Key Concept Cohort One - Units 2 & 3 Review
Role and Purpose of Accounting
Analyze Transactions: Accounting systems help to dissect and understand individual financial events.
Handle Routine Bookkeeping: They automate and manage daily financial record-keeping tasks.
Structure Information: Accounting systems organize financial data to facilitate the evaluation of a company's performance and overall health.
The Accounting Cycle and Financial Statements
End Goal: The ultimate aim of the accounting cycle is the preparation of general-purpose financial statements.
Users: These statements are primarily for external users (investors, creditors) but are also used internally for decision-making.
Key Financial Statements:
Balance Sheet
Income Statement
Statement of Cash Flows
Special Reports: Additional reports may be required for entities like the SEC, IRS, or other government bodies.
Managerial vs. Financial Accounting
Managerial Accounting (Forward-Thinking): Focuses on future planning, looking at where the business is today and where it's headed. It uses historical data as a basis but emphasizes future decisions.
Financial Accounting (Historical Focus): Concentrates on past performance, using historical numbers to make decisions based on what has already occurred within the company.
Steps in the Accounting Cycle
Analyze Transactions: Identify the financial impact of business activities.
Record Transactions: Document these financial events in the accounting system.
Summarize Effects: Aggregate the recorded transactions to see their cumulative impact.
Prepare Financial Statements: Generate the final reports to evaluate company performance and aid decision-making. This is a continuous, ongoing cycle.
The Basic Accounting Equation
Foundation of Accounting: This is a crucial concept, representing the core relationship between a company's resources and claims against those resources.
Equation: \text{Assets} = \text{Liabilities} + \text{Owner's Equity}
This equation must always remain in balance.
Nomenclature for Equity: Owner's Equity can also be referred to as Partner's Equity (for partnerships) or Stockholder's/Shareholder's Equity (for corporations).
Memory Aid: Some students use the acronym "ALE" to remember Assets, Liabilities, and Equity.
Balance Sheet Connection: The accounting equation is essentially the structure of the balance sheet.
Components of the Accounting Equation
Assets: Something the company owns that has value.
Examples: Cash, Equipment, Inventory, Property, Accounts Receivable (money owed to the company for credit sales).
Liabilities: Think debt. Amounts owed by the company for goods/services purchased on credit.
Keyword: "Payable" generally indicates a liability (e.g., Accounts Payable, Notes Payable).
Example: When a company buys something on credit from a vendor.
Equity: The owners' investment in the company.
Examples:
Owner's Investment: Cash or other assets invested by the owner at startup.
Retained Earnings: Cumulative profit of the company that has not been distributed to owners (net income less dividends).
Common Stock: Represents shares issued to owners/investors.
Expanded Accounting Equation and Impact on Equity
Expanded Retained Earnings: \text{Retained Earnings} = \text{Beginning Retained Earnings} + \text{Revenue} - \text{Expenses} - \text{Dividends}
Impact on Equity:
Increase in Revenue: Increases equity.
Increase in Expenses: Decreases equity.
Payment of Dividends: Decreases equity.
Chart of Accounts
Purpose: An organized system (like an index) used to categorize and track all financial transactions.
Structure: Typically includes an account title and an associated reference number.
Order: Accounts are generally listed in financial statement order: Assets, Liabilities, Equity, Revenues, and then Expenses.
Key Account Types Explained
Revenue Accounts: Recorded when a product is sold or a service is performed.
Expense Accounts: Costs incurred during normal business operations.
Examples: Utility Expense, Payroll Expense, Cost of Goods Sold, Marketing/Advertising Expense.
Dividends: Money distributed from the company's earnings to its stockholders or owners. Decreases equity.
Analyzing Transactions and Their Impact
Understanding the impact of transactions on the accounting equation (rather than debits/credits) is essential.
Owner Investment: Tivo invested $110,000 cash and $55,000 office equipment.
Accounts Affected: Cash (Asset), Office Equipment (Asset), Owner's Equity.
Impact: Assets \uparrow (110,000 + $55,000 = $165,000), Equity \uparrow (165,000).
Balance: Equation remains in balance.
Purchase Equipment with Note Payable: Company purchased computer equipment by using a note payable for $75,000.
Accounts Affected: Computer Equipment (Asset), Note Payable (Liability).
Impact: Assets \uparrow (75,000), Liabilities \uparrow (75,000).
Balance: Equation remains in balance.
Purchase Supplies on Credit: Company purchased $20,000 of computer supplies on credit.
Accounts Affected: Computer Supplies (Asset), Accounts Payable (Liability).
Impact: Assets \uparrow (20,000), Liabilities \uparrow (20,000).
Balance: Equation remains in balance.
Billed Customer for Services: Company billed a customer $7,800 for services provided.
Accounts Affected: Accounts Receivable (Asset), Service Revenue (Equity affecting).
