 Good morning class, last class when we were discussing about the principles of preparing a cash flow statement. I had advised the class to answer this question, when we finished the class we were able to identify and segregate activities based on whether they are operating investing or financing activities and as explained for the purpose of preparing a cash flow statement we compared the values between two successive accounting periods to understand the flow of cash as related to any of these activities and found that in some cases there was a net cash inflow, in some cases net cash outflow operating investing and financing and the net of all these activities in the example that we chose in last class we found that the net cash from the operating investing and financing was 116 and I explained that to prepare a cash flow statement we are beginning with the net income of this accounting period and then to it we are adding depreciation because it was it is a non-cash expense. And then understand the transfer the flow of cash between the previous accounting period and this accounting period under the three titles namely operating investing and financing activities and finally, the net cash that is either generated or consumed in this case the net cash that is generated from these three activities is 116 and we need to add it to the opening cash which is this accounting periods opening cash which is available in the balance sheet that I gave you before which I have written here it is 230. Now this opening cash for this year is nothing but the closing cash for the previous year so in effect what we are trying to do is to see whether if we add the opening cash or the closing cash of the previous year to this year's net cash outflow or inflow and see whether it equals the closing cash for this year and this we can see it from the balance sheet and in the balance sheet the example that I gave you before the closing cash is I remember it to be 326 the opening cash was 230 the closing cash is 326. So if we have prepared the cash flow statement correctly then this 230 plus 116 must be equal to 326 which of course it is not it is 346 so last class I left with the question how do we accommodate for this difference of 20 the answer to that is very simple. Now remember that there was one particular transaction wherein we had dealt with the disposal of a fixed asset when we actually calculated the cash flow from investing activity and I told you that acquisition or disposal of fixed asset is an investing activity. And the example that was given last class was there was an asset whose cost of acquisition was 150,000 and after it has served its entire life it has been disposed of or it has been sold and the net proceeds that the entity gained by disposing of that particular asset was 20,000 and this is what we recorded here in previous class this is this 20,000. Now when we go back to our T accounts and journal entries to see how we actually recorded this particular transaction then you will find that this asset that was disposed of for 20,000 resulted in a cash inflow of 20,000 so you would have recorded that entry while you had prepared the journals and T accounts as cash that came in 20,000 and where did this cash come from it was gains that the entity got because this asset was disposed and it was one revenue generating activity. So, you would have recorded it as cash debit and revenue credit and since that this is been reflected in the balance sheet this cash item and also in the revenue for this particular year this 20,000 would have been accommodated and that would have been accommodated in your income statement example that I gave you when we actually wrote the income statement for the previous year I am sorry this year we started off with the net income of 200. Now this net income 200 is from the income statement of this particular year in which this 20,000 has already been recorded as a revenue activity in the total sales revenue that we recorded in the income statement. So, in effect what it means is that this 200,000 net income is a result of all the revenues minus all the expenses and by all the revenues I mean this 20,000 also included in that revenues and this 200,000 net income is post revenues minus expenses and hence adding this 20,000 again in the cash flow statement amounts to double counting because we have already accommodated that in ever income statement. Now how do we do the adjusting entry so that the cash flow statement reflects this double counting we have to in the operating activities remove the gains from asset disposal of 20 then this would become 228 then ultimately this will become 96. Now if you look at the cash at the beginning of this year 230 plus the net cash flow for this particular year from all these three activities it is 326 and this 326 will be cash that appears in your balance sheet at the end of this particular year. Remember we did not start with this 326 we started with net income added back depreciation and found the net cash inflow or outflow from three broad categories namely operating investing and financing activities added with this 230 and find that it equals this 326 and this is the purpose of creating this cash flow statement so that we can understand how different activities have either consumed the cash or generated cash and within each of these activities what has happened to specific activities for example if we are talking about financing activities how much did we raise as new capital how much did we repay as loans how much did we disperse as dividends how much did we raise money in the form of issuing shares all this information will be available in a cash flow statement if you go particularly to financing activities and see what is the additional cash outflow or inflow during this accounting period by comparing it with what happened in the previous accounting period and this information is useful for those who want to track the behavior of cash between two successive accounting periods because what you see in the balance sheet is just cash per se I told you before the difference this 230 and 326 between two accounting periods that just tells you that between these two accounting periods