 Good morning class. Last class we covered the first five concepts of accounting based on which the accounting principles were framed. Those were the concepts of money measurement, going concern, entity concept, cost concept and the principle of duality. Now I thought before I go to the next six concepts, I think there is enough input that is already given for you to understand what a balance sheet is based on these five concepts. So before we go into the six concepts, remaining six, I will just give you a quick overview of what a balance sheet is and how you view a balance sheet as a critical financial statement. Now I have already told to the class that a financial statement that shows the financial position of an entity at a given point of time is a balance sheet. So balance sheet as I told you it is a status report, status report at a point of time. Based on this we can understand the financial position of the entity. Now how do we understand? Because the balance sheet reports two entities namely the assets and the liabilities and I had told you last class the assets will definitely be equal to the liabilities because that is the underlying basis of a balance sheet. So you should not be surprised looking at a balance sheet and that the assets is equal to liabilities. There is nothing significant because assets definitely have to equal the liabilities. So a statement that reports both assets as well as liabilities based on which one is able to judge the financial position of an entity is called a balance sheet. Now a balance sheet has a specific nomenclature or a balance sheet has a specific structure, a specific form in which it is been expressed. Let us for example say I am going to write a balance sheet for an entity namely a firm XYZ. So what we typically do is we write the name of the firm XYZ. So this is the name of the entity and that since we are talking about balance sheet we write that the statement that we are going to create is the balance sheet which is the name of the statement. And balance sheet I told you is a report at a given point of time. So we need to know at one point of time are we creating this balance sheet as on which date are we creating this balance sheet. So that is why you would see in various balance sheets that there is a specific date that comes along with it as of let us say December 31, 2011. So this is the moment of time. Now this typically constitutes the heading of a balance sheet. So XYZ balance sheet as on 31, 12, 2011. Now let us see how balance sheet in terms of some of the concepts that we already covered last class. Let us see how the balance sheet adheres to those specific concepts. Now a balance sheet is typically represented as I told you before to show the assets and liabilities. So let us say we are going to report assets on the left hand side and liabilities on the right hand side. You can also report assets at the top as well as liabilities at the bottom. There are two ways of reporting or presenting a balance sheet. It begins with current assets and I am going to explain what this current assets, what is current liabilities and all those terminologies later. But just for the purpose of understanding what a balance sheet is, let me just say current assets, cash, accounts receivables, inventory. So this will be total current assets and then you have fixed assets in a balance sheet which will be plant, equipment, building. So total fixed assets and then finally you have total assets which will be your total current assets plus your total fixed assets. So all of this will have some number. Let us say 1, 2, 3, 2, 3, 4. Let us say we are expressing this in thousands. So that will also be indicated in your title of the balance sheet for the sake of simplicity. I am just writing 3 digits, 565. So the total of these 3 will come here. That is 12 and then again let us say you have plant and equipment, 1000, building, 2000. So total fixed assets is 3000. So the total assets will be 3922. Likewise on the liabilities you will have current liabilities which comes in the form of accounts payable and then you have let us say wages payable. You have deferred revenues. These are all current liability items. These are current liability items and then you have total current liabilities and then let us say you have long term debt. This is a long term liability, long term debt and then in the liabilities you will also have another section called shareholders equity which comprises of the owners, capital, retained earnings. I am going to explain each of this later and then the total liabilities which will be equal to your total current liabilities plus long term debt plus shareholders capital. So this will be a number which definitely will be equal to 3922 just for the sake of understanding and just leaving these unfilled. But a balance sheet as the name clearly suggest will give you a statement that equates the total assets to the total liabilities. Now the point that I want to just highlight here is that let us see how a balance sheet actually confirms in terms of the concepts that we covered last class. All the events events is expressed in terms of money. That is the first concept of monetary measurement. So you can see that all of this is expressed in terms of money. So you cannot say accounts receivable 10 tons of apple that you sold that cannot be in your bank account. So that is again not a form in which you express an inventory in your balance sheet. All of this gets converted into a monetary measurement. So all these gets monetized. So the first principle is that you can very clearly see that all of these are expressed in terms of money. And the entity involved here is XYZ. So that is your concept of entity, the entity concept. And though not explicitly stated in the balance sheet, it is assumed that this is a going concern. It is very unlikely that in every balance sheet that you will find that the entity explicitly stating that this entity is a going concern. But it is taken that this entity is a going concern. Then the cost concept is also followed especially when we are going to spend more time on this fixed asset portion. What we usually do is this plan equipment that the value of 1000 is actually