Impact: Assets \uparrow (7,800), Equity \uparrow (7,800 due to revenue increase).
Balance: Equation remains in balance.
Paid Half of Credit Purchase: Company paid half of the balance due from a previous credit purchase ($10,000).
Accounts Affected: Cash (Asset), Accounts Payable (Liability).
Impact: Assets \downarrow (10,000), Liabilities \downarrow (10,000).
Balance: Equation remains in balance.
Purchased Advertising on Credit: Company purchased advertising, payment due in 30 days for $950.
Accounts Affected: Advertising Expense (Equity affecting), Accounts Payable (Liability).
Impact: Equity \downarrow (950 due to expense increase), Liabilities \uparrow (950).
Balance: Equation remains in balance.
Collected Balance Due: Company collected $7,800 from the customer previously billed.
Accounts Affected: Cash (Asset), Accounts Receivable (Asset).
Impact: Assets \uparrow (Cash by 7,800), Assets \downarrow (Accounts Receivable by 7,800).
Balance: Total assets remain unchanged; equation remains in balance.
Received and Paid Utility Bill: Company received and paid a utility bill for $900.
Accounts Affected: Cash (Asset), Utility Expense (Equity affecting).
Impact: Assets \downarrow (900), Equity \downarrow (900 due to expense increase).
Balance: Equation remains in balance.
Consulted for Customer (Part Cash, Part Credit): Company consulted for $3,500; customer paid half, remainder due in two weeks.
Accounts Affected: Cash (Asset), Accounts Receivable (Asset), Service Revenue (Equity affecting).
Impact: Assets \uparrow (Cash by 1,750), Assets \uparrow (Accounts Receivable by 1,750), Equity \uparrow (Service Revenue by 3,500).
Balance: Equation remains in balance (1,750 + 1,750 = 3,500 for assets, \text{Revenue} = 3,500 for equity).
Flow of Information: From Transactions to Financial Statements
Summarized Balances: The end balances of all accounts (cash, equipment, liabilities, etc.) after all transactions flow to the balance sheet.
Income Statement First: The income statement is prepared first, calculating net income (Revenue - Expenses).
Example: If net income is $9,450 for the period, this is a provisional total.
Closing Entries: Net income/loss from the income statement must be transferred to the owner's equity account on the balance sheet through a "closing entry." This ensures the balance sheet's assets equal liabilities plus equity.
Impact: Increases equity by the amount of net income (or decreases for a net loss).
Key Differences: Income Statement vs. Balance Sheet
Income Statement
Components: Only shows revenue and expense accounts.
Purpose: Measures how well the company is operating (profitability).
Time Frame: Over a period of time (e.g., for the month ended, quarter ended, year ended). It has a defined start and end date.
Balance Sheet
Components: Only shows asset, liability, and equity accounts.
Purpose: Shows the financial picture or position of the company (what it owns, owes, and owner's investment).
Time Frame: At a point in time (e.g., as of 30 November). It's a snapshot, like the balance in a bank account on a specific date.
Crucial: Know which types of accounts belong to which financial statement.
Financial Statement Analysis
Horizontal Analysis
Approach: Compares financial data across years.
Purpose: To analyze changes and trends in performance from one year to the next.
Focus: Determining if changes (e.g., in revenue or cost of goods) were expected.
Formula: Requires calculating the percent change from a base year to a current year.
Vertical Analysis
Approach: Compares line items downward within a single financial statement (e.g., income statement) as a percentage of a base amount.
Income Statement Base: Typically uses total revenue (or sales) as the base (100\%).
Calculation: Each line item (e.g., Cost of Revenue, Operating Expenses) is divided by total revenue to express it as a percentage of revenue.
Example: \frac{\text{Research and Development Expenses}}{\text{Revenue}} = 13.34\%
Purpose:
To understand the proportional relationship of each item to the base amount.
To identify areas of potential concern (e.g., operating expenses increasing as a percentage of sales).
For internal comparison across different periods (e.g., comparing % of sales for marketing from one year to the next).
For external comparison with other companies in the same industry.
Assessment Tips for Financial Analysis
Formulas are Key: For assessments, the focus is on correctly applying formulas (e.g., using absolute references, copying/pasting formulas correctly) rather than just getting the correct numerical percentage.
Managerial Focus: Pay attention to line items that have a substantial impact on the bottom line from a managerial perspective, such as:
Sales
Cost of Goods Sold (COGS) – often a large dollar amount, can be constant as a % of sales.
Operating Expenses – can show significant year-to-year changes as a % of sales.
Less Focus: Interest and tax expenses are generally smaller and less emphasized for analysis in this course.
Significance of Small Changes: Even a seemingly small percentage change (e.g., 5% increase in operating expenses as a percent of sales) can represent a very large dollar amount and significantly impact net income.
Resources: Additional videos are available on the course resource page to provide more specific details on formulas and analytical techniques.