 Good morning class, till the last class we had covered the 11 concepts which provide the framework on which accounting principles exist and then we also understood how a balance sheet will look like and before I start explaining the double entry bookkeeping you should also know the various ingredients of an income statement and the class already knows that an income statement is a flow statement for a period of time used to measure the financial performance of an entity. Just as I explained that a balance sheet you will have assets and liabilities, current assets, fixed assets, current liabilities, long term liabilities and that a balance sheet is categorized under different heads and identical sets will fall under each of these categories. Likewise an income statement is a flow statement which will begin with the net sales, the sales revenue of an entity and then you will have to remove the cost of making the sales, the expenses incurred for making the sales revenue from the sales revenue that is recognized to arrive at the net income of an entity and only then you will be able to make an estimate on how profitable that this sales revenue activity has been. So this is the purpose for which we create an income statement. Now just as balance sheet when we saw the balance sheet we saw that it was for a firm that it was as on a particular date likewise the income statement will also be for a particular firm so that it adheres to the principle of the entity concept. So this is the name of the entity and that you will write that this is an income statement for the year ended let us say 31 3 2012. So this gives you the time period. Now it begins with the sales revenue, the total sales revenue from the beginning of the accounting period till the end of the accounting period and as I told before that generally the accounting period is assumed to be one year. So let us say from 1st April 2011 up to 31 3 2012 the aggregate of all the sales gets recorded as your sales revenue. So what does it it will be the total invoice amount of all the products and services that have been sold or delivered by this entity during this particular period. It usually does not include some statutory taxes like a sales tax or an excise tax. It usually does not include these types of statutory taxes because that is collected on behalf of the government. So it is not revenue to the entity usually it is ignored. So that is your sales revenue. From the sales revenue you will have to detect what is called cost of goods sold. What do I mean by cost of goods sold? The cost of goods or services that are being sold is called the cost of sales. What do I mean by that? Cost is the monetary measurement of the resources that have been used to generate the revenue. Let us say I consumed some level of inventory which got converted into a finished goods which was sold for a particular price. So the cost or in this case the economic resource the value of the economic resource that got consumed before the sale was been made is the cost of goods sold. Cost is the monetary measurement of resources used for sales and the aggregate of all the resources used for the sale is the total cost of goods sold. Now usually when you see any income statement it begins with sales and then less cost of goods sold. So x, y, z, a, b, c this is called the cross margin. Some firms you will find an income statement of this type. There will be some entities in which there is something called cost of goods sold. Every expenses record under different headings wage expense, utility expense, rent expense. This will all be in different headings and it is quite likely that you will see an income statement without the cost of goods sold. Cost of goods sold will be there as long as we are able to match the economic resource of specific set of resources that have been used directly to generate this revenue which can be easily identifiable to this particular revenue. Now from sales you detect the cost of goods sold that is your gross margin. After the gross margin there will be a set of expenses which is your let us say selling general and administrative expenses usually it is called SGA. You have R and D expenses. In selling general administrative expenses typically you will have utility rent wages and all that. So let me just pause here so that you understand the difference between expense and expenditure. The purpose of this income statement is to carve out from the revenue certain expenses responsible for this revenue recognition and after doing that try to understand what the net income the amount of money that is available for the firm after meeting all the commitments financial liabilities. There is often this question how do I treat cash outflows? See revenue activity is an activity which generates cash or generates accounts receivable. A cash a source of cash inflow to the firm. Expenses are activities that consume cash cash moves outside moves out of the firm. So does that mean that any activity that consumes cash is an expense that is the question. That question is relevant here because you need to understand whether activities that consume cash are to be reflected only in the income statement. If income statement is the one that actually removes expenses from the revenue that is the definition. Now you will have to look at the type of expenditure that is involved. It is easy to confuse an activity that consumes cash without creating asset with an activity that consumes cash that creates asset when you broadly define expenditure as any activity that consumes cash. See expenditure will either reduce cash or increase liability. How it increases liability you probably say I am going to pay cash later which means it increases accounts payment. Now this expenditure can be for two purposes capital expenditure or revenue expenditure or revenue expense. Now when do I say an expenditure is of capital nature. It