 Last class we just stop with a series of transactions and then I was explaining how under some circumstances you decide to realize a sale despite the fact that you have not received the payment for the sale and I said I will qualify the statement and the example that we took was when the firm actually cater to a party to a customer who happens to be a very close friend of the owner of the firm and then the customer says that he will pay for this a little later. The question is how certain the entity is to receive this full payment now there should be some reasonability in the certainty of this sale if I feel my judgment says that yes historically this customer has been paying and that there is no problem with this customer I adopt the principle of conservatism where I am reasonably certain that this sales will generate a cash in the future and hence I decide in recognizing this sale now there are times where even after doing this I do not get the money also but that does not mean that I have not consumed the resources for which the sale for which I did not receive money happened I need to also record that because I did not receive money for the sales does not dismiss the fact that no resources were consumed for the sale usually you will find in some accounting transactions the cost of goods sold gets reduced to that extent the resources that got consumed gets reduced to that extent but I did not generate sale and then the corresponding dual entry would be a bad sale expense and we just write it off as a bad sale expense so we do not actually ignore the fact that the resources have been consumed because the sale value was not collected so you might encounter such examples such transactions in the day to day life and it is on a pure judgment as to how much as the first place whether you will recognize this sale because conservatism is about recognizing the sale and then to what extent will you realize the sale if you feel that this sale will generate only 60 percent 70 percent to that extent you will treat it as a sales revenue or the first stage itself so it is based on judgment for you to decide on the timing whether to recognize it as a sale this period even without collecting cash or just recognize the sale only after I collect the cash so it is about timing as well as how much will I be able to collect later the amount as well the extent to which this sale gets realized both of these depend on the objective judgment that you can take based on historical experiences now having said that let us proceed further now let us say based on that I realize I record this sale of 200 for which I have not received the money because I feel that I am reasonably certain that I will be able to collect this money which happened immediately where the friend paid the outstanding sales now how do I record this transaction now when I the entity has received this 200 rupees as cash so cash as a result of which no longer is my accounts receivable 200 because I have received this 200 so my accounts receivable which was 200 a current asset is no longer 200 because I have already received the money for that it drops by 200 and that is why it is credit 200 now let us assume these were all the transactions that happened during this month and at the end of this month I am interested in knowing what is the cumulative effect of all of these transactions this is the very purpose of a financial statement to understand the cumulative effect of all the transactions that have an effect on the balance sheet and then income statement and how my balance sheet in income statement would look at end of this accounting period in this case let us say it is for this one particular month that I am interested in seeing the balance sheet and then income statement now what how do we go forward in creating this balance sheet and income statement now before we go there what we need to do is now we know that these are the transactions that have happened during this particular month and we need to take each of the account some made them to understand the closing balance for each of the account which means you would see that in these transactions in these 13 14 transactions that have happened the account cash has been affected more than probably 3 4 5 times and we need to understand after all this what is the closing balance for cash for example let us say cash account if you look at what has happened to cash account it started with an opening balance of 0 no cash only after the owner put in money that the firm got cash then if you trace what has happened to cash throughout you would find that there were these entries on the debit side of cash and then these entries on the credit side of cash so in essence what has happened is after all these cash transactions have been submitted we find that the cash is left over with a balance of 5450 on the debit side and it is this balance actually as a closing entry there is usually you do not have to do I am just trying to explain for the purpose of easy understanding what actually happens in each of the closing entries for each of these transactions the first understanding is when you submit all these entries that have affected cash you will definitely notice that the cash will have 5450 excess on the debit side which means there is a cash balance of 5450 and debit and credit need to match to just match that to balance 5450 credit 21,200 credit and debit of cash balances but that is not the point that I want to explain the point that I want to explain to you is at the end of this particular month you find that cash has a debit balance of 5450 this is one account where the balance is 5450 on the debit side likewise you have different accounts and each of them will have a debit balance or a credit balance based on how each of these transactions have affected each of these accounts now let us say I am not sure whether what I have done is correct there might be some mistakes in the entry let us say I am interested in knowing before I proceed further to take a quick check on whether I have followed the principle of dual accounting and whether my debit is equal to the credit and I need to do this interim check before I go to the other adjusting entries and before I start preparing the balance sheet and an income state for which I am going to create what is called a trial balance now trial balance is just a simply a list of all these account names and then it lists the debit or the credit balance against each of these account names and then when we create the trial balance we will see that the debit the total debit of all the accounts is equal to the total credit of all the accounts I will just create one for you to understand let us say we are going to create this XYZ restaurant right and it is a trial balance as of 34 2012 end of this particular month I told you trial balance is just a list of all these accounts now