the cash has increased from 230 to 326 but then if I probe further to understand what has cost this increase it could be as simple as an activity that just brought in cash 230 plus 96, 326 or as complicated as a set of activities as we see here the aggregate of which results in a net cash inflow of 96. Now it is that understanding of all those activities that have either consumed or generated cash that we are interested in knowing by way of creating this cash flow statement and for the purpose of easy understanding I had told you that we started with net income then with operating activities investing and financing activities. So if you start with your net income and with specific examples I told you how you will handle increases in accounts receivable increases in accounts payable increases in inventories increases in deferred taxes what actually it means what does increase in accounts receivable between two successive accounting period means whether it is a cash inflow or a cash outflow what it means if there is a decrease in accounts payable between two successive accounting periods whether it is a cash inflow or cash outflow. Now this is the underlying concept that we understood last class to decide whether such differences be it an increase or a decrease is a cash inflow or a cash outflow to just sum it up to calculate the operating expenses we started with net income we added depreciation we add increases in deferred taxes this is just a quick summary we add decreases in accounts receivable we add decreases in inventories decreases in prepaid expenses increases in accounts payables and also just as we added subtracted the gains on disposal in that particular transaction there was a 20,000 that the entity gained because it disposed of its existing assets it could also happen in some transactions where there is a loss on disposal and just as gains were already a part of net income the loss is also a part of net income that is already factored in and hence such losses on disposal for the purpose of calculating the cash flow statement is added back to the net income. So, the loss on disposal is added back then what gets subtracted is exactly the opposite of this it will be decreases in deferred tax increases in accounts receivable increases in account inventories increases in prepaid expenses decreases in accounts payable and gains on disposal. So, what is this this net income plus and minus of the increases or decreases in these operating activities will be your net cash from operating activities this is just a quick guide for you of course, the understanding always has to be embedded you have to understand the logic behind the treating decreases in accounts receivables as a cash inflow or increases in accounts payable as a cash inflow why decrease in accounts payable is treated as a cash outflow this understanding has to be always there, but as a quick guide I am just giving you this. So, that you can immediately understand and relate as to why increases in accounts receivables is treated as a cash outflow and hence subtracted from the net income and this gives the net cash flow from operating activities plus investing activities plus financing activities plus opening cash will be equal to your closing cash this in effect summarizes the cash flow statement. So, what we have done in the last 10 to 12 classes is we have understood the principles of accounting and how to understand activities how to record those activities first identify the activities measure the activity in terms of monetary value and communicate by way of generalizing them and creating T accounts and then creating balance sheets income statement and cash flow statement. So, this in effect summarizes on how we actually understand the principles behind which these three main important financial statements are being created the balance sheet the income statement and the cash flow statement, but however I again reiterate that I have not handled this class from an accountants perspective because I am not training you to clear a chartered accountants examination, but as managers you must be able to interpret information that you see in the balance sheet income statement and cash flow statement and to understand and make some sense and what this quantitative information reflects what it actually conveys in the financial sense the strength of the entity or the organization that you are actually analyzing it was only in that perspective that we handle this class and of course there are many special cases and it could be very complicated how we need to handle those special cases is again a big subject matter by itself, but I think I just would like to provide the class with three special cases that are easy to understand and at the same time very useful again from a managers perspective as to how these three special cases three special accounting entries are being handled. The first thing is the principle of recording revenues and these three that I will be handling today will be the revenues the cost of goods sold and depreciation not that these are the only three special cases. That are considered to be special, but for the purpose of our classroom discussion and the requirement of the course I am just going to handle these three special cases and in more specifically cost of goods sold and depreciation. See recording revenues and recording cost of goods sold is very integral to your profit and loss statement when you prepare the income statement you see in your income statement it starts the top line starts with revenue and immediately it is the cost of goods sold. So, when it comes to revenues two principles that govern the way in which we handle transactions that generate revenue is the principle of conservatism and the realization concept. The conservatism concept and realization concept provides the underlying accounting principle when it comes to recognizing revenues and I have spent enough time on that and this I leave it to the judgment of people who actually handle these transactions conservatism I said you record revenues if you reasonably certain. Now reasonably certain is based on the judgment of the person who feels that it is reasonably certain or not