recorded at the cost of its acquisition initially. Let us say we bought this equipment for 2000 rupees. And the cost of acquisition gets first written cost of acquisition 2000 and let us say 5 years since we purchased this equipment. Then less accumulated depreciation. I already told last class what depreciation is. As and when an equipment gets used, we charge the equipment a specific value and that specific charge is the depreciation. So when it was purchased at 2000 and now the value of the equipment, the book value of the equipment is 1000. It means in the last 5 years the equipment has been charged a sum of rupees 1000. And let us say we are having a linear depreciation which means every year the cost of depreciation is 200. So the cost of acquisition is 2000. Now the value of the equipment is 1000. Though I have not recorded the cost of acquisition which actually I should have. So before this you should see in balance sheets that they would record the fixed assets at the cost of its acquisition. In this case 2000 then less accumulated depreciation 1000 and the resultant value is this 1000. That is the principle of cost concept. The other aspect is the dual aspect which is very evident from the fact that the assets is equal to the liabilities. And I already told you that you know you should not be surprised that the assets is equal to liabilities because the principle of duality means this that the asset has to equal to the liability because for every event that we record as an accounting transaction it impacts in two ways so that the assets is equal to liabilities that fundamental equation does not get compromised. Now as I told you this can be expressed in two ways assets on the left hand side the liabilities on the right hand side or assets on the top and liabilities at the bottom. If you express in left right fashion it is called an account form. If you express in the top down format it is called the report form. So this is the account form and if it is top down we call it the report form of expressing a balance sheet. Now there are two views of looking at a balance sheet. Two views of looking at a balance sheet and both the views are acceptable views except that the way in which we look at the balance sheet differs a little bit. The first one is the resources and claims view. Now this understanding this resources and claims view of understanding what a balance sheet is one way in which when you look at the balance sheet you see the items on the asset side these are economic resources of an entity. So the assets is equal to the economic resources of the entity in this case we just wrote it was x, y, z. So it is economic resources of that particular entity x, y, z. The liabilities which is the right hand side is the claims against the resources and since it is a balance sheet it is the claims against the resources as on today. Suppose this is the balance sheet today today what is the claim against each of the assets on the balance sheet. Now what do I mean by claim? So the liabilities are claims of outsiders. It could be anybody I mean those who have a claim against the asset and invariably it would be the banks who should have given the entity some money or it could be the owners themselves who have also put in their own money to start the business. It could be vendors to whom the entity owes money. It could be even the employees to whom the entity's own wages, salaries etc. So there are different sources of this claims against the assets. So it is this view which is called the resources and claims view which says that for every asset that is created that you see in the balance sheet there is a liability partner who has a claim against the asset that is being created. Now this liabilities I told you last class has two components liabilities will have the shareholder liability or the owners liability as well as the other liabilities in the form of banks accounts payable the vendors and other creditors. But you must understand that the owners do not have a claim in the same sense as the creditors have just a quick example for you to understand. Let us say in the balance sheet that we discussed suppose there was another current liability item called taxes payable and that taxes payable was let us say 100. Now not a penny more or a penny less than 100 is the amount that the firm the entity is liable to pay. To that extent we can say that 100 has some specific claim against an asset created here and that specificity is not more or not less than 100. So to that exact amount we can say that taxes payable is a claim against an asset whose value is 100. Now the question is whether we can in the same exactness say that the different claims have the same level against the assets that are being created. Let us for example say that the shareholder's equity here the shareholder's equity total is this entire total is around 1000. So the shareholder's equity let us say is 1000. Now let us say that the entity is going to get liquidated. Now the shareholder's equity of 1000 means that in the event of liquidation if all the assets on the left hand side is sold at the book value at which it is being recorded and if all the existing liabilities are met which means I am paying the bank loans I am paying all my existing accounts payable. So all the claims against the assets are met then finally the shareholder receives 1000. So that is the meaning of the shareholder's equity being 1000. But then in real sense does it happen because there is a lot of if first on liquidation if the assets are being disposed at book value if I am able to meet all the liabilities and after meeting all the liabilities the shareholder gets this 1000. Now this if condition could be unrealistic during different circumstances. Let us say for example the shareholder's equity the book value what we see here is the book value. Suppose let us say that this entity has got a tremendous growth opportunities. So the shareholder equity could be greater than the book value that we see in the balance sheet if the entity has tremendous growth potential because remember last class I told you that the value of the shareholder's equity that you see in the balance sheet is the book value. But