 Good morning class. The last class we saw how the entries that were created following the principle of double entry bookkeeping, how they were aggregated and finally created the closing balance for each of the accounts. And then as an interim measure, we also checked by using a trial balance and to make sure whether the aggregate of the debits is equal to the aggregate of the credits. And I had already explained that the trial balance does not exactly tell you that all the entries that you have made is correct. It tells you that the entries that you have made is correct to the extent that the total debits is equal to the total credits and hence you can go ahead under the assumption that the fundamental concepts, the accounting principles have not been violated. That is why even if you err on the right side, still your trial balance would show debit is equal to credit. But then when you go ahead somewhere, when you create the other financial statements, either the balance sheet or income statement, the errors that you have inadvertently made will show up. But let us for the moment assume and not only assume, I think all the entries that we have made, we have not violated any accounting principles. And when we completed the trial balance, we did understand how the debits is equal to the credits. And hence at this decision making point, we take the decision, yes everything is correct and let us go ahead. Now what do I mean by going ahead? We have made all the entries, we have recorded all the entries. And last class I explained some adjusting entries. I gave you three examples, the depreciation expense, the prepaid expense, the accrued interest or the interest payable. Now these are all examples of adjusting entries. They are not the only type of adjusting entries, these are some examples of adjusting entries. But in real life, when you encounter such business activities, there will be other types of adjusting entries beyond these three. But all of them will be treated as the case demands. And then before we go ahead in preparing the other financial statements, we will record these adjusting entries just as we did for depreciation and the other adjusting type entries. Now after the adjusting entries are made, the next step is to see how we have to prepare the financial statement. Let us begin with a balance sheet and income statement first. The trial balance that we saw last class was a list of all the accounts. And if you go back to your class notes, you will see that list comprises different types of accounts. You would see cash there, you would see accounts receivable there, you would see sales revenue there, you would see wages there. So you understand that the trial balance comprises a list of accounts which are either from the balance sheet category or from income statement category. And within the balance sheet, it can be from the asset side or the liability side. And from the income statement, it will be sales revenue and other expenses. So in a nutshell, a trial balance would have more or less listed all the accounts which either fall under the balance sheet or under the income statement. Now you understand that a balance sheet and an income statement is hence an extract of those accounts that have been listed in the trial balance. And you would notice that in the trial balance, we have not recorded those adjusting entries. So we need to add those adjusting entries for which we have already made the debit and credit entries as I showed in last class, how we recorded the depreciation, depreciation expense and accumulated depreciation. So from the trial balance plus the adjusting entries, we are now in a position to create a balance sheet and an income statement. Let us first start with a balance sheet. Now how do we create a balance sheet? In the first few classes, I had given you a Norman Clature. The common understanding, the normal set of rules that is followed when we actually create a balance sheet. That begins with writing the name of the firm. In this case, we said it is a restaurant. So let us say it is x, y, z restaurant. And I told you that we are going to create a balance sheet. So this is a balance sheet. Balance sheet as of April 30 2012 because remember, we recorded all the transactions for a given particular month. In this case, we assumed it to be April 2012. So this is the balance sheet of x, y, z restaurant as of April 30 2012. Now the balance sheet begins with recording those accounts under the assets categories and the liabilities categories. Let us begin with assets. Now under the asset category, there are two types, the current assets and the fixed assets. So let us begin with current assets. In the order of liquidity, we start with the current asset that is most liquid. And I explain to you that cash gets the first position in that order of liquidity. So we begin with cash. What is the corresponding value that needs to be recorded here? It is nothing but your closing balance which is available in the trial balance that we created. And what was the closing balance that was available? It was 5, 4, 5, 0. That is the closing balance. Next to cash is accounts receivable. What is the closing balance in accounts receivable? The trial balance shows 0. Why? Because within that accounting period of one month, whatever the firm had to receive was collected. So we had an accounts receivable at some point of time during that one month period. And before the end of that one month that was also collected as a result of which the accounts receivable is 0. But in real time, you will have some closing balance. So whatever is that closing balance will be reflected in your trial balance and that is what gets incorporated in your balance sheet. In this case it is 0 but it might happen that you will have some numerical value in case you have some receivables yet to be collected at the end of the accounting period. Now what is the closing balance in inventory? From your trial balance you find that the inventory value is 550. Next is prepaid expenses. Now if you look at your