Econ 111 (Accounting, and Banking/rick

Double-entry bookkeeping

For every event that impacts an asset or liability, the change is recorded twice — once to assets/liabilities and once to net worth — so books always balance.

Generally accepted accounting principles (GAAP)

Rules requiring accountants to value assets objectively and conservatively, assume the organization continues existing, and apply the same criteria over time.

Income statement

A summary statement of the changes in expenditures and receipts during a given period. Shows a firm's profitability over that period.

Receipts

The total value of the revenue of the firm in a given period of time.

Expenditures

The value of the financial outlays the firm has made in a given period of time.

Gross income (operating gain)

Receipts minus the cost of goods sold by the firm in a given period of time.

Net income

Receipts minus (cost of goods sold + fixed costs + depreciation/amortization + interest + taxes).

Burn rate

The total amount of cash that the company loses in a given period, usually measured in months.

Runway

The period of time left before the company runs out of liquid assets (cash) with which to pay for its expenditures and make up any losses.

Balance sheet

The firm's itemized valuation of assets, liabilities, and net worth at a given point in time.

Assets

An economic resource owned by the firm. Includes cash, accounts receivable, and other valuable capital.

Liabilities

An obligation to pay (or IOU) extended by the firm. Current liabilities are due within one year; others are not.

Net worth

The summed value of assets of the firm minus the summed value of liabilities. Recorded as a liability because owners' claims come after creditors.

Paid-in capital

The sum of payments received from investors in exchange for an entity's stock.

Reserves

Cash on hand reserved for future expenses.

Accumulated retained earnings (deficits)

Residual earnings from operations, not distributed to shareholders. Negative when the company has accumulated deficits instead of profits.

Cost principle of asset valuation

Assets should be valued at the cost they were purchased for. Gains are only recognized once the asset is actually sold.

Illiquidity

when a firm lacks sufficient cash to meet short-term debt obligations

Insolvency

The firm's net worth is negative — total liabilities exceed total assets. Creditors can force the firm into bankruptcy.

Write-off (write-down)

When an asset's economic value is permanently less than its book value, the difference is written off, reducing the asset's stated value.

Bankruptcy

The legal status of a firm whose liabilities exceed its assets. The firm can work within the legal system to restructure back into solvency.

Liquidation

The process of bringing a business to an end and distributing its assets to claimants. Can be voluntary or mandatory (forced by creditors).

Risk

The set of possible negative outcomes, and the probabilities assigned to those outcomes. The future is not certain, but it is predictable.

Expected value

The average of the values of the various outcomes, weighted by the probability of occurrence.

Risk aversion

When an individual will pay less than the expected value for a risky project because of the inherent uncertainty of the payoff.

Diversification

Reducing risk by combining a large number of small risks whose outcomes are not correlated with each other.

Insurance

A promise of compensation if a specified outcome occurs, consisting of a premium (the cost) and a payout (the compensation if the bad event occurs).

Premium

The cost of buying insurance.

Hedging

Purchasing or selling financial instruments to offset your current risk.

Derivative

A financial instrument whose value is derived from an underlying asset, commodity, or index; a contract between two parties who agree to some future action if conditions related to the underlying asset are met.

Mortgage-backed security (MBS)

The bundling of thousands of mortgages together in a portfolio, sold in shares by the lender to other parties. Buying a share entitles you to a piece of the revenue from all future mortgage payments.

Credit default swap (CDS)

A financial agreement where the seller compensates the buyer in the event of a debt default or other credit event — essentially insurance against an asset defaulting. Anyone can make this bet, not just the original lender.

Speculation

Purchasing or selling financial instruments to gain a risky profit, based on the belief that the asset has a positive expected value.

Arbitrage

Profiting from price differences of the same asset in different markets, with little or no risk.

Moral hazard

Having insurance reduces your incentive to protect yourself against risk, since you won't bear the full cost of a bad outcome.

Adverse selection

The problem that arises when one party knows more about the quality of a good than the other; the less-knowledgeable party ends up at a disadvantage. Occurs before a contract is signed.

Asymmetric information (private information)

When one party in a transaction knows something the other doesn't. The basis for both adverse selection (pre-contract) and moral hazard (post-contract).