what are these accounts that we created let us say we begin with cash this is a balance and whether it is debit or credit depends on how each of these accounts have been impacted and that we will know when we just trace back each of these accounts and just as we did a summation of all the cash entries to understand that cash as a debit balance of 5450 we will do a summation of each of these accounts and then arrive at the final debit or credit for each of these accounts now I explained for cash that it was 5450 debit at the end of this particular month likewise you will be doing it for all the accounts that you have created let us quickly run through all of them accounts receivable you find that you had an accounts receivable of 200 which you received later so there is no entry for accounts receivable because it is left with a zero balance zero on debit and zero on credit inventory remember you had two transactions one you in fact three transactions you purchase inventory twice and then the inventory got consumed once so after you take the summation of all those transactions that affected inventory you will notice that inventory was left with a debit balance of 550 prepaid expense again debit of 750 we are the end of this month I already told you that have this prepaid expense at one corner of your mind because we are going to revisit this but at the end of this month based on those 13 transactions I have just handle prepaid expense in only one particular way leaving it with a debit balance of 750 which I am recording now which will change very soon because we have not completed with the adjusting entries equipment we purchase remember we purchase an equipment whose value was 7200 and what was the balance there credit or debit you go there paid 7200 cash then likewise the summation accounts payable will be 2200 loans payable the summation would be 4000 paid in capital started with an initial paid in capital of 5000 and then sales revenue 12200 remember you had a 12000 sale once and a 200 sales later then cost of sales was 6000 then wage expense or salary expense we had an entry there salary expense 3000 we had another accounting entry called utility expense was 450 so now this is a trial balance that just records all your transactions the summation of all the equipment transactions so if you take a total of all of them here 6200 11200 plus 12200 will be 23400 so it is basically the summation of these four let me check whether it is correct yeah 23400 now if you are very confident that all the transactions that you have done is correct you can blindly put 23400 on this side as well only then will the summation of all your debits will be equal to summation of all your credits if you are very confident you can just put 23400 on this side as well let me just quickly check also be 6000 750 13000 950 19000 950 22000 950 23400 so the summation of all of this is also 23400 now you see that your trial balance which is a list of all the accounts and against which each of their credit and debit balances get recorded and then the summation of all the debit balances for each of the accounts and the summation of each of the credit balances for each of the account will necessarily match it has to match because you have not compromised on the equation you have not compromised on the duality concept and every transaction that you have recorded you have ensured that each stage the debit is equal to credit now does that mean that my accounting statement the resultant accounting statement the balance sheet or the income statement is correct no the reason is the trial balance will only ensure at this interim stage your debit is equal to credit now if your debit is not equal to credit the signal that the trial balance senses something wrong has happened in the transactions that were recorded and even before you went to create your balance sheet and income statement if you are able to because of the trial balance understand that there is something wrong then you are just trying to control the level of damage by diagnosing the entries even before you went to the balance sheet and income statement so now you just go back to each of the accounting transactions why because your trial balance said that your debit is not equal to credit and then identify each of the accounts where the mistake has happened and then rectify to that for that purpose the trial balance is useful now that does not mean that all the transactions that you have done is correct you have you could have probably erred on the right side you could have recorded some transaction wrongly on the debit side and wrongly on the credit side still your debit will be equal to your credit and your trial balance will not certify that all the transactions that you have entered is correct it is only a marker if your debit balance is equal to your credit balance then you have not compromise on the principle of duality to that extent a trial balance is helpful mind you does not certify the accounting validity of the transactions that you have recorded as I told you could have erred on the right side and changed the debit and credit entry and still your trial balance will balance but then when you look at your balance sheet you will see that there is some mistake it is quite possible such examples I mean such real time cases will happen but never the less we need this trial balance as an interim measure to just take a quick stock and understand whether we have really captured all the accounting transactions correctly and if it is correct the summation of all your debit balance and summation of all your credit balance will match now are we done with this can we go ahead with the balance sheet and income statement is an x question because we are just interested in knowing at the end of this particular month how may balance sheet and income statement will look like now before we actually go into that I am just trying to introduce three more entries and I call them adjusting entries so that your balance sheet and income statement captures the big picture including all these adjusting entries so that your balance sheet and income statement while capturing the bigger picture reflects the correct financial strength and the correct financial performance since balance sheet and income statement are related to both these financial strength and the performance now what are these three adjusting entries the first one is depreciation notice that you purchase an equipment and when you revisit those accounts you will find that the cost of acquisition was 7200 and you have used that equipment for this one month period which means the equipment that is expected to give you some benefits has been used for one month and to that extent you have been benefited now what is the cost of using that equipment for that one month period you have to charge the entity for using that particular equipment