trial balance under the category prepaid expenses, you will have some value. But then remember when we talked about the adjusting entry, in this case this was about the rent of 750 that we paid. At the end of this month the value of the 750, the entity, the firm has derived the value. So no longer is that 750 an asset that the entity will be enjoying. It has actually derived the benefit of that. So your prepaid expenses will no longer be 750 or the asset value of the prepaid expenses is no longer 750 and at the end of this month the value of that gets diminished to 0 and that is what we saw when we did the adjusting entry for prepaid expenses. So your prepaid expense at the end of this accounting period is hence 0 and I do not see any other current asset items in the trial balance nor in the adjusting entries that we have made which means the total current assets will be 6000. So this is our total current assets. Now after current assets in the balance sheet we have the fixed asset. The fixed asset when we look at the trial balance, the only fixed asset that we purchase was the equipment. So the equipment and remember our cost principle says recorded at the cost of acquisition. So equipment at cost remember we purchase that for 7200. Now what do we do here? We are at the end of this accounting period in this case one month. We purchase an equipment whose cost of acquisition is 7200 at the beginning of the month and we have used that equipment. I told you there is a charge for using an equipment for a period of time whatever be the period on assuming that this is the a linear depreciation to that extent we will charge the entity for using the equipment. And this we call it as a depreciation expense and since this is a straight line linear depreciation I told you that the life of the equipment is 10 years. So the monthly charge for using this equipment is 60. So less accumulated depreciation which is 60. So what is the net of the equipment? Equipment net is 7140. Now where will this depreciation expense set that we will understand when we actually do the income statement. But in the balance sheet side you have reduced the value of the equipment by the monthly charge that is recovered from the entity for using the equipment that is 60. So the book value of the equipment at the end of one month is no longer 7200 but 7150. Do we have any other fixer assets? No. The building that we are using it is on a rental basis. So we do not capitalize rent expense that is because we do not own the building. If it was our own building then it would have found a place in the balance sheet. Till such time an asset is capitalized we do not consider it as a fixer asset. In this case the equipment is the only asset that is been capitalized and depreciated. So our total assets in this case will be the current assets 6000 plus the total fixer assets 7140 this case 13140. Now this is the asset side. On the other side will be the liabilities plus owner's equity. Now let us begin the liabilities with the accounts payable. What is the accounts payable? Again we go back to the trial balance and see that the closing balance for the accounts payable is 2200. Then we had the loans payable 4000 and then for this loan I also said in the adjusting entries the accrued expenses which is the interest that I am liable to pay on a quarterly period. For that particular month is charged at the rate of 40 which is a liability which I have to pay not necessarily now but at the end of the quarter. So till such time this will be a liability. So next month when you do the closing entry it would be 80 because the monthly accrued expense accrued interest expenses 40. Income tax liability is 285. How did we get that? This is actually linked to the income statement. So when we go to the income statement I will also explain how we got that. We have not paid the interest I mean the income tax. We will be paying it at a time when we actually make the payment when we are supposed to make the payment. Till such time we treat it as a liability because for the purpose of calculating the income statement I have identified that the income tax expense is so and so and that we will be paying sometime later and hence till such time it will become a liability. So I am recording this as a liability. So the total liabilities is 6525. I can also probably differentiate here I can also use current liabilities and long term liabilities where in long term liabilities the loan payable I will take it to the long term liabilities but that does not alter the total liabilities which will still remain 6525. Then is the owners equity portion. In the owners equity we can again go to the trial balance we will see that the paid in capital. The paid in capital is 5000 that was the owners money that was put in. Now what is the total? The total will be 11,525 total liabilities plus paid in capital 11,525. So there is a difference a balance sheet should balance but then here we have 13,140 and here we have 11,525. So we will leave this here and again revisit after we finish the income statement. So let us begin with income statement. Now this will establish the connect between the income statement and the balance sheet. It is not that I am just leaving the balance sheet incomplete. I know that there is some portion that needs to be filled but then I will be filling that after establish the connect between the income statement and the balance sheet. Then you will understand how all the pieces fall in place. Now this is an income statement for the month of August sorry for the month of April for April 2012. What is the top line in an income statement? It is sales revenue. So you go to your trial balance you find that the sales revenue is 12200 and the cost of goods sold or COGS is 12200. We have recorded it to be 6000. So the next will be gross margin. So gross margin in this case is 6200. So your sales revenue minus your cost of goods sold is a gross margin. So after that we record our operating expenses to calculate the operating expenses. What are the operating