means that the amount that I spent has been used to create an asset whose life is more than one year or the asset is going to be used for more than one year for the purpose of generating revenue. So your mind should immediately take you to your balance sheet where you would find fixer assets and under that these capital expenditures are recorded at the end of every year or every accounting period it is depreciated and the new value of the capital asset gets recorded as the new book value of the asset. So that expenditure finds its place in the balance sheet. So you will not be recording it here in the income statement because it is a capital generating expenditure. The life of the asset that is created out of this is more than a year and so it will be depreciated it finds its place in the balance sheet. Contrast this with a revenue expense example you go for let us say you entertain some of your customers that is a promotional event you pay some money that did not create any asset it just got expense for that particular year you write it down as an expense that was created for the purpose of generating revenue which has no tangible value over a period of time over one year. I went to a promotional activity incurred this expense I paid it right away I paid rent for this building I pay it right away I pay electricity bill for this utility I pay it right away. Now all these are expenses remember these have consumed cash but not of capital nature and hence we categorize these expenses as revenue expenses and it is these expenses that will be recorded in your income statement. So your income statement as I said will have sales cost of goods sold sales minus cost of goods sold will be your gross margin selling general R and D expenses all your revenue expenses will be here. So your operating margin or operating income will be your gross margin minus all of this your operating margin why is this operating margin because I call this my operating income because from the sales revenue I have detected all the expenses which are operating in nature what do I mean by that they are non operating in other way which means these are expenses that are directly related to the day to day operations of the entity the utility the rent the R and D the selling expenses the marketing expenses administrative expenses they are operating not financial in nature. Now if these are operating expenses is there something called non operating expenses yes there are certain expenses that are called non operating expenses which means they are not concerned with the day to day operations of the firm but very much essential for the firm. This is also in some business conversations you would come across this firm this terminology called EBITDA which means earnings before interest tax depreciation and amortization. So after this you will have your interest expense depreciation which is the cost of using the asset is an expense and the extent to which you use the asset the extent to which hence it is depreciated is the depreciation expense that is the charge of using the asset during this period. So this minus this you will have your earnings before tax or also called profit before tax. Now after this you will have your tax after you pay your tax is your net income sometimes it is called profit after tax. So this is your income statement it starts with the total sales revenue minus cost of goods sold which is your gross margin from that you remove all your selling general administrative and R and D expenses you will arrive at your earnings before interest tax depreciation and amortization in other words it is called EBITDA or your operating income from that you remove your interest expense. Interest expense is your cost of financing the amount that you pay to banks as interest then every asset gets depreciated which means there is a charge there is an expense to use the asset after that you get your earnings before tax and you pay your tax the net income. The income that is available to the firm after it meets all its liabilities that is the expenses the liabilities to the banks liabilities to the government in the form of tax. So this is net income that is available to the firm which means to the shareholders and income statement stops with this there is also something called the statement of retained earnings. Now what does this mean from this income statement you know this is the net income net earnings it is also called net earnings as I told you this is the total that is available to be given to the shareholders the owners of the firm assume that there are 1 million shares outstanding you would often hear this terminology called EPS. So EPS is earnings per share which will be your total earnings by shares outstanding typically an income statement will stop with this. The statement of retained earnings goes one step further when we saw the balance sheet we saw that on the liabilities per owner's equity side and in that in the owner's equity portion in that after the paid in capital and additional paid in capital you had something called retained earnings. And I told you that it is the total net income minus the total dividends that have been declared till this point of time is retained earnings and that gets into the balance sheet. So when we have to prepare a statement of retained earnings where do we start we start with the opening retained earnings for this particular year that you can get it from the balance sheet of the previous year. Let us say it is some x y z then that is your opening retained earnings now you know this year you had total net income of some amount total net income is A B C. Now this net income is the amount of money that is available to be distributed to the shareholders. You would see in some annual reports some AGM's in this general body meeting they will announce that I am going to disperse dividend of 10 percent 20 percent 50 percent which