say that the sum of all debits must equal the sum of all credits in the accounting system. If debits do not equal credits, then an error has been made. The trial balance is a tool for detecting such errors.

The trial balance is calculated by summing the balances of all the ledger accounts. The account balances are used because the balance summarizes the net effect of all of the debits and credits in an account. To calculate the trial balance, construct a table in the following format:

Debit and Credits

Debits and Credits are used to track the changes of account values. They can also be thought of as mirror opposites: Each debit to an account must be accompanied by a credit to another account (that's how the phrase "double-entry bookkeeping" gets its name). Understanding debits and credits is essential for bookkeeping and analysis of balance sheets.

Familiarize yourself with the meaning of "debit" and "credit." In bookkeeping, the words "debit" and "credit" have very distinct meanings and a close relationship. Debits and credits balance each other out —if a debit is added to one account, then a credit must be added to the an opposite account.

• In accounting, the debit column is on the left of an accounting entry, while credits are on the right.
• Debits increase asset or expense accounts and decrease liability or equity. Credits do the opposite — decrease assets and expenses and increase liability and equity.
• To make sense of this, take a look at the basic accounting equation, which is Assets = Equity + Liabilities. Assets are paid for by equity and/or liability —you cannot have one without the other. So if you complete a transaction that increases assets (and you debit the asset account), you must also increase the equity or liability (by crediting the equity or liability account) so that Assets remain equal to Equity and/or Liability.

General Ledger

While the journal lists transactions in chronological order, its format does not faciliate the tracking of individual account balances. The general ledger is used for this purpose.

The general ledger is a collection of T-accounts to which debits and credits are transferred. The action of recording a debit or credit in the general ledger is referred to as posting. The posting of a journal entry to the general ledger accounts is a purely mechanical process using information already in the journal entry and requiring no additional analysis.

To understand the posting process, consider a journal entry in the following format:

General Journal Entry

Date	Accounts	Debit	Credit
mm/dd	Account 1	xxxx.xx
	Account 2		xxxx.xx

Journal Entries

After a transaction occurs and a source document is generated, the transaction is analyzed and entries are made in the general journal. A journal is a chronological listing of the firm's transactions, including the amounts, accounts that are affected, and in which direction the accounts are affected. A journal entry takes the following format:

Format of a General Journal Entry

Date	Accounts	Debit	Credit
mm/dd	account to be debited	xxxx.xx
	account to be credited		xxxx.xx

In addition to this information, a journal entry may include a short notation that describes the transaction. There also may be a column for a reference number so that the transaction can be tracked through the accounting system.

The Source Document

Source documents are the physical basis upon which business transactions are recorded. Source documents are typically retained for use as evidence when auditors later review a company's financial statements, and need to verify that transactions have, in fact, occurred. 

They usually contain the following information:

• A description of a business transaction
• The date of the transaction
• A specific amount of money
• An authorizing signature

Many source documents are also stamped to indicate an approval, or on which to write down the current date or the accounts to be used to record the underlying transaction. 

A source document does not have to be a paper document. It can also be electronic, such as an electronic record of the hours worked by an employee, as entered into a company's timekeeping system through a smart phone.

The Accounting Cycle

Accounting cycle is a step-by-step process of recording, classification and summarization of economic transactions of a business. It generates useful financial information in the form of financial statements including income statement, balance sheet, cash flow statement and statement of changes in equity.

The time period principle requires that a business should prepare its financial statements on periodic basis. Therefore accounting cycle is followed once during each accounting period. Accounting Cycle starts from the recording of individual transactions and ends on the preparation of financial statements and closing entries.

Major Steps in Accounting Cycle

Bookkeeping

Single Entry Bookkeeping

Most of financial accounting is based on double-entry bookkeeping. To understand and appreciate the advantages of double entry, it is worthwhile to examine the simpler single-entry bookkeeping system. In its most basic form, a single-entry system is similar to a checkbook register and is characterized by the fact that there is only a single line entered in the journal for each transaction. In a simple checkbook, each transaction is recorded in one column of an account as either a positive or a negative amount in order to represent the receipt or disbursement of cash. This system is demonstrated in the following example for a repair shop business:

Single Column System

Date	Description	Amount
Jan 1	Beginning Balance	1,000.00
Jan 2	Purchased shop supplies	(150.00)
Jan 4	Performed repair service	275.00
Jan 7	Performed repair service	125.00
Jan 15	Paid phone bill	(50.00)
Jan 30	Ending balance	1,200.00

Basic Financial Statement

Businesses report information in the form of financial statements issued on a periodic basis. GAAP requires the following four financial statements:

• Balance Sheet - statement of financial position at a given point in time.
• Income Statement - revenues minus expenses for a given time period ending at a specified date.
• Statement of Owner's Equity - also known as Statement of Retained Earnings or Equity Statement.
• Statement of Cash Flows - summarizes sources and uses of cash; indicates whether enough cash is available to carry on routine operations.

Balance Sheet
The balance sheet is based on the following fundamental accounting model:
Assets  =  Liabilities  +  Equity Assets can be classed as either current assets or fixed assets. Current assets are assets that quickly and easily can be converted into cash, sometimes at a discount to the purchase price. Current assets include cash, accounts receivable, marketable securities, notes receivable, inventory, and prepaid assets such as prepaid insurance. Fixed assets include land, buildings, and equipment. Such assets are recorded at historical cost, which often is much lower than the market value.

Account Information for Decision Making

Small business owners are faced with countless decisions every business day. Managerial accounting information provides data-driven input to these decisions, which can improve decision-making over the long term. Small business managers can leverage this powerful tool to help make their business more successful by understanding how management accounting benefits common business decision contexts.

Management accounting is fundamental in strategic planning. When a business is looking to make a strategic decision, for example, whether to develop a new product line, acquire another business or expand into other countries, the CIMA trained management accountant can provide advice. They can use a number of tools to assist decision-making. These include ratio analysis, budgets and forecasts (such as cash flow and variances).

The main ratios used in management accounting are: 

• efficiency or activity ratios, including liquidity - these show whether the business is able to pay its debts. They look at whether the assets of the company (its buildings, land equipment) could repay any debts.
• gearing- shows the long-term financial position of the business. It can show balance of funding in a business i.e. how much money is from loans (on which it needs to pay interest) and how much is from shareholder funds (on which it needs to pay a dividend to shareholders). More money from loans carries more cost and therefore more risk.
• profitability or performance ratios - show how well a business is doing. They relate to the business objectives, which might be to make profit or obtain a return on investment, or collects its debts quickly.