for that one month period and that charge is your depreciation expense how much you need to know how long or how much is the equipment's lifetime let's say in this case the equipment's lifetime is 10 years so you know that the 7200 the annual cost of using this equipment hence is 720 now how long have you used this equipment I have used this for this particular month so what is the monthly cost of using this equipment 720 divided by 12 it is 60 so now you know that the depreciation expense or the charge for the entity to use this equipment and that is the depreciation expense is 60 and I need to record this how do I record one I straight away record depreciation expense this is treated as an expense because this is the expense that the firm incurs because it is used to this equipment for that one month period and since this is an expense this reduces the retained earnings since this reduces the retained earnings it reduces your owner's equity anything that reduces your owner's equity is a bit how much 60 why 60 because it is one month period now how do I record the corresponding second entry I bring in what is called an accumulated depreciation 60 why 60 because accumulated depreciation reduces the value of the equipment which was purchased at a particular cost which is the price of its acquisition by that depreciation expense for that particular period suppose I got this for 7200 and at the end of this particular month what happens to the book value of this equipment it would be 7200 minus this accumulated depreciation of 60 so in your balance sheet you would see that the equipment cost of acquisition because your accounting principle says always you will have to bring in the cost principle which is cost of acquisition which is 7200 less the accumulated depreciation of 60 it has reduced the asset value to that extent reduction in asset value is right hand side credit so this is one adjusting entry and we will see how this sits in your balance sheet and income statement when we actually create a balance sheet and income statement now the next accounting entry the adjusting entry is your prepaid expense that is for your rent remember remember you paid that rent of 750 rupees at the beginning of this particular month and I told you that you are treating that prepaid expense as an asset because that gave you a right to use this space for this one month period and now we are at the end of this month and I am interested in knowing end of this month what is the status of the asset liability is my income and when you approach the end of this month ask this question whether this prepaid expense continues to be an asset for you an answer is no because you have used this space for this one month period the benefit that accrued to you by paying the 750 as rent ceases to exist at the end of this month because you have used this so your prepaid expense as eroded it is value from 750 and since it is end of month to 0 now how do we record this transaction your prepaid expense initially was an asset now it no longer is your asset the value of your prepaid expense has reduced so you are not going to write 0 here you are writing 750 here because what we are trying to record is that the asset value of 750 at the beginning of the month has gone down by 750 the resultant prepaid expense is 0 but to what extent it has fallen down it is 750 to that extent it has reduced prepaid expense has reduced from 750 to 0 which means there is a reduction to the extent of 750 in my current asset prepaid expense and hence any reduction in this particular current asset any reduction in this asset is right hand side credit now how will I treat the corresponding entry simply as rent expense 750 expense reduces retained earnings and hence debit 750 now why all this adjusting entry prepaid expense and all this is there any other better way I could have a simple way that I could have treated at the first place on August 1 or April 1 when I actually paid this rent could I have avoided this complicated entry of prepaid expense and then bringing this adjusting entry yes you could have then what you would have done at that point of time on April 1 is at that point of time you would have treated this entire 750 as a rent expense itself so what you would have done is you would have returned cash 750 rent expense 750 so on April 1 at that point of time itself you would have expense this rent at the end of this month also ultimately you are doing only this because what you have done as an adjusting entry is you have reduced the intervening prepaid expense prepaid expense on 7 on April 1 is now reduced to 0 right and no other cash account is affected cash the fact that you have spent 750 does not change because the prepaid expense has reduced what has changes the value of the prepaid expense itself and the rent expense you are now recognizing 750 you see now how these are interlink to finally affect only two entities cash and rent expense so in your income statement you would see rent expense in your balance sheet will you see prepaid expense no why because the value of the asset prepaid expense is 0 you can still write prepaid expense in your balance sheet but the value of that will be 0 because we have adjusted for it at the end of this month why did we adjust because it no longer continues to be a prepaid expense continues to be an asset so this is one adjusting entry I mean this I chose this to be very specific for you to understand why prepaid expense is a current asset and how at the end of the asset period this account has been adjusted only for that purpose as I told you you can even write away expense it and treated as a rent expense on April 1st itself but for you to understand this I just took it as a prepaid expense what is the other adjusting entry interest expense now I told you that the entity borrowed 4000 from the bank at an interest rate of 12 percent per annum so at the end of this particular month please note that I have used this entire 4000 which means there is cost of using this capital 4000 the cost of using the banks money has to be recorded as an expense though the interest is payable on an annual basis but for the purpose of being exact in the financial performance suppose I want to treat this as an expense for that particular month because it is to that exactitude that I want to understand the financial performance then I can say that you know I am trying to record that portion of the interest expense for that particular month and how do I do that first let us see what is the quantum of interest for that particular month it is a very straight forward calculation 12 percent is your annual interest your loan outstanding is 4000 so your monthly interest will be 40 rupees correct interest expense 40 why debit because interest expense reduce your retainer what will be a corresponding dual entry accrued expense or simply interest