means 10 percent of the total net income 50 percent of the total net income is going to be distributed as dividend. How much you will get as dividend income depends on how much how many shares of the particular firm you hold. So from that you detect the dividends. So let us say that this will give retained earnings at the end of year which will be A plus B minus C. Now it is this retained earnings figure which will find its place in the balance sheet. Now your balance sheet will look like this assets liabilities plus owner's equity you will have current assets fixed assets all after depreciation total assets. Then in liabilities you will have current liabilities long term liabilities then in owner's equity you will have share capital. So all this will be there and then this retained earnings will come and sit here and after this you will have your B total liabilities both of this will be equal. This retained earnings will form a part of your balance sheet. So looking at this you can say that your income statement in a way is subordinate to your balance sheet it is because from the income statement you calculated your net income. From the net income you removed your dividends you reduce the dividends that were disposed to shareholders. That from that you calculate the total retained earnings and it is that retained earnings that forms one part of your balance sheet which is here. So to that extent I am right in saying that your income statement is subordinate to your balance sheet because your retained earnings is just one part of your balance sheet. That is why I have always been telling you in class that balance sheet is one that is important. Somebody asks you how are you measuring the performance of a firm? Of course you see the income statement to know the profitability but it is not just about profitability you also need to know about the financial strength of the firm. It is easy to just boost revenues it is easy to just record revenues just like that and then expenses show a lot of net income. But if you do not have a strong financial position to back all these revenue generation activities still it is a great issue of concern. That is why we always see the balance sheet more meticulously than the income statement to understand whether the firm is highly leveraged to understand the total assets that the firm has created to see the capital structure and all these about which we will be talking later. So it is a balance sheet that is more important. I am not saying income statement is not important it is a little subordinate to the balance sheet. So now you will understand that the financial statement hence comprises the balance sheet and income statement which we have understood from the perspective of the concepts that govern these accounting principles. I think with this input we will now try to understand at the first place how did we arrive at these aggregate numbers. I showed you with examples of XYZ and ABC but that XYZ is some amount sales revenue XYZ is some amount inventory ABC is some amount. Now these amounts are arrived based on some system which recorded as and when activities of that particular type happen in an entity and the aggregate and the net effect of all these activities is the amount that you see at the end of a particular period either in your income statement or your balance sheet. So it is important for you to understand the system based on which accounting records are being created and when these records are created how is that all these accounting records are aggregated and then presented in the form of income statement and balance sheet or in short how are these accounts maintained you would often see that in any company the finance department the accounts department will say that this is the book of account. It means yes it is a book of account today it is been computerized you use tally and other things. So tally is a digital book computerized it is a digital book that still maintains some basic book keeping fundamentals. This book keeping fundamentals will provide you an analytical understanding of how this balance sheet and income statement is getting prepared. You are not being trained to be book keepers but you will be having an analytical mindset to look at a balance sheet and income statement and understand how at the first place these were created for which you need to understand the accounting record and systems based on which these accounting records are created. The very fundamental to this accounting record is the word account itself. Now what do you mean by a title account? Now assume that in an entity you get cash you get 10000 rupees the entity gets cash 10000 rupees then 2 days later it spends 3000 rupees cash and then again it gets 15000 it spends 3000. So a lot of activities that either generate cash or consume cash happens in an entity but in your balance sheet you just see cash 100000 rupees. Now that 100000 rupees is the effect of many activities that have either consumed or generated cash during this accounting period and I have to record all these many activities. I cannot write cash 10000 the moment I get 20000 I erase the 10000 and 20000 and then I consume 5000 I do not erase and then say 15000 it is a cumbersome process. Think of a system where you have a specific title to this activity in this particular case cash and then you record all cash inflows you record all cash outflows the sum of all cash inflows and the sum of all cash outflows and the difference between these two is your 100000 cash that you see in the balance sheet plus the opening balance of course. So every such activity is given a title account title namely cash or accounts receivable or accounts payable or inventory. So this device is called an account it is an accounting device for easy identification and they are identified in different forms most of the most popularly used form is a t account where