expenses? You go to the trial balance we see that the wage expenses incurred was 3000, the rent was 750, utilities expense was 450, depreciation is 60. Now here I have treated the depreciation as an expense. The accumulated depreciation of 60 that was in the balance sheet. The corresponding dual entry here will be the depreciation expense in the income statement. Whether cash has really gone out we will answer that question when we actually discuss about cash flow. But we since we have charged the entity an accumulated depreciation of 60 for using the asset we are treating that as a depreciation expense for the purpose of an income statement. Likewise the interest expense which is an accrued expense of 40 is treated as an interest expense here. Now the question is I have not paid the interest now but I have already told you that I will be paying it sometime later. Now assume next month I am paying this 40. So next month when I am doing the same income statement balance sheet because I paid the interest next month will I be recording it as an interest expense is a question a very reasonable question that will arise. No we will not treat that as an expense because we have already treated this as an expense in the previous month and identify that expense to be a liability that is why in your balance sheet you saw that accrued expense liability. And when we actually make the payment next month what will happen is cash will be reduced by 40. So what will you do cash credit 40 because cash is reduced because you actually paid the interest. And then from an accrued expense it was 40 it no longer is a liability. So a liability gets reduced by 40. So when a liability gets reduced by 40 it will be debit 40. So actually when you make the interest payment next month the dual entry will be cash credit 40 accrued expense which had a liability opening liability of 40 becomes 0 for which the entry will be accrued expense debit 40. That will not alter your balance sheet because already you have treated it as an expense in the previous month. So that is an interest expense of 40. So what is the total operating expense 4300. So your income before tax is hence 6200 minus 4300 is 1,900. Income tax expense at some percentage rate is 285. Therefore my net income tax expense income is 1615. Now this income tax expense of 285 is what you saw in your balance sheet as an income tax liability. Just as we treated an interest expense as an expense for that particular period but then we will be paying it sometime later. Likewise the income tax expense also I am just treating it as an expense for the purpose of this accounting period. And the fact that I have not paid it during this accounting period gets recorded as an income tax liability in my balance sheet. That way it does not compromise the fundamental equation the double entry bookkeeping requirement is met. So actually when we pay the income tax later just as the interest expense was adjusted likewise the income tax expense cash 285 income tax liability gets reduced from 285 to 0. This is how the closing entry will be made. Now I said we will establish a connect between this net income and now the balance sheet. This net income is 1615. Now for this example that we have created we know that this restaurant is owned by an individual who is put his own money of 5000 in the business. So after meeting all the liabilities, tax interest everything we find that the net income is 1615. And this is for the sake of example an entity that is owned by an individual. So it is the individuals the 1615 is the net income available to the owner of the entity in this case the individual. So it is the individual's money. Now what is he doing? He is taking it back and investing in the firm. So the earnings that is freely available to the owner of the firm if it is brought back and reinvested into the firm already I have told you that is called the retained earnings 1615. Now we add all of this your balance sheet balances. Now the question is what if this 1615 was not fully reinvested into the business. In this case it was a very simple example where it was a single ownership and entire money was reinvested. One the owner would have taken it and enrich his capital then my capital gets increased by that amount or assume that it is a listed company there are lot of owners and from this net income we distributed some portion as dividends. Then what will happen is net income dividends let us say it is x then what will happen is your net income after dividends will be 1615 minus x. Now this is the amount that will go and sit in your retained earnings. Will your balance sheet balance? Yes why because the net income minus dividends that was disbursed that amount would be reduced in your cash because no longer will your cash be 5450 it will have reduced by an amount that was disbursed as dividends so your cash will also be adjusted so that your balance sheet now balance and whatever is the income that is available after dividend disbursement is the one that gets into the balance sheet as retained earnings. Now you can understand that there is a connect between the income statement and the balance sheet where the retained earnings which is the free cash or the free income that is available to be reinvested into the business gets and sits into the balance sheet in the owner's equity part because it is the owner's money that is why it sits into the owner's equity part and then the balance sheet balances. That is why I remember I told you in the beginning of the class that the income statement is a little subordinate to the balance sheet because the end the end product of the income statement which is your net income is identified as one small entity in the balance sheet in the form of retained earnings. So it is a balance sheet that will give more information I am not saying that the income statement is not important but an income statement does not convey enough financial information as much as financial information as a balance sheet convey based on which we can take informed