George Diianni, CPA

In accounting, adjusting entries are journal entries that are prepared at the end of a company’s fiscal year to correct the balances of certain accounts. Why are they necessary? The reason is that certain accounts are too much trouble to keep accurate on a daily basis. It is not important for these accounts to be accurate every day, but they do need to be accurate at the end of the company’s fiscal year, because that is when the financial statements are prepared. For example, it would be too much trouble to reduce the balance of the Office Supplies account every time an employee grabs a pencil or a pad of paper out of the supply closet, so this account is allowed to have an inaccurate balance until the balance is corrected by an adjusting entry at the end of the company’s fiscal year.

Since public companies must issue financial statements every quarter, they would need to do the adjusting entries at the end of each quarter. Companies that would like to prepare financial statements for their own use every month would need to do the adjusting entries at the end of each month.

Once a month Americans hear about 2 unemployment statistics – the unemployment rate and the labor force participation rate – so let’s see how these numbers are calculated. Every month the Bureau of Labor Statistics surveys many households and classifies each adult surveyed as employed, unemployed, or not in the labor force. The employed category includes adults who are self-employed or who are employed by others either full-time or part-time. The unemployed category includes adults who are not currently employed but who are available for work and have sought employment in the last 4 weeks or are temporarily laid off from their jobs. All adults who are not classified as employed or unemployed are classified as not in the labor force.

Based on the number of adults found to be in each of these categories, the BLS makes the following calculations:

Labor Force = number of adults employed + number of adults unemployed

Unemployment Rate = number of adults unemployed / number of adults in the labor forced

Labor Force Participation Rate = number of adults in the labor force / total adult population

In economics, the law of demand states that people will buy more of a product if its price is lower, and conversely they will buy less of a product if its price is higher, all other things being equal. Therefore, if at your local supermarket tomatoes were selling for $3 per pound last week, and $2 per pound this week, the law of demand says that people will buy more tomatoes this week than they did last week, all other things being equal.

The phrase “all other things being equal” is very important. For example, if people did not buy more tomatoes this week even though the price is lower than it was last week because the quality of the tomatoes this week is much lower than the quality of the tomatoes last week, this would not disprove the law of demand, since in this case all other things are not equal – the quality of the product has changed.

Sometimes what has changed is not the quality of the product itself but people’s perception of the quality of the product. For example, I was once told by a gas station attendant that the gas station had recently temporarily lowered the price of the gas to $1 per gallon because they wanted to get rid of the gas for some reason. However they were surprised to see that nobody would buy the gas at $1 per gallon because people thought that if they were willing to sell the gas at such a low price there must be something wrong with the gas. Actually the quality of the gas had not changed at all. What might seem like a violation of the law of demand really was not a violation. Although the quality of the gas had not changed, people’s belief about the quality of the gas had changed, so all other things were not equal.

The central limit theorem is an important concept in statistics, and it tells us 2 things. The first thing it tells us is that if we draw thousands of samples of a particular size from a population that is normally distributed, the means (averages) of those samples will also be normally distributed, regardless of the sample size. (The sample size is the number of people, or observations, in each sample.) For example, if the weights of the students at a particular school are normally distributed, and we drew thousands of samples from this population with 10 students in each sample, the means of those samples would also be normally distributed. The sample means would also be normally distributed if there were just 2 students in each sample, or 2,000 students in each sample, or any other number, as long as the weights of all the students at the school follow a normal distribution, also known as the bell curve.

The central limit theorem tells us a second thing, which is that even if a population is not normally distributed, the means of the samples drawn from that population will be approximately normally distributed, as long as the sample size is at least 30. Therefore if the weights of the students at this school do not follow a normal distribution, and we draw thousands of samples of a particular size from this school, the sample means would be approximately normally distributed, as long there were at least 30 students in each sample. This is important because it means that as long as we include at least 30 observations in a sample, we can assume that the sample means for samples of that size are normally distributed and possess the properties of normal distributed data, regardless of whether the population from which the sample is drawn is itself normally distributed.