the perception that the value of the shareholder's equity could be more than the book value in this case because there is a great potential for the entity to grow. So the shareholder's equity could be more than the book value and hence what you see there as 1000 in the book value need not necessarily be what the shareholder will get in case he decides to sell his stakes in this entity. It is also possible that the shareholder's equity is less than the book value let us say the company is sick if the entity is sick. So I would not even accept that the book value itself is a share is a fair value of the shareholder's equity. So that could be instances where even the book value is exactly not the shareholder's fair value it could be even less than that because the entity is sick and there is it is very unlikely that there is tremendous growth potential in the entity. Let us say even a worst case scenario where the company is bankrupt leave alone shareholder's equity even if you dispose all the assets there might be instances where the stages of bankruptcy the assets disposed would not have generated enough resources to meet even the liabilities like banks or accounts payable or other forms of liabilities leave alone shareholder's equity. So different stages or different perceptions of what could be the true value of shareholder's equity and hence whether this resources and claims view is the best form of viewing a balance sheet becomes a genuine question and there are a lot of theories that say no this is not necessarily the only way of viewing a balance sheet but that does not mean that this is not a correct way to view a balance sheet there is also another way in which you can view a balance sheet which is the sources and funds view the previous one was the resources and claims view which is very clear that the asset that is created has somebody on the right hand side on the liability side who has a claim against the asset the sources and funds view is that again it is got to do with the assets and the liabilities it says the asset represents the form in which the funds is utilized or invested the liabilities represents the sources of these funds which means for every 1 rupee asset that I create where did I get that 1 rupee from that is from the liability side so both views are correct both views whether it is the resources and claims view or the sources and funds view both views are correct but for easy understanding the sources and funds view because it very clearly says that you know the asset represents the way in which all the funds that were received have been utilized or invested and the liabilities represent the sources of these funds where did I get these funds from did I get it from banks did I get it from raising money in the stock market or the fact that I did not pay my vendor money but still manage to get some inventories in my balance sheet is an inherent source of fund the accounts payable is a source of fund and hence the liability because I have not paid the vendor I am only deferring my payment so it is an inherent fund that I have generated the result is that I have utilized that to get some inventory which shows up in my asset current assets as inventories so both forms are acceptable except that the sources and funds views more convenient and comfortable to understand now if you look at the balance sheet a balance sheet as I told you before is categorized assets liabilities under assets you will have current assets and fixed assets under liabilities you will have current liabilities long-term liabilities which is debt bank loans then shareholder equity I will be referring this to as SHE now this categorization is done for easy understanding identification you can also present a balance sheet by just recording all the assets you have a value a total value record all the liabilities you have a value total value both the values will equal but then for easy understanding and for easy interpretation of the financial strength of the entity you categorize these accounts now current assets fixed assets all these category heads will have under them different subcategories all those subcategories will be identical to the extent that they are current assets likewise all subcategories of fixed assets will be identical to the extent that they are fixed assets and those subcategories let us say for example cash or inventories so those will be the aggregate of all those individual events that are identical to this subcategory I will explain that in detail later but for you to understand you should know that such categories under each of these are created cash accounts receivable inventory etc likewise here building land machine here accounts payable wages payable debt retail earnings paid in capital etc. So these are subcategories and under these subcategories will represent the aggregation of all those identical events that have happened that relate to this specific subcategory let us for example say accounts receivables so for easy identification aggregation and then title them under specific subcategories and then group them under a bigger category called current assets and then present them in the balance sheet this way you will easily understand and interpret a balance sheet by creating these subcategories. Now the assets of a balance sheet I told you that an asset is an economic resource let us just extend this definition a little further that is controlled by an entity because now we are getting into the finer details of what qualifies an asset controlled by an entity whose cost of acquisition is objectively measurable. So the key words it has to be an economic resource should be controlled by the entity and it has to be objectively measurable. So what do I mean by economic resource it means that an asset is an economic resource if the entity derives a future benefits like cash or benefits that can be easily converted to cash or it could be inventories finished or work in process that can be converted to finish good and then sold to generate cash or it could be equipment which can be utilized in future so this equipment can be used in future for activities which will result in finished goods which can be sold to generate