it is given a heading let us say cash and I told you the best way to record this is you let us say you have an opening cash opening cash balance let us say it was 0 and it is in this side you increase you record all the increases or inflows and in this side you record all outflows and then you had 1000 2000 3000 total is 6000 and then you spend around 500 2000 one day and then sometime later 400 so 2900 looking at this account you can say that the new balance cash is 3100 in this side. So this is with respect to the account called cash likewise you will have accounts receivable plus plus minus minus minus the net effect is your closing balance likewise for each even transaction you will have different account titles. Identified in this particular format called the t account all of this will find its place in what is called a ledger so this will be a book that contains all account titles. So this will have easily identifiable see a ledger book you will have cash accounts receivable and all this in the first page they will have the chart of accounts it will have the list of each ledger account it will have a list of each ledger account let us say one it will say it has current assets in that current assets 1.1 is cash in that cash 1.1.1 is cash in hand 1.1.2 will be cash in Indian overseas bank 1.1.3 cash in bank 1.1.3 SBI and so on. So till the last level if you are able to characterize accurately record this transaction till the last mile you will be having a chart of account of this type. So what you will in essence be doing is for a particular cash that affects SBI you will have a t account for cash in SBI. If it is IOB you will have so issue an IOB check cash moves out from this cash account. If you issue an SBI check cash moves out from this cash. So ultimately what comes to your balance sheet as cash is the balance of this plus balance of this plus cash in hand. So this plus this all these three will be your cash in the balance sheet. Likewise you will have current assets 1.1 was cash 1.2 could be accounts receivable 1.3 will be inventory in accounts receivables also you can have 1.2.1 accounts receivable from XYZ client 1.2.2 from different client like. So you will understand that each account will have a t account for itself which records inflows outflows and aggregation of all this is ultimately what you find in the balance sheet or the income statement. Now why is that for example if I get cash I record here if I spend cash from this account I record here. Why not I record it here if I get cash and 500 if I spend why cannot it be on the left side. And likewise how different accounts are been are been measured and recorded and on the basis of what you decide whether it has to be in the left hand side or the right hand side. For that welcome to the world of debit and credit. This is the fundamental principle of double entry book keeping based on which each transaction which already as explained has the principle of duality and hence impact two parameters which means a minimum of two entries also needs to be recorded one each definitely on the left hand side on the other on the right hand side. How do we do this what is the nomenclature that is follow it is very simple. Let us first understand without questioning that debit means left hand side and credit is right hand side. So amount entered on the left hand side is debit amount entered on the right hand side is credit. This is the first non-negotiable principle. So do not get guided by the English grammatical understanding the accounting understanding to the verb to debit means left hand side to credit means right hand side. That is the accounting definition to this verb. In English credit means something good. So it is not that in accounting you credit all entries that bring in cash because bringing cash is something good it does not mean that you credit all the entries. So forget about the English understanding of the verb debit and credit for the purpose of accounting debit means very clearly left hand side credit means right hand side that is it. Now the rule that is made for you to record transactions either on the debit side or credit side is important for you also to understand. The principle of duality says that each transaction has to necessarily affect has to have a two dimensional impact and that impact must ensure that your debit is equal to credit for any transaction. Which means suppose you are going to record a transaction you have to record it in such a way that at the end of the transaction after you have made after you have recorded the entry the debit is equal to credit. You cannot say that you have recorded a transaction and that the debit and credit do not match. Now how is that we will ensure that this principle of duality is not compromised. This is something that I want you to understand very carefully. I have already told you that this is the fundamental equation the accounting equation. Now if I am explaining this from the T account perspective remember assets. We will have a host of entities current assets long term assets in current assets cash everything. So you can assume that all the small small small t accounts in the asset sides will all be aggregated that is your total assets. And I told you left hand side is debit right hand side is credit. Left hand side is debit right hand side is credit left hand side is debit right hand side is credit. Let us for example say cash the entity receives cash of 1 million rupees right. So what do I do shall I say debit t account cash and let us say the entity received this cash from bank as a loan. How do I record this transaction because cash is an independent t account. Bank loan is an independent t account here in the liabilities side when this is the activity that has happened. I have just said that you ensure that debit is equal to credit. I can do it two ways say cash debit bank loan credit debit is