payable interest payable is 40 it is a liability which is increased I have not paid the interest but I am supposed to pay interest since a liability has increase it is on the right hand side credit what will I do assume that on May 2nd I paid this interest expense what will you do now I did this end of April because I wanted to allocate even to that specific interest component I wanted to identify the interest expense and charge it so that my financial performance my net profit is exact to that extent I told you May 3rd or May 5th I pay this interest so what will happen nothing can happen your interest expense does not change cash would have paid 40,000 and your interest payable will not change or your accrued expense will be 40 rupees that would be the effect on the accrued expense so you might have a doubt when actually when we pay the interest sometime later are we double counting this interest expense no we are not double counting because I have already factor this interest expense previously all that I have done subsequent to the payment of interest is that recorded the cash outflow because that did not happen previously no cash went out now this cash went out only to offset this interest payable account and my interest payable drop from 40 to 0 so if you take an interest payable concept consolidation you will understand that interest payable 40, interest payable 40 both will balance against each other the closing balance will be 0 which means you have paid your interest and you have accounted for the interest expense only once so in terms of accounting you have perfectly satisfied all the principles you have not overstated your interest expense so now these three adjusting entries the depreciation interest expense and prepaid expenses these three are the adjusting entries that we will have to introduce depreciation expense is something that you cannot avoid I mean as an adjusting entry interest expense and prepaid expense you can avoid as an adjusting entry because it is left to you to choose whether you want to exactly and in this case because you wanted to know your monthly income statement I decided to put this interest expense for that particular month but I can also decide to say no I would rather put my interest expense only after I pay the interest fine because then for that particular amount your net earnings would look better and there is nothing wrong in it likewise prepaid expenses the moment cash left out for the purpose of rent you could have immediately treated as a rent expense instead of creating an interim current account prepaid expense and then closing it to find so let us assume that this rent was for three months then at the end of this month the prepaid expense of 750 let us assume it was for three months it would have dropped by 250 so the closing prepaid expense at the end of this particular month would have been 500 why because you when you actually paid the 750 record in this transaction as a prepaid expense now had I as I told you before I could have also chosen not to record this as a current asset I could have just set 750 cash rent expense for three months cash and expense it right on day one that is also possible but I am just trying to explain to you that these type of adjusting entries you will encounter when you are actually trying to record transactions to that specificity now assume that these are the only three adjusting entries that we have in hand and then in the trial balance we saw the summation of all the remaining accounts your debit equals to your credit because of this adjusting entry will your trial balance change no because in each of your adjusting entry your debit is equal to your credit so if you have your trial balance you will add depreciation 60 debit and then accumulated depreciation 60 prepaid expense credit 750 rent expense debit 750 and then interest expense debit 40 interest payable credit 40 all this will again get added into your trial balance but ultimately your trial balance will balance because your individual debit and credit balanced after taking these three into account are we ready to create a balance sheet and an income statement I would say yes because we have enough transactions for us to construct a sensible balance sheet and an income statement why because we have cash we have some equipment that we have purchased that has been depreciated we have some inventory on the liability side there was owner's equity in it you had a bank loan and I think you also have an accounts payable and then an income statement yes during this month you made some sales revenue there was some cost of goods sold you had some wage some utility expense there was some expense and then you have a net income what more do you need than this to create a balance sheet and income statement so next class when we sit from this data that we have in hand I will tell you how a balance sheet is constructed at an income statement is constructed and then let us understand the third important financial statement which I will be covering next class is a cash flow statement because more often than not people get confused they think income is cash income is not cash cash is the value that you see in your balance sheet while income is an income statement the sales is your income statement entity so how can cash in your balance sheet be equal to your sales revenue in your income statement it is not then how do you know that these two are different while you understand a cash flow statement you will understand that cash is different from income the cash that you see in a balance sheet is the summation of all the transactions that have affected cash either by way of getting consumed or getting generated so you either get cash inside the firm or cash goes outside the firm how much was it at the beginning what happened that we got cash inside what happened that cash went out and how much is the close closing cash this you need to understand for a different reason you need to understand the various sources and uses of cash for that perspective we will create a cash flow statement also so next class we will construct a balance sheet an income statement and a cash flow statement but before you come to next class make sure you are comfortable with this double entry bookkeeping and with these examples you are able to understand why transactions are first titled under a particular account and then why they are entered in the debit side and credit side but this forms the very basis on which your bigger financial statements are being built so you can practice some more transactions you can probably add more to your transactions also and then when we finish balance sheet an income statement next class with additional transactions that you have already added you can build your own balance sheet an income statement so I want you to practice more before we set for the next class thank you