cash. So broadly an economic resource is one that can generate cash or can be converted to cash and hence qualifies to be an asset the second key point is that it has to be controlled by the entity which means let us say you the building that the entity is operating is on a 25 year lease then I can assume that this building is an asset to the entity as against using a different economic resource which is not owned by the entity let us say it has been leased for a short period of six months or ten months or less than a year then I cannot say that I own this entity because the lease duration is very short term which means I do not have direct control on this entity the ownership will pass after the end of the lease period it gets transferred under these circumstances I do not treat this though it can be used to generate cash I cannot treat this as an asset because I do not directly control the asset or I do not own this particular asset and the third thing is that it has to be measurable objectively so I pay cash to buy an asset I may trade my existing asset to get a new asset that is measurable because the existing asset will have a value the new asset that I get is traded for this particular value the question is whether it is measurable or not it is measurable because the existing value of the asset that I use for trading has a measurable value or I could probably sell shares raise capital that is also measurable as again suppose I have gained reputation I have been in business for 25 years and I have gained a reputation it can be an asset to the entity but very difficult to objectively measure reputation of an entity so I cannot record that as an asset item it has to be a measurable item and also let us say if I purchase building I use 30,000 rupees of my money and then 70,000 rupees I borrowed from the bank and use this 1 lakh to purchase a small building so it is not just the entities the owners contribution in creating the asset needs to be measurable it is both my 30,000 as well as the money that I got from the bank the 70,000 that also needs to be measurable only then there is some objectivity in measuring the asset that we have created. So asset will have three important elements that it has to be an economic resource directly controlled by the entity and objectively measurable at the time of its acquisition. Now I told you that there are account categories that we create in a balance sheet let us begin with current assets what does current assets mean current assets are type of asset categories that can be consumed within one year less than a year let us say for example cash or accounts receivable marketable securities marketable securities or cash equivalence short term investments or inventories. So current assets are the ones that are reasonably expected to be realized in cash or sold or consumed during the normal operating cycle in this case less than one year and if that is the case then it can be classified as current assets. So for example cash is a current asset there is no current asset more current than cash because it is cash it is hot cash funds that are readily available for disbursement for whatever purpose it may be the next could be marketable securities I am just trying to explain this in the order of liquidity cash is the most liquid form of asset marketable securities let us say you have a short term deposit in a bank. So it can be easily converted into cash or accounts receivable what is accounts receivable suppose the entity makes a sale and there are times where I record a sale and that I do not receive money for the sale that I have made but at the same time I know that I will be receiving this money within a reasonable period of time in the future that amount that I have to receive would appear under the heading accounts receivable in terms of the liquidity cash marketable securities and the next liquid current asset means that suppose I want this money I have cash I have marketable securities converted to cash and still I do not I do not have enough cash to meet some of my commitments the next current asset that can be converted into cash is my accounts receivables then is inventories that is also current asset inventories could be in different forms I could have purchased some raw material or some raw material would have undergone some process and it is in the stage of being processed into finished goods so we usually call that as work in process or an inventory that has been converted into finished good but not at sold now all these three inventory classes are current assets because they can be sold at some point of time to be converted into cash and hence it is a current asset why is it in the order of liquidity next to accounts receivables or cash or marketable securities because you cannot immediately convert inventories to cash and assume you are in raw material unless you just dispose the raw material for some price raw material needs to be converted into finished good the finished good needs to be sold and then your sales should generate cash so in the order of liquidity it will be always cash marketable securities the accounts receivable inventories also you might have some prepaid expenses which can also be your current assets and usually these are intangible in nature for example an insurance policy I the entity pays some amount for an insurance protection in advance and let us say it is a two-year insurance cover and at the end of one year it let us I paid around 250,000 for insurance protection for two years and one year has gone now what happens to the amount of this current asset at the end of one year which means no longer is this 250,000 the value of the insurance that I paid one year back one year has gone so the prepaid expenses of two 250,000 has reduced to 125,000 which is the cost of the one year protection that I have enjoyed or the one year protection that is remaining so prepaid expenses at the time of purchasing this in advance is a current asset whose value will keep reducing proportionately as and when you start losing the benefit of paying the advance to get that current asset now just as we have current assets we also have fixed assets these are assets that are tangible and relatively