decisions. So this is how an income statement and a balance sheet will be prepared and I just took a very fundamental easy example for you to understand how to prepare an income statement and a balance sheet. However in real terms nothing is going to change the accounting principles will remain the same the way in which we analyze the transactions and record them as t accounts will remain the same. There will be some amount of subjectivity in analyzing the transactions and as a result of which you might have two forms of statements for the same transactions both can be correct except that the way in which I have interpreted and analyze the transaction is different from the other person and both of them have followed the accounting principles it is bound to happen as long as you are able to justify why you interpreted this transaction this way then both are accepted forms of financial statements. But the fundamental framework that you will be following for any transaction for any entity the first thing that you will do is the moment there is a transaction you analyze the transaction what do you mean by analyzing the transaction this is the process where once you see some activity has happened and you know that this is going to affect impact some account you will analyze and see what account gets impacted then you journalize the entry then you post them to a ledger then you had the adjusting entries and as an entry measure you also did a trial balance adjusting plus those closing entries if there are any and then prepare your financial statements. So, you there were transactions you analyze the transactions on the analysis you know what type of accounts get affected you post the debit credit and then collectively identify identical accounts find the closing balance after you have journalize them and posted them in the ledgers as an entry measures check whether your debit is equal to credit by way of a trial balance and then you prepare your financial statement. So, this is one accounting cycle after an accounting cycle is over what happens next the same thing gets repeated the same process gets repeated. So, your closing balance at the end of an accounting period becomes the opening balance and then you have transactions to that opening balance you will again add the effect of these transactions and again undergo the same process and again at the end of the accounting period you create financial statement. So, you keep on doing this and at the end of the accounting periods you will be in a position to create a balance sheet or an income statement. So, this is how a balance sheet and an income statement is prepared I would encourage the class to actually create your own balance sheet and income statement you do not have to start a business real time to understand this you can imagine that you are starting a business and then different ways that you got the finances you had certain set of operations you can record these transactions and create a balance sheet and income statement on your own and this by this you will be able to appreciate the ways in which transactions are analyzed recorded and how each of these transactions are aggregated. So, that you are able to create meaningful financial statements like a balance sheet and then income statement. Now, I told you that the third important financial statement is your cash flow statement what do I mean by a cash flow statement see a balance sheet as I told you it is a status report it is a snapshot that indicates the financial strength of an entity. Now, an income statement is a different statement it is a flow report an income statement actually focuses on the economic results of an entity's operations that is the income statement and we understood how both a balance sheet and an income statement are prepared. Now, what is the need for a cash flow statement now our revenue recognition we are we are actually recognizing revenue generating tasks whether cash has gone into the entity because of this revenue generation task we are not that much concerned because the moment we recognize that this activity is a revenue activity we recognize that likewise when we actually measure the resources that have been consumed to generate this revenue we treat them as expenses whether cash has gone out because of this resource conception we are not concerned not that we are not recording we really do not wait for cash to go out before it is treated as an expense that also becomes an expense because we are following an accrual method of accounting where we do not wait for cash to physically get in or cash to physically get out to recognize our revenues or expenses. Our principle of revenue recognition and the matching concept informs us that as long as we are reasonably certain that this is a revenue generating task we please recognize it as a revenue as long as it is reasonably possible that this will be an expense we treat it as an expense so with that understanding not waiting for cash to physically get in or get out we treat certain transactions as revenues or expenses. But that does not mean as I told you cash has gone in or cash has got out which means the cash that we see in the asset is not the income is not the revenue that is why you see your net income is different your sales revenue is different whereas your cash in your balance sheet is different which means that the behavior of cash has to be understood properly. Now why do we need to understand the behavior of cash we need to understand that because that is the one that provides information on three broad set of activities of a firm what are these activities I will explain in detail later but there are some activities within a firm that influences the behavior of cash it could be an operating activity it could be a financing activity or an investing activity broadly these three type of activities will influence the behavior of cash and remember when we discussed about balance sheet I said there is this source and use of fund view of a balance sheet where did we generate the source of finance