and I already explained that what appears to be reasonably certain for me as an accountant in entity X need not necessarily be reasonably certain for a different accountant in a different entry Z or a different accountant in the same entity X. So, it is left to a fair judgment that accountants take to record and interpret certain revenue generating activities as reasonably certain or not. And after recognizing it as a revenue based on historical experiences we also know to what extent will I be able to realize whether I will be able to get the 100 percent revenue as cash inflows or not that again it is left to the judgment of the accountant. Now since this is being left open to the judgment of the accountant there is not an empirical formula that tells you that this is the way that you have to recognize revenues and realize the extent. So, both the timing as well as the amount there is not a scientific formula that tells you if the timing behavior is this way this proportion must be recognized as revenues no this is left open for accountants to make a very fair judgment. So, I am not going to give you any formula, but you have to understand that when it comes to recognizing revenues two concepts that always must be born in mind is the conservatism concept and the realization concept. And based on that you make a fair judgment, take a fair call and recognize revenues and recognize the amount that you think is fair and reasonable. So, I leave it at that when it comes to revenue recognition, but what is more important in addition to revenue recognition is the cost of goods sold. Remember when I was talking about the income statement I had mentioned that it starts with sales revenue and then the next is the cost of goods sold. And I told you that the cost of goods sold is the value of the economic resources that are being consumed to generate a product or a service that is ultimately sold. And I told you that there are also some entities that actually if you see their income statement they will start with sales revenue and you would not even see cost of goods sold. Typical are these merchandising entities where they buy some and they sell it. So, there is no value addition in it. So, cost of goods sold is not a very it is not a major addition in the income statement that you see. Now contrast that with manufacturing firms they are not into trading. Typically in manufacturing firms cost of goods sold is an important entity that is calculated. And when you calculate the correct cost of goods sold in a manufacturing firm there is a little complication to the issue. Now if you look at a manufacturing firm you get raw material X and it involves labour probably it also involves additional material to get converted into Y to get converted into Z which is then being sold. And this process will consume some material plus labour. This is typically what happens in a manufacturing firm and there might be value addition in each of the stage. There might not be value addition in each of the stage, but what you get as raw material is not sold as finished goods. There is some addition in terms of material and in terms of labour that gets into the raw material and finally gets sold as your finished goods inventory. Now the finished goods inventory gets sold. Now when this happens in a manufacturing firm the material that gets recorded in your inventory in your balance sheet could be in different stages. It could be as a raw material, it could be as a work in process, it could be as a finished goods. I will just illustrate this with an example so that you will understand this better. Suppose there are three stages that I would like to capture. Let us say this is the raw material inventory. So you had something in the beginning and you actually purchase this one is raw material and you make some purchases. Let us say this is the ending you make some purchases and then you use the materials. You use these materials and in the process you are also probably consuming some labour plus other manufacturing cost let us assume. This also gets into the process. Now let us say this is your work in process. Here again you had a beginning inventory. Let us say you have an ending inventory here. So it is this that gets translated as work in process and after you work on this you have some completed goods that gets to your finished goods inventory. Here again you would have a beginning finished goods. Now in all these three stages we find that it starts with raw material and finally ends up with cost of goods that is available for sale. Now let us say we have chosen an accounting period. Now it is very likely that during this accounting period the entity has consumed inventory different levels of inventory at different stages and very likely that the cost of acquisition of the inventory has changed over this accounting period. Which means we need to know that let us say inventory x k g that is consumed during a particular accounting period. We need to understand what is the value of that inventory that was consumed. Now that value could be the value of the inventory that was purchased during time t or value of the inventory that was purchased after t plus delta t. The delta t could be so long that the value itself is totally different. Now what will happen is if I am interested to find the cost of goods sold. This cost of goods sold is after the finished good product is available for sale and assume that the sale has happened. You are recognizing revenues. Now when you recognize revenues there is no problem in the principle of duality you get cash for that so sales revenue cash there is no problem. But the matching concept says that you should also record the relevant cost of goods sold. And when we are able when we are going to do that the cost the value of the cost of goods sold needs to be recorded properly. And how will you do that? The duality is cost of goods sold in inventory we saw that in the example. The cost of goods sold is debit and the extent of inventory that gets consumed is credit we removed from the inventory account. But what is the value is the key question. Now your cost of goods sold is your cost of goods manufactured plus your beginning finished