long lived long-term assets these are not the current assets type where you had that one year time period so these are assets that are relatively long lived and typically you will have land building equipment all machinery all sorts of assets for which the life of the asset let us say is more than a year but that is not the it is a relatively long lived we will put it that way these are assets that are called fixed assets and these come next to your current assets now if you look at the balance sheet the fixed assets in the balance sheet I told you that let us say building building at cost will have some value then less accumulated depreciation it will have some value and then the building value which is the book value that you see in the balance sheet will be x y z minus a b c I will leave the class a copy of a sample balance sheet actually then you will be able to understand better but then if you look at any balance sheet you would see that these fixed assets because of the cost concept they are recorded at the cost of its acquisition less accumulated depreciation and then finally the book value of the asset which means the original cost of acquisition of the fixed asset is recorded and then a portion of that original cost is removed as we start using the fixed asset and that portion is your depreciation and over a period of time you use it the depreciation gets accumulated and let us say six years later you would say cost of acquisition less the total accumulated depreciation will be the value of the fixed asset at that point of time apart from these long term fixed assets you can also have other investments as your fixed asset these could be your long term investments could be that you have used the firms resources cash to purchase let us say a 10 year government bond so that is a long term investment and that is an asset to this firm or you could probably hold shares of some other entity that is an asset to this particular firm. So on the asset side you have current assets fixed assets the only thing that differentiates both is their lives fixed assets are depreciable not all fixed assets I am talking about land building machinery equipment current assets are the ones whose propensity to be converted into cash cash equivalence and consumed within a one year period are not generally depreciated likewise on the liability side you have different account categories now what is liability liability is an obligation to some external parties for events of the past let us say as on December 31, 2011 I am preparing a balance sheet and that I have not paid wages for my employees for the week December 26 to December 31 so the amount that I am supposed to pay is a liability and this is as on December 31, 2011 I am creating this balance sheet let us say on timeline today I am on January 10 and that I am preparing this balance sheet as of December 31 and I am not paid salary for January 1 to 10 but that is not a liability that has to be shown in the balance sheet because our balance sheet is as of December 31, 2011. So obligations to external parties for events that have happened in the past there might be some exceptions about which I will be talking later are liabilities so a liability as I told you before is a claim against the particular asset but you cannot say that a liability that has arisen out of let us say an accounts payable or wages payable or some short-term debt or some long-term debt is against a specific asset an accounts payable of 100 rupees is against this particular asset whose value is 100 rupees specific claim against specific assets is very unlikely usually not the case but there are instances where let us say a case of mortgage loans where you identify a specific asset class and tell that it is for this particular asset that I have taken this loan. So the underlying asset that is being mortgaged has a specific claim against it which is the mortgage loans so these are typically called secured loans. So unless you have categories of that type there isn't a specific claim against an asset for the existing liabilities sorry. So just as you had current assets you can also have current liabilities so your current liabilities or your accounts payable or accrued expenses what is accounts payable suppose the entity manufactures some product and for the purpose of manufacturing I need to buy some raw material and I buy raw material and I promise the supplier that I will pay this money sometime later which means I am bound to pay this money to the supplier sometime later till the time that I pay the supplier the money these accounts payable will be a liability so the amount that I have to pay is recorded as an accounts payable likewise accrued expenses these are expenses that are earned by outside parties but the entity has not paid it usually we categorize all this and then call it as accrued expenses or if we know who these external parties are what type of amount is outstanding then we categorize them according to those types for example if it is about salary suppose the accrued expense relates to salary I just simply use the heading salary payable suppose the accrued expense is related to interest then the corresponding current liability item is interest payable there is also another current liability item called deferred revenue is an advance payment that I the entity has received for a revenue service that is yet to be delivered that is deferred revenue and it is also a liability because I have received some advance payment for some service that I have to give in the future which means I am liable bound to deliver that service in the future. So these are current liability items so let us just stop here before we go to long term liabilities which will include your long term debts as well as shareholders equity I am sure this class you would have understood what a balance sheet is different components of the balance sheet and how it is viewed both from a sources and funds point of view and resources and claims point of view and how asset classes are defined and categorized what are the first places asset and then how liabilities are classified and categorized you will see next class on what long term liabilities are thank you.