When you hear people say that the stock market was “up 80 points today” or “down 200 points today”, they are generally referring to the Dow Jones Industrial Average (often just called “the Dow”), which is the most widely followed indicator of how the United States stock market is doing. The Dow is an index of the stocks of 30 of the largest corporations in the United States. This index is price-weighted, which means that stocks that have higher prices carry more weight in the index than stocks with lower prices.When you hear people say that the stock market was “up 80 points today” or “down 200 points today”, they are generally referring to the Dow Jones Industrial Average (often just called “the Dow”), which is the most widely followed indicator of how the United States stock market is doing. The Dow is an index of the stocks of 30 of the largest corporations in the United States. This index is price-weighted, which means that stocks that have higher prices carry more weight in the index than stocks with lower prices.When you hear people say that the stock market was “up 80 points today” or “down 200 points today”, they are generally referring to the Dow Jones Industrial Average (often just called “the Dow”), which is the most widely followed indicator of how the United States stock market is doing. The Dow is an index of the stocks of 30 of the largest corporations in the United States. This index is price-weighted, which means that stocks that have higher prices carry more weight in the index than stocks with lower prices.When you hear people say that the stock market was “up 80 points today” or “down 200 points today”, they are generally referring to the Dow Jones Industrial Average (often just called “the Dow”), which is the most widely followed indicator of how the United States stock market is doing. The Dow is an index of the stocks of 30 of the largest corporations in the United States. This index is price-weighted, which means that stocks that have higher prices carry more weight in the index than stocks with lower prices.

Although it does not get as much attention, a better measure of the performance of the American stock market is the Standard & Poor’s 500 Index. It is better for 3 main reasons. First, it includes many more stocks than the Dow, 500 as opposed to only 30 for the Dow. Second, it includes stocks from many industries that are not represented in the Dow. Third, instead of being weighted by the price of each stock, it is weighted by the total market value each stock. The total market value of a company’s stock is called its market capitalization, or just its “market cap”. A stock’s market capitalization = the number of outstanding shares of a stock times the price of one share of the stock. For example, if there are 2 billion shares of a stock outstanding and the price of the stock is $40 per share, the market cap of the stock would be 2 billion X $40 = $80 billion.

It is important to remember that what matters is the percentage change in these indexes, not the point change. For example, on October 19, 1987, the Dow was down over 500 points in one day, which was a drop of over 20% at that time. This meant that many stocks lost over 20% of their value that day, the worst day in the history of the stock market. With the Dow now around 35,000 at the time I am writing this, a 500 point drop in the Dow would not be nearly as terrible, because it would be a drop of less than 2%.

Convertible securities are bonds or preferred stocks that can be converted by the holder of such securities into a fixed number of shares of the common stock of the issuer of the convertible seccurity. This gives the holders of convertible securities the potential to profit if the issuer’s common stock rises substantially.

A convertible bond pays interest to the bondholder just like most other bonds do. Suppose that based on the amount of interest it pays, a convertible bond issued by QXZ Corporation would sell for $900 if it was not convertible, and the price of QXZ’s common stock is $10 per share. Suppose further that this bond can be converted into 40 shares of the common stock of QXZ. If the price of a share of QXZ’s common stock were to rise from $10 per share to $35 per share, the holder of the convertible bond could exchange it for common stock of QXZ worth 40 x $35 = $1,400. On the other hand, if the QXZ common stock price falls to $2 per share or lower, the price of the convertible bond described above is unlikely to fall significantly below $900, as long as a similar QXZ bond would sell for $900 if it was not convertible. Convertible preferred stocks work similarly, except of course they pay dividends, not interest.

Since the opportunity to exchange a convertible security into the issuer’s common stock is such a wonderful feature, why would anyone want to buy a bond or a preferred stock that is not convertible? Finance professors like to say that there is no such thing as a free lunch. Because of the attractiveness of the convertibility feature, the issuers of convertible securities know they can get away with paying an interest rate (on a convertible bond) or a dividend (on a convertible preferred stock) that is significantly lower than the interest rate or dividend on comparable nonconvertible securities. Therefore, investors in convertible securities are sacrificing some interest or dividends in order to get the convertibility feature.