and how it got deployed this we will understand it when we see the balance sheet. Likewise when we see cash 5450 the balance sheet it is not that 5450 got into the firm it means a lot of activities have happened in the firm within a given accounting period or between two accounting period the resultant of all these activities have impacted cash in different ways and when we analyze the ways in which this has impacted cash we find that the sum total of all the impact has resulted in a final closing balance of 5450 it is not that just the closing balance was 3000 somebody cash came into the firm the value of that was 2450 on the closing balance is 5450 it is not as simple as that it could be as simple as that but invariably a lot of activities would have happened which would have changed the behavior of cash and the resultant change of that behavior is this 5450 that you see sitting in the balance sheet. We need to understand what has happened to cash why is that resultant 5450 how is that the resultant cash flow is 5450 why is it important to understand this because there are users of this information could be internal or external as somebody internal to the organization I need to see whether the result of all the operating activities has actually generated cash or consumed more cash is there an operating profit or not as an external user let us say I am an investor in this I will see the propensity of the firm to generate enough cash that can be disbursed as dividends as a banker who has lent money to the entity I can see the potential of this firm I want to see the potential of this firm to generate cash to meet my interest liability. Suppose there is an operating loss that is the firms operations is not generating enough cash to cover its own operations then as a banker I would be concerned because if it is not able to generate cash to cover its own operational activities it cannot meet its bank liabilities versus the case of a share holder I can never expect dividend. So these are different types of users of this cash flow information who will actually dissect the cash movements to see whether each of their liabilities is not able to generate will be met by this entity whether this entity is generating enough cash to meet such liability and it is for this purpose we will need to understand what a cash flow statement is all about. Now this cash flow statement summarizes two important things and this typically we say it as where got where gone or the source and use of cash between two accounting periods. Let us say we had a balance sheet end of one accounting period and we have a balance sheet at the end of the successive accounting period and in each of the balance sheet you will have the cash figure. So you will find that there is a difference. Now the endeavour to prepare a cash flow statement is to understand what has happened between these two successive accounting periods that has resulted in this difference in the cash that we see in the balance sheet. Now how do we know that? That we will know if we study what has happened to the various activities that are related to the cash generating sources, sources of cash versus those that have consumed the cash or uses of cash, the source and use of cash. How will we do that? Then we will begin to look at different type of activities that have actually used cash that have actually brought in cash to the firm. Could be because of various operational activities, some new borrowings, stocks could have been issued or you would have disposed assets and that could have brought in cash. Likewise the use of cash could be to pay dividends, repayment of loans, probably you could have used cash to retire some stocks, stock repurchases by new equipment. So you will have different activities that affect some of the account categories which have a direct bearing on cash. Either it could be the ones that have consumed cash or the ones that have generated cash to the firm. Now we need to see how this has influenced the opening cash and what has happened during this accounting period and why the closing cash is this way. So when you make a cash versus cash comparison between two successive accounting periods, a cash flow statement will capture precisely the influence of certain activities on critical accounts which could be operating, investing or financing activities and how that has changed the value of cash from what it was during the time of the opening that is the beginning of the accounting period and what has happened during this accounting period, the end of the accounting period as a result of what has happened, how the opening cash balance has changed and how we have arrived at this closing cash balance. For this, for the purpose of easy understanding I told you that the activities are divided into broadly three categories, the operating activities, the investing activities, the financing activities. So next class we will sit and understand how when we take the balance sheet between two accounting periods and make a comparative analysis of each of the account categories that have a direct bearing on cash and then understand how this has changed the behavior of cash whether it has increased or decreased whether it has consumed cash or generated cash and the formation of all this plus the opening cash balance has to necessarily be the closing cash balance for the successor accounting period that you see in the balance sheet. Will that happen? If our understanding if the way in which we are doing this analysis is correct which means if our cash flow statement is correct then you will see that the ending cash balance in the balance sheet for the successive accounting period can be obtained by just taking the opening cash balance of the previous accounting period and analyze the impact of all the transactions during the accounting period, the next accounting period and add it to the opening cash balance it will definitely match with the closing cash balance that you see in the balance sheet. How we will see that in next class. Thank you.