equal to credit or bank loan debit cash credit still debit is equal to credit but which is correct. Now to understand which is correct here is the fundamental requirement. It says do not ask any questions any activity that increases the asset is on debit any activity that increases asset is debit. So I put plus here and this is the asset again a non negotiable principle of double entry book keeping and once this falls in place the rest is all simple. So any decrease in asset is credit any decrease in liability is debit any increase in liability is credit. Any decrease in owner's equity is debit any increase in owner's equity is credit. Now I again ask this question an entity got one lakh cash from a bank and there are two t accounts right one is cash the other is bank loan. Now look at this equation here now tell me one lakh whether it is debit cash credit cash and as a result of which wise was a credit bank loan or debit bank loan and the question you should ask is what is happened because of this transaction cash has come into the firm what is cash. Cash is asset it was 0 now I have one lakh rupees from 0 cash has increased to one lakh. So increase in asset increase in asset means debit what has increased cash has increased 100,000. Now blindly you can put bank loan 100,000 here because if debit is 100,000 and you know this 100,000 was from bank loan only then blindly it has to be credit that is one way of saying credit 100,000 and that is the reason I put it as credit. The other way of understanding through this equation is what has happened in bank loan before you got this cash you did not borrow money. Now you have borrowed money what is your outstanding to the bank this one lakh what was outstanding before 0 what is outstanding liability from 0 my liability is 100,000 my liability has increased my liability has increased means credit so 100,000 bank loan credit. So this way every transaction can definitely be captured into this fundamental equation every transaction can be captured in this fundamental equation assets is equal to liabilities plus owners equity and that any increase in asset is debit any decrease in asset is credit as a result of which any decrease in liabilities is debit any increase in liabilities is credit any decrease in owners equity is debit any increase in owners equity is credit. This has to be integrated embedded into all of your mind because this is the fundamental accounting equation based on which you will be recording transactions under different account categories T accounts debit credit and when you do this at the end of the transaction you will be surprised that the balance sheet balances because you have followed a set of principles uncompromisingly as a result of which all of this aggregated to ensure that your balance sheet balance I could give you a cash bank loan example to understand this likewise revenues and expenses revenue expense I sold something the entity sold something it got cash 1 lakh and revenue 1 lakh how do I record this transaction now let us begin before this revenue happened cash was x after this revenue happened cash was x plus 1 lakh so what has happened to cash it is increased by 1 lakh so what is cash it is an asset it has increased by 1 lakh so it is 100,000 why did it increase not because I got a bank loan because I made a sale so sales is the T account relevant T account is sales now I should put sales here why should I put sales here two reasons one because I have put cash here debit must be equal to credit so I put credit sales but that is not the way I want to explain I want to look at the equation and explain this from the equations point of view why did I put sales credit 1 lakh is it liability no it is not liability can I explain this from owners equity point of view I think so I can explain how because sales revenue increases owners equity how does it increase owners equity it is from sales revenue you knock off all your expenses and then finally net income after dividends is your retained earnings and retained earnings goes into your owner's equity part of owner's equity so any sales generating activity increases the retained earnings so any revenue is retained earnings increasing activity so anything that increases the owner's equity is credit and that is why sales revenue here is credit the same thing if you look at expenses it is opposite any expense will reduce owner's equity that is I pay money as electricity expense cash 1000 rupees cash rent expense 1000 how do I record this cash has gone out before I paid the rent I was having 1000 rupees more after I paid the rent 1000 rupees has gone out so cash went out reduction in asset is credit why should I put rent expense debit here because cash is credit but that is not explanation I want the explanation from this equation point of view is any expense will reduce owner's equity in this case it is rent expense it has reduced owner's equity because it has reduced owner's equity it has to be recorded in debit side so I have recorded it in debit 1000 so remember that the fundamental equation assets is equal to liabilities plus owner's equity has to be viewed from the perspective whether each transaction has increased or decreased the assets or liabilities or owner's equity to decide whether the value of that particular transaction has to fall under the debit head or the credit head of that particular account and if you are doing all of this based on this rule and aggregate all of the accounts then you will see that you have a good balance sheet in place you have a good income statement in place now to understand this better next class I will be giving you a series of transactions that happen in a business entity and let us see whether we are able to record these transactions and then aggregate them to add meaning to this transaction and then construct a financial statement we will do that next class. Thank you.