Convertible securities are often very complicated and may contain some provisions that make these securities less beneficial for their holders, so most people who want to invest in convertible securities would be better off buying shares in a mutual fund, closed-end fund, or ETF that invests in such securities.

There are 2 types of stocks – common and preferred. Every corporation has common stock; a much smaller number have preferred stock. Both types of stock represent ownership of a corporation, and the owners of both types of stock may receive dividends from the corporation if the corporation’s board of directors declares (announces that it will pay) those dividends. (A dividend is a distribution to the stockholders of some of a corporation’s profits.) However, there are major differences between the 2 types of stocks.

The common stockholders control the corporation, at least in theory, because they elect the board of directors that oversees the management of the corporation. If a company goes bankrupt, the preferred stockholders would be paid before the common stockholders, and sometimes there is no money left to give to the common stockholders after the preferred stockholders have been paid what they are entitled to.

With some exceptions, the annual dividend on a preferred stock is a fixed amount that is specified when the preferred stock is first issued to the public. This specified amount never changes no matter well or how poorly the company is performing. Unlike with the interest on bonds, a corporation will not be declared to be in default if it fails to pay the preferred stockholders some or all of their specified fixed dividend in a particular year. However, the corporation cannot pay any dividends to the common stockholders in a particular year unless the preferred stockholders receive the full amount of their specified fixed dividend in that year, and also receive, if the stock is a “cumulative” preferred stock, any dividends that the corporation failed to pay to the preferred stockholders in previous years. (If the preferred stock is “noncumulative”, any dividend that the corporation fails to pay to those preferred stockholders in a particular year will generally never be paid to them).

By contrast, the dividend on a common stock is not fixed. Very often a company’s board of directors will increase the dividend on a common stock when the company’s profits are rising, and sometimes a company’s board of directors will decrease the dividend on a common stock when the company’s profits are declining. Many common stockholders have become wealthy by holding their stock for many years while the company they owned stock in saw its profits rise tremendously over the years, which resulted in a tremendous increase in the dividends paid to those stockholders and a tremendous increase in the price of the stock.

What is the difference between a stock and a bond? A stock represents ownership of a corporation, while a bond represents a loan to a corporation or to a government. Every corporation has what is called common stock. (There is another type of stock called preferred stock, which I will discuss in another post. When people talk about stocks, they are almost always talking about common stocks.) The common stock of a company is divided into shares. If a company has 2,000 shares of common stock and no preferred stock, and you own 300 of the common shares, you own 300/2,000 = .15 = 15% of the company. If the company decides to distribute some of its profits to the owners of the company’s stock, the money that is distributed to the owners is called a dividend, and you would be entitled to receive 15% of the dividends.

On the other hand, if you buy a bond that is issued by that company, you have loaned money to that company, and you are called a bondholder. The bond entitles you to get back a certain amount of money, called the face value, or par value, of the bond, at some point in the future when the bond expires. It also entitles you to receive interest on the money you loaned to the company in the meantime. The face value and the amount of interest paid each year to the bondholders are fixed by the bond’s contract, and there are serious consequences to a company if it fails to pay either the interest or the face value to the bondholders.

If you are in a statistics course, it is important to be careful when calculating the variance or the standard deviation for a set of numbers. The reason is that the formula for the variance is slightly different when the data set is a sample as opposed to when it is a population. Therefore the variance itself will be different when the data set is a sample as opposed to when it is a population. When the data set is a population the denominator in the formula to calculate the variance is the number of numbers in the data set, whereas if the data set is a sample the denominator is the number of numbers in the data set minus one. In math a smaller denominator makes the result bigger, so the variance will be larger if the data set is a sample. Many students have had an answer marked wrong on an exam because they did not pay attention to whether the teacher said the data set was a population or a sample.

Since the standard deviation is simply the square root of the variance, the standard deviation will also be larger if the data set is a sample rather than a population, so the same word of caution applies when you are calculating the standard deviation – pay attention to whether the data set is a population or a sample.

As I discussed in my previous blog post, one definition of money is known as the “M-1 money supply”. The M-1 money supply is defined as paper money and coins in the hands of the public, checking accounts, and traveler’s checks. It does not include paper money or coins held by banks, nor does it include checking accounts owned by the United States Treasury. These are the things we can most easily use to purchase goods and services.

However, there is a second definition of money used by the Federal Reserve, which is the central bank of the United States, and it is called the “M-2 money supply”. The M-2 money supply is larger than the M-1 money supply, because it includes the all of the M-1 money supply plus several other items. Those other items included in M-2 are money market mutual funds and 3 types of bank accounts – savings accounts, money market deposit accounts, and time deposits (also called “certificates of deposit”) that are less than $100,000.

Some economists have devised other definitions of money for their own use, but M-1 and M-2 are the definitions used by the Federal Reserve, so M-1 and M-2 are very closely watched for clues about the future performance of the American economy.

It may seem silly to ask, “What is money”? We all know that those pieces of paper and those coins we use to buy things are money. However, economists define money more broadly than paper money and coins. After all, we often buy things by writing a check, so economists also consider what you have in your checking account at a bank to be money too.

Economists actually have more than one definition of money. One definition of money is known as the “M-1 money supply”. (There is also an M-2 money supply that I will talk about in my next blog post.) The M-1 money supply is defined as paper money and coins in the hands of the public, checking accounts, and traveler’s checks. It does not include paper money or coins held by banks, nor does it include checking accounts owned by the United States Treasury. These are the things we can most easily use to purchase goods and services. By the way, even though we often use a credit card to buy things, credit cards are not considered to be money, perhaps because when you buy things with a credit card you are just borrowing money that you eventually have to pay back with actual money – paper money, coins, or checks. So credit cards are just a convenient way of buying things that you will actually pay for later.

The real interest rate is the rate that lenders earn, and borrowers pay, after adjusting for inflation. For example, if you loan someone money for one year, and one year later that person pays you back the money you loaned them plus 5% interest, you now have 5% more money than you did when you made the loan. However, if you take that money to the store and you find that everything costs 3% more than it did a year ago when you made the loan, you have not really gained 5% in terms of your purchasing power – how much you are able to buy. You can only buy approximately 2% more goods with the money you got back from the borrower, calculated as 5% - 3%, so we say that your real interest rate was approximately 2%. I used the word approximately because this method of using subtraction to find the real interest rate only gives you an approximation of the real interest rate; a more accurate calculation of the real interest rate requires a slightly more complicated formula that uses division, not subtraction. However, the subtraction method of finding the real interest rate is often used when a more precise calculation is not needed. In my example above the 5% that you charged the borrower is called the nominal interest rate, and the 3% increase in the price of goods is called the inflation rate.

In financial accounting, which is different from accounting for income tax purposes, a revenue occurs when a business earns money by providing goods or services to a customer. An expense occurs when a business incurs a cost of producing that revenue. Revenues increase a company’s profit (net income), while expenses reduce a company’s profit.

Financial accounting is done on an accrual basis. This means that a revenue is recognized when a business provides goods or services to a customer even if the customer has not yet paid for the goods or services and still owes money for them. Likewise an expense is recorded whenever the business incurs it, even though the company has not yet paid the money it owes for that expense. For example, when a business receives a phone bill for $100, a $100 expense is recorded immediately even if the company does not pay the bill right away.

Why does accrual accounting make sense? The reason is that accountants know that a business would not provide products or services to a customer before the customer pays for them if the company was not very confident that the customer would eventually pay for them, so accountants assume that the company will eventually be paid for the goods or services. (They also record an expense called bad debt expense if a certain percentage of the customers are expected to not pay what they owe.) Likewise, it is reasonable for an accountant to assume that the company will eventually pay for the expenses it has incurred.

Think of it this way: If you win a million dollars in the lottery, you immediately feel richer, even though you have not yet received the money, because you are confident that you will receive it. Likewise, if you receive a bill for $200 from the cable company, you immediately feel poorer even if you don’t pay the bill right away, because you know you will have to pay the bill eventually. That’s the rationale behind accrual accounting.