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For its third quarter of fiscal 2024, which ended on October 29,

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2023, NVIDIA reported a net income of 9.2 billion dollars.

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Not revenue, not cash flow—net income.

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Investors use numbers like this to assess performance and make decisions.

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But what is that number? It’s not a physical object you can

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count. It’s an abstraction, the output of a complex measurement system.

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How do NVIDIA’s executives know that’s the right number?

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More importantly, how do they convince millions of global investors, who have

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never set foot in their headquarters, that this number is a credible

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representation of economic reality? This is the central question of our course.

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We are here to understand the system that allows us to 'keep

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score' in the game of capitalism.

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It’s a system of rules, assumptions, and conventions that translates the messy,

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chaotic reality of business into a structured, comparable, and decision-useful language.

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Welcome to Accounting and Finance.

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The core problem that accounting solves is information asymmetry.

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Managers and insiders know the true financial health and performance of the

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firm, while outside investors, creditors, and other stakeholders do not.

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This information gap creates what economists, starting with George Akerlof in his

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1970 paper "The Market for Lemons," call an adverse selection problem.

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If investors cannot distinguish good firms from bad firms, they will be

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unwilling to pay a fair price for any firm, fearing they might

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be buying a 'lemon.' Capital markets would seize up.

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Good firms would be unable to raise capital for growth, and bad

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firms could perpetuate fraud. Think of the South Sea Bubble in the

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1720s or the Theranos scandal in the 2010s.

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Both were fueled by a lack of credible, standardized information.

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Accounting, therefore, is not just about bookkeeping.

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It is the fundamental mechanism we have developed to mitigate this asymmetry.

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It provides a standardized, audited language for firms to communicate their performance,

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allowing outsiders to make informed decisions and fostering the trust necessary for

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a functioning market economy.

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So what is this 'firm' that we are trying to measure?

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Legally, it's an entity, a 'person' with rights and obligations.

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But economically, it's more useful to think of the firm as a

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nexus of contracts. This is the theory famously articulated by Michael Jensen

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and William Meckling in their 1976 paper, "Theory of the Firm."

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They argued that a firm isn't a monolithic entity but rather a

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focal point for a complex set of relationships—or contracts, both explicit and

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implicit—between different parties. There are contracts with employees who provide labor, suppliers

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who provide materials, customers who buy goods, creditors who lend money, and

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shareholders who provide risk capital. The firm is simply the legal fiction

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that sits at the center of this web, simplifying the process of

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contracting among all these stakeholders. From this perspective, accounting's role becomes crystal

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clear. It is the information system that underpins these contracts.

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It provides the common language and the verifiable numbers—like revenue, cost, and

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profit—that define the terms of these agreements, measure performance, and determine how

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the economic pie generated by the firm is divided among all the

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claimants.

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The technology we use to solve this information problem is surprisingly old.

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Its formal description dates back to 1494, to a Franciscan friar and

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mathematician named Luca Pacioli. He was a friend of Leonardo da Vinci,

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and in his magnum opus on mathematics, the Summa de arithmetica, he

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included a 27-page treatise titled "Particularis de Computis et Scripturis"—Details of Calculation

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and Recording. Pacioli didn't invent the system, but he was the first

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to codify and publish a detailed description of the method used by

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the great merchants of Venice. This was the system of doppia scrittura,

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or double-entry bookkeeping. The problem these merchants faced was immense complexity.

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They were managing ventures that spanned years, involved multiple partners, extensive use

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of credit, and voyages across the known world.

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They needed a system to track who owed what to whom, what

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ventures were profitable, and the overall state of their wealth.

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Pacioli’s treatise laid out the use of journals and ledgers, and the

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fundamental principle that for every credit, there must be a corresponding and

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equal debit. This provided a robust, self-checking system for recording economic events.

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Let’s get into the engine room. How does this system actually work?

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The core insight of double-entry is that every business transaction has two

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sides, a duality. It affects at least two accounts.

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We label these two effects 'debit' and 'credit'.

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It is critical to understand that these are not moral terms.

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They are directional. 'Debit' comes from the Latin debere, 'to owe', and

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refers to the left side of an account ledger.

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'Credit' comes from credere, 'to trust' or 'to entrust', and refers to

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the right side. The fundamental rule is that for any transaction, total

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debits must equal total credits. This keeps the entire system in balance.

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Think of it this way: every economic event is a flow of

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resources. There must be a source of the resource and a use

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of the resource. For example, if a company buys a new machine

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for cash, the 'use' is the increase in its machinery assets.