good inventory minus ending finished good inventory. This is this process but it is not as simple as that. I told you I am interested in knowing what is the exact value of the cost of goods sold. It is important in knowing the exact value of the cost of goods sold because we are going to express the cost of goods sold in monetary terms. There is a problem if it is reported very high or there is a problem if it is also underestimated. So, we need to have a fair basis on which this monetary value of cost of goods sold is being recorded. The reason being that during the accounting period the value of the inventory has changed. And we need to understand and capture this change in value of the inventory during this accounting period. And when a sale transaction happens and let us say we are going to close and calculate prepare a balance sheet and income statement the cost of goods available for sale gets split into two components. One the cost of goods that is sold and the rest remains as inventory. So, broadly we need to understand the value that stays as inventory and the value that gets recorded as cost of goods sold when a sale transaction happens. So, these are the two things that we would be interested in knowing. Because the cost of goods available for sale once a sales happens it gets captured in two forms one as inventory the other as cost of goods sold. Now, the relevant question is what is the value of the inventory what is the value of the cost of goods sold. Why is this relevant because the cost of acquiring this inventory changed during this accounting period. And so there has to be some fair principle that captures this change. There are four ways that I will explain to the class how this particular cost of goods sold is being captured. The first thing the first example is specific identification method. Now, before I get into the methods I will give you an illustration example that we will use to understand the four different methods. Let us say the beginning inventory on January 1 was 100 units. And this 100 units I purchased at the cost of rupees 8 per unit. So, that my total cost is 800. Then I purchased some more inventory later. And I purchased 60 units which costed 9 rupees per unit. So, the total cost is 500. And again during October 1 I purchased additional 8 units at the cost of 10 per unit making the total cost 800. So, the goods available for sale 240 the average unit costed is 240. And I am just giving an illustrative example considering this entity to be a merchandising entry. But the principle remains the same if you do it for a manufacturing firm also it is the same principle that needs to be followed. Let us say during this period goods sold during this year. Suppose I sell 150 units which means my ending inventory is 90. Now, the question is what is the value of the cost of goods sold? And what is the value of the ending inventory? Let us say this is the question that needs to be answered. And this is what I have been telling you that the moment sale happens the cost of goods that is available for sale gets captured in two forms one as cost of goods sold. And then the and it is not the quantity that we are keen to know because in your balance sheet you do not record it as 150 kgs of finished goods 90 kgs of goods sold. What is the value is what gets recorded in your balance sheet as an inventory item and in your income statement as your cost of goods sold and it is that value that we need to record correctly. How do we record the correct value? The first thing let us say is the specific identification method. As the name suggests this is this is more of identifying the cost of item as and when it is purchased. And as and when it gets consumed also identifying the relevant inventory as and when it is consumed. How do we do this? There are number of ways today you find detailing company is barcoding each of the inventory that they purchase and then record the cost of purchase. The barcode gives you that information the cost of acquisition the moment it gets consumed again you are able to track that information till the last mile. That is possible if the the quantum of inventory that you are handling is very limited not voluminous or if the inventory that you are handling is very expensive especially the jewellery industry if it is very expensive inventory it is better it gets barcoded and then the cost of acquisition once it is consumed gets into cost of goods sold. So, the this method relies on the fact that you are able to capture the value of the inventory at the acquisition stage. And you are able to capture this for all the material that you acquire and the moment it gets processed and sold you are again also able to capture this information to that specific extent. Now, if it is if it is very voluminous the way in which you are handling the inventory is very voluminous you are not able to do this. This is a good method, but in practical sense in reality it is little difficult to do that if you are handling voluminous inventory then what do you do? Another method that could be adopted is the average cost. Now, what do we do in an average cost? Now, let us say this example says that I have sold 150 units during this accounting period. Now, the average cost method you know that the total cost is 2140. So, the average cost per unit is 2140 divided by 8.917. Now, this average cost if I am going to adopt this for the purpose of calculating my cost of goods sold and the value of the finished good inventory then the cost of goods sold will be 150 times this 8.917 which will be equal to 1338. And the ending inventory that we saw 90 times 8.9137. So, the total in this case the total does not alter because again we are working backwards we are calculating the per unit cost and then adopting this per unit cost to the 150 unit that gets sold and the 150 that stays as finished good inventory. The method is important that we are not specifically identifying each of the unit as and when it got purchased and as and when it got consumed. We just broadly assume that the cost is calculated based on averages and that 2140 units of inventory was purchased sorry 2140 worth of inventory was purchased and it was around how much