Key Formulas & Frameworks
This is the foundation of double-entry bookkeeping. Every transaction affects at least two accounts.
Gross Profit: Gross Profit = Revenue − Cost of Goods Sold (COGS)
Operating Income: Operating Income = Gross Profit − Operating Expenses
Quick Ratio (Acid Test): Quick Ratio = (Current Assets − Inventory) ÷ Current Liabilities
Cash Ratio: Cash Ratio = (Cash + Marketable Securities) ÷ Current Liabilities
Debt Ratio: Debt Ratio = Total Liabilities ÷ Total Assets
Equity Multiplier: Equity Multiplier = Total Assets ÷ Total Equity
Return on Equity (ROE): ROE = Net Income ÷ Average Shareholders' Equity
DuPont Identity: ROE = Net Profit Margin × Asset Turnover × Equity Multiplier
Days Sales in Inventory: DSI = 365 ÷ Inventory Turnover
Receivables Turnover: Receivables Turnover = Net Credit Sales ÷ Average Accounts Receivable
Double-Declining Balance: Depreciation Expense = (2 ÷ Useful Life) × Book Value at Beginning of Year
Break-Even Point (Sales $): BEP = Fixed Costs ÷ Contribution Margin Ratio
Contribution Margin: CM = Sales − Variable Costs
Net Present Value: NPV = Σ [CFt ÷ (1+r)t] − Initial Investment
Internal Rate of Return: The discount rate that makes NPV = 0
Price-Earnings Ratio: P/E = Market Price per Share ÷ EPS
Gross Margin: Gross Margin = (Revenue − COGS) ÷ Revenue × 100%
Core Concepts
Double-Entry Bookkeeping
Every financial transaction affects at least two accounts — one account is debited and another is credited, with total debits always equaling total credits. This system ensures the accounting equation (Assets = Liabilities + Equity) remains balanced.
Accrual Basis Accounting
Revenue is recognized when earned (not when cash is received), and expenses are recognized when incurred (not when cash is paid). This matches revenues with the expenses that generated them, providing a more accurate picture of financial performance than cash-basis accounting.
GAAP (Generally Accepted Accounting Principles)
The standard framework of guidelines for financial accounting used in the United States. Key principles include: Revenue Recognition Principle, Matching Principle, Full Disclosure Principle, Cost Principle, and Conservatism Principle.
The Accounting Cycle
The 8-step process: (1) Analyze transactions, (2) Journalize entries, (3) Post to ledger, (4) Prepare unadjusted trial balance, (5) Prepare adjusting entries, (6) Prepare adjusted trial balance, (7) Prepare financial statements, (8) Close temporary accounts.
Financial Statements
The four primary statements: (1) Income Statement — revenues, expenses, and net income over a period; (2) Balance Sheet — assets, liabilities, and equity at a point in time; (3) Cash Flow Statement — cash inflows/outflows from operating, investing, and financing activities; (4) Statement of Changes in Equity — changes in owners' equity over a period.
Depreciation & Amortization
Depreciation allocates the cost of tangible assets (machinery, buildings) over their useful lives. Amortization does the same for intangible assets (patents, copyrights). Common methods include straight-line, declining balance, and units of production.
Internal Controls
Processes designed to ensure reliability of financial reporting, compliance with laws, and operational efficiency. Key components (COSO Framework): Control Environment, Risk Assessment, Control Activities, Information & Communication, and Monitoring Activities.
Cost Accounting
The branch of accounting focused on capturing a company's total cost of production by assessing variable and fixed costs. Key concepts include job costing, process costing, activity-based costing (ABC), and standard costing with variance analysis.
Worked Examples & Case Studies
Example 1: Journal Entries
Transaction: A company purchases equipment for $10,000 cash.
Journal Entry:
Debit: Equipment (Asset) — $10,000
Credit: Cash (Asset) — $10,000
Effect on Accounting Equation: Assets (Equipment +$10,000, Cash −$10,000) = No net change. Liabilities = No change. Equity = No change. Equation remains balanced.
Example 2: Break-Even Analysis
Problem: A company sells widgets at $50 each. Variable costs are $30 per unit. Fixed costs are $100,000 per year. Calculate the break-even point in units and dollars.
Solution: Contribution Margin per unit = $50 − $30 = $20. BEP (units) = $100,000 ÷ $20 = 5,000 units. BEP (dollars) = 5,000 × $50 = $250,000. CM Ratio = $20 ÷ $50 = 40%. BEP (dollars) = $100,000 ÷ 0.40 = $250,000 ✓
Example 3: Financial Ratio Analysis
Problem: A company has: Current Assets = $500,000 (including Inventory = $200,000), Current Liabilities = $250,000, Total Assets = $1,200,000, Total Liabilities = $600,000, Net Income = $120,000.
Solution:
Current Ratio = 500,000 ÷ 250,000 = 2.0
Quick Ratio = (500,000 − 200,000) ÷ 250,000 = 1.2
Debt-to-Equity = 600,000 ÷ 600,000 = 1.0
ROA = 120,000 ÷ 1,200,000 = 10%
ROE = 120,000 ÷ 600,000 = 20%
Case Study: Enron Scandal (2001)
Background: Enron, once the 7th largest US company, used Special Purpose Entities (SPEs) to hide billions in debt from its balance sheet. Mark-to-market accounting allowed them to book projected future profits as current revenue.
Accounting Failures: (1) Off-balance-sheet financing through SPEs, (2) Inflated revenue recognition, (3) Conflict of interest (CFO Andrew Fastow profited from SPEs), (4) Auditor complicity (Arthur Andersen shredded documents). Result: $74 billion in shareholder value destroyed, bankruptcy, and the Sarbanes-Oxley Act of 2002.
Case Study: Inventory Valuation — FIFO vs. LIFO
Scenario: A company has the following inventory transactions: Jan 1: 100 units @ $10; Jan 15: 200 units @ $12; Jan 31: Sold 250 units.
FIFO: COGS = (100 × $10) + (150 × $12) = $1,000 + $1,800 = $2,800. Ending Inventory = 50 × $12 = $600.
LIFO: COGS = (200 × $12) + (50 × $10) = $2,400 + $500 = $2,900. Ending Inventory = 50 × $10 = $500.
Analysis: In inflationary periods, LIFO produces higher COGS (lower taxable income) but lower reported inventory values. FIFO produces lower COGS (higher net income) but higher inventory values on the balance sheet.
Practice Problems
Problem 1: A company has Assets of $300,000 and Liabilities of $180,000. What is Owner's Equity?
Answer: Equity = Assets − Liabilities = 300,000 − 180,000 = $120,000
Problem 2: Revenue is $500,000, COGS is $300,000, and Operating Expenses are $120,000. Calculate Gross Profit, Operating Income, and Net Income (assuming no taxes or interest).
Answer: Gross Profit = 500,000 − 300,000 = $200,000. Operating Income = 200,000 − 120,000 = $80,000. Net Income = $80,000.
Problem 3: Beginning Inventory = $50,000, Purchases = $200,000, Ending Inventory = $70,000. Calculate COGS.
Answer: COGS = 50,000 + 200,000 − 70,000 = $180,000
Problem 4: A machine costs $50,000 with a salvage value of $5,000 and a useful life of 5 years. Calculate annual depreciation using straight-line method.
Answer: Annual Depreciation = (50,000 − 5,000) ÷ 5 = $9,000 per year
Problem 5: Net Income = $200,000, Average Total Assets = $2,000,000, Average Equity = $1,000,000. Calculate ROA and ROE.
Answer: ROA = 200,000 ÷ 2,000,000 = 10%. ROE = 200,000 ÷ 1,000,000 = 20%.
Problem 6: A company has Current Assets of $400,000, Inventory of $150,000, and Current Liabilities of $200,000. Calculate the Current Ratio and Quick Ratio.
Answer: Current Ratio = 400,000 ÷ 200,000 = 2.0. Quick Ratio = (400,000 − 150,000) ÷ 200,000 = 1.25.
Problem 7: An investment costs $100,000 and generates cash flows of $30,000/year for 5 years. The discount rate is 10%. Calculate NPV.
Answer: NPV = 30,000 × [1 − (1.10)−5] ÷ 0.10 − 100,000 = 30,000 × 3.7908 − 100,000 = 113,724 − 100,000 = $13,724. Since NPV > 0, accept the project.
Problem 8: A company has Net Credit Sales of $600,000 and Average Accounts Receivable of $75,000. Calculate Receivables Turnover and Days Sales Outstanding (DSO).
Answer: Receivables Turnover = 600,000 ÷ 75,000 = 8 times. DSO = 365 ÷ 8 = 45.6 days.