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The 'source' is the decrease in its cash assets.

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One account is debited, the other is credited, for the same amount.

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What if the company buys the machine on credit?

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The 'use' is still the increase in machinery.

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But the 'source' is now an increase in its obligation to pay

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the supplier—a liability. This elegant, self-balancing logic ensures that every resource is

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accounted for, both where it is and where it came from.

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The logic of double-entry bookkeeping is elegantly summarized in a single, powerful

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identity: the fundamental accounting equation. It states that Assets equal Liabilities plus

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Equity. Let's break this down. Assets are the economic resources controlled by

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the firm from which future economic benefits are expected.

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Think cash, inventory, buildings, patents. Liabilities are the firm's obligations to non-owners.

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These are the claims of creditors—like banks or suppliers—on the firm's assets.

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Equity is what’s left over. It is the residual claim of the

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owners on the assets, after all liabilities have been settled.

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So, the equation Assets equals Liabilities plus Equity, or A equals L

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plus E, is simply stating a logical truth.

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It says that everything the company has, its resources, must be claimed

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by someone—either by outsiders, the creditors, or by insiders, the owners.

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Every transaction we record must keep this equation in balance.

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It is the bedrock on which all of financial accounting is built.

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This structure, born from Pacioli’s codification, gives rise to several powerful properties.

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First, a disciplined record. Recording a transaction with equal debits and credits

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prompts us to capture both sides of the event—the source and the

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use of funds. But a transaction omitted entirely can still leave the

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books in balance. Second, it's error-checking.

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The requirement that total debits must always equal total credits provides a

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powerful, built-in mechanism for catching mistakes.

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If the books do not balance, an error must be found and

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corrected. Balanced books, however, do not prove that every amount, account, or

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transaction is correct. Third, the system embodies the principle of duality.

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The accounting equation constantly reminds us that there's a direct link between

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what a firm does with its resources—its assets—and how it finances those

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activities, through liabilities and equity. Finally, it enforces the entity concept.

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By separating the firm's assets and liabilities from those of its owners,

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the system creates a clear boundary around the business.

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This accounting boundary applies to many business forms.

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Limited liability is a separate legal feature; keeping separate accounts does not

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create it.

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Let's make this concrete. Imagine a new startup.

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Initially, its balance sheet is all zeros.

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Transaction one: The founders invest 10,000 dollars of their own cash.

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What happens? The firm's Cash, an asset, increases by 10,000.

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Simultaneously, the owners' claim on the firm, Equity, increases by 10,000.

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Our equation is now Assets of 10k equals Liabilities of zero plus

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Equity of 10k. It balances. Transaction two: The firm gets a 5,000

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dollar loan from a bank. Cash, an asset, increases by 5,000.

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And a new liability, Loans Payable, increases by 5,000.

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The equation is now Assets of 15k, which is the 10k plus

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5k in cash, equals Liabilities of 5k plus Equity of 10k.

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It balances. Transaction three: The firm uses 3,000 dollars of its cash

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to buy equipment. Here, one asset, Equipment, goes up by 3,000, while

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another asset, Cash, goes down by 3,000.

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The total assets remain unchanged at 15,000.

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The right side of the equation is unaffected. The identity still holds.

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Notice how every single transaction maintains the balance of Assets equals Liabilities

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plus Equity.

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For all its elegance, the system has significant limitations.

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One is the use of historical cost for many assets.

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Other measurement rules, including fair value, also apply.

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We record assets at their original purchase price because that value is

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objective and verifiable. We have a receipt.

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However, the value of assets changes over time.

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A parcel of land bought for 100,000 dollars in 1980 may be

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worth 5 million dollars today, but under a historical-cost model, its carrying

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amount may remain at 100,000 dollars.

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This creates a significant divergence between a company's 'book value'—the value on

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its balance sheet—and its 'market value'—what it's actually worth.

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In this tradeoff, historical cost emphasizes verifiable transaction amounts over a current

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estimate of value. Furthermore, the system struggles mightily with intangible assets.

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How do you value a brand, a patent, a brilliant research team,

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or a company's culture? These are often the most important drivers of

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value in a modern, knowledge-based economy, yet many internally generated intangibles are

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not recognized as assets. Acquired intangibles can be recognized under the applicable

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standards. This means the financial statements, while essential, provide an incomplete and

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often distorted picture of the firm's true economic position.

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It's important at this early stage to distinguish the perspective of accounting

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from that of finance, as they are distinct but deeply related disciplines.

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Accounting is fundamentally a measurement and reporting function. It is retrospective.

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It looks at past events and transactions and records them according to

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a set of established rules, like Generally Accepted Accounting Principles or GAAP.

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The goal is to create a faithful and verifiable representation of what

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has already occurred. The financial statements—the balance sheet, income statement, and statement

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of cash flows—are the primary outputs of the accounting process.

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Finance, on the other hand, is primarily a decision-making discipline.

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It is prospective. It takes the data provided by accounting, combines it

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with forecasts and models of the future, and uses it to make

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decisions about resource allocation under uncertainty.

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Questions like 'Should we build this new factory?'

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or 'What is the intrinsic value of this company's stock?'

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are questions of finance. So, if you think of a business as

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a moving vehicle, accounting is the instrument panel, showing you your speed,

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fuel level, and engine temperature. Finance is the driver, using that information

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to decide where to go and how to get there.

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As you begin to work with these concepts, there are several common

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traps to avoid. First is confusing profit with cash.

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We will see later that under accrual accounting, a company can report

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high profits while simultaneously running out of cash and facing bankruptcy.

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They are not the same thing.

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Second is equating book value with market value.

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We've discussed this, but it bears repeating: the balance sheet uses accounting

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measurement rules, often historical cost; it is not a direct estimate of

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the firm's market value. A company's stock price reflects investors' expectations of

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future cash flows, a fundamentally different concept.

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Third, please do not attach a moral valence to debits and credits.

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They are not 'good' or 'bad'; they are simply bookkeeping conventions for

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'left' and 'right'. A debit can increase an asset, which seems good,

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but it can also increase an expense, which reduces profit.

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A credit can increase revenue, which is good, but also a liability,

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which is a claim against you. Finally, never forget the entity concept.

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The firm's finances are separate from its owners'.

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Mingling them is the root of countless legal and financial problems.

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To move beyond the textbook, you need to engage with the tools

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and primary sources used by professionals and academics.

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For a very readable and engaging history of the subject, I highly

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recommend Jane Gleeson-White's book, "Double Entry."

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To see accounting in practice, you must learn to read corporate financial

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reports directly from the source. The US Securities and Exchange Commission's EDGAR

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database is the public repository for all required filings, including the annual

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10-K report. This is your primary data source.

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For those interested in the academic frontier, the top journals to be

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aware of are The Accounting Review and the Journal of Accounting and

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Economics. Finally, for large-scale quantitative research, the workhorses of the field are

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the Compustat database, which contains standardized financial statement data, and the CRSP

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database for stock price information. These datasets may be available through an

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institutional subscription to Wharton Research Data Services, or WRDS.

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Access is not included with this course.

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Learning to navigate these resources is a critical skill.

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Here is your assignment for this week.

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I want you to go to the SEC's EDGAR database and pull

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the most recent annual report, the 10-K, for two companies: a heavy

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industrial firm like Ford Motor Company, and a technology company like Meta

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Platforms. Find the consolidated balance sheet in each report.

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Your task is not yet to understand every line item.

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Instead, I want you to look at the composition of their assets.

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For each company, calculate the value of 'Property, Plant, and Equipment' as

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a percentage of total assets. Then, find intangible assets like 'Goodwill' and

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calculate that as a percentage of total assets.

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What does the difference in these ratios tell you about the fundamental

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business models of these two firms?

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How does the accounting equation, A equals L plus E, manifest differently

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for a company whose value lies in physical factories versus one whose

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value lies in code and network effects?

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I want you to write a one-page memo summarizing your calculations and

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your analysis. This is about moving from abstract concepts to concrete observation.

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So, let's recap. The firm is an economic construct designed to organize

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production, and accounting is the language it uses to report on its

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activities. This system, rooted in the double-entry logic of Venetian merchants, provides

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the trusted information necessary for capital markets to function.

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The key takeaways are these: The firm is a 'nexus of contracts'

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that requires a common information system.

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Accounting's purpose is to reduce information asymmetry between managers and outsiders.

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Double-entry bookkeeping records paired effects and helps catch some errors; balanced books

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do not guarantee completeness or accuracy.

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The accounting equation, Assets equals Liabilities plus Equity, is the system's core

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identity. And finally, remember that many accounting values use historical cost, while

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other measurement bases also apply. Book value is not the same as

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market value. That's all for today.