Everything boils down to A = L + E

Everything in a double-entry accounting system is based on one equation:

A = L + E

Some historian might try and tell you the most important equation is Einstein's general relativity equation,  E = MC², but don't believe them. The most important equation is the one in the title.

I'll go into these components a little more in depth in a later post, but for now I'll briefly introduce them. And check out this picture:

A is for assets. They are any resource that may change the value of the business.

L is for liabilities. They are promises or obligations to pay back creditors in money or some other asset. If you started a business and bought the assets with money you borrowed from the bank, that is a liability.

E is for Equity. Some people call it "owner's equity", "stockholders' equity", "capital", "net assets" or some other name. It is a claim of ownership. So if you start a business with your own money, the assets you buy are owned by you.

Assets must always equal liabilities plus equity. If one side increases, then the other side must also increase (or a component of the same side must decrease). Like I said, I'll go into detail in a later post, but for now know A = L + E.

Here are some free resources I found online, that you can check out if you want more on the subject:

http://www.youtube.com/watch?v=SRf_M1NRru4

http://www.accountingcoach.com/online-accounting-course/14Xpg01.html

http://www.investopedia.com/terms/a/accounting-equation.asp

http://en.wikipedia.org/wiki/Accounting_equation
http://www.cliffsnotes.com/study_guide/The-Accounting-Equation.topicArticleId-21081,articleId-21003.html

Accounting Basics

The purpose of this blog was originally to help aspiring accountants study for the CPA Exam. This unavoidably involves advanced and heavily technical material, and may scare away beginner's looking for insight on basic concepts. In order to appeal to a wider audience, I'm going to include some posts on the basics of accounting and build on that. The general outline for the next few posts will explain:

1. the fundamental accounting equation
2. assets, liabilities and equity
3. income and expenses
4. debits and credits, double-entry bookkeeping
5. financial statements - the balance sheet
6. financial statements - the income statement
7. financial statements - statement of cash flows
8. financial statements - statement of retained earnings

This is the plan for now but may change as feedback comes in. I will provide explanations of my own as well as link to other resources I find helpful. Accounting, like the alphabet or the decimal number system, takes practice and repetition. Starting out, some concepts may be difficult to grasp, but with enough practice, you will work your way to countless "a-ha" moments. There is a learning curve, and with enough practice you can get over it. And it will be glorious.

Started studying for REG...

Skipped ahead to federal taxation of individuals (since it's the most heavily tested), and here's a quick tip on reporting annuities:

"If a taxpayer dies before total cost of the annuity is recovered, unrecovered cost is allowed to be deducted as a miscellaneous expense on the taxpayor's final tax return."

Lol.

A quick basic EPS calculation

Remember with basic EPS calculations to subtract dividends from preferred stock when they are cumulative, whether they're declared or not. Here is a problem out a practice book to illustrate:

During the current year, Dan's Co. had outstanding: 25,000 shares of common stock, 8,000 shares of $20 par, 10% cumulative preferred stock, and 3,000 bonds that are $1,000 par and 9% convertible. The bonds were originally issued at par, and each bond was convertible into thirty shares of common stock. During the year, net income was $200,000, no dividends were declared, and the tax rate was 30%. What amount was Dan's basic earnings per share for the current year?

a. $3.38
b. $7.36
c. $7.55
d. $8.00

The EPS equation goes like this:

EPS  =

Net Income – Preferred Dividends Weighted Avg. Common Shares

The problem has a bunch of extra information, but basically we need Net Income ($200,000) and Preferred Dividends ($16,000 = 8,000 * $20 * 10%) for the numerator (top) and # of shares outstanding (25,000) for the denominator (bottom). When you plug those numbers into the equation above, you get $7.36, answer b. If you didn't subtract preferred dividends from net income, then you would have arrived at the sucker answer of d., with an EPS of $8.00.

The math here is simple, the tricky part comes in knowing to subtract cumulative preferred dividends, even though none were declared. The stuff about convertible bonds would have been relevant if the problem asked for diluted EPS, instead of basic.

SFAS No. 128 provides all the guidance you'll want on EPS. For further guidance SFAS 128 was amended by SFAS 150 and 160.

Percentage of completion method, a practice problem from a CPA book

This is an old problem about the percentage-of-completion (p-o-c) method that I have seen in two different books I'm studying out of for the FAR, and it goes like this:

1. Some Co. recognizes construction revenue and expenses using the percentage-of-completion method. During 2010, a single long-term project commenced, which concluded at the end of 2011. Information on the project follows:

	2010	2011
Accounts receivable from contract	$100,000	$300,000
Construction expenses	105,000	192,000
Construction in progress	122,000	364,000
Partial billings on contract	100,000	420,000

Profit recognized from the long-term construction contract in 2011 should be:

a. $50,000
b. $108,000
c. $128,000
d. $228,000

The question is asking us to calculate 2011 Profit. Normally profit for a construction contract calculated under the p-o-c method would be calculated using this formula:

Profit  =

Σ CTD Σ CTC

(Contract price – Σ CTC) – PY Profit

Where:
Σ CTD is Total Costs To Date;
Σ CTC is Total Expected Costs To Completion;
Contract Price is the total price of the contract;
and PY Profit is the profit recognized in Prior Years.

It may seem scary, but this is the easy way to calculate profit under the p-o-c method. Unfortunately there isn't enough information to use this equation, so we have to calculate 2011 profit indirectly.

Under the p-o-c method, three things affect the Construction in Progress (CIP) account: 1) to record accumulated costs, 2) to record recognition of interim revenue and expenses, and 3) to close the CIP and Billings account at the completion of the project. In this problem we only have to worry about 2): recording recognition of interim revenues and expenses. Expenses and revenues both get debited to CIP. Here's a t-account:

CIP (similar to WIP)

2010 Expenses	105,000
2010 Profit	x0
12/31/2010 Balance	122,000
2011 Expenses	192,000
2011 Profit	x1
12/31/2011 Balance	364,000

We don't really care about x₀ in this problem, but for the record, it's $17,000. It's x₁ we're after, and that's $50,000 (364,000 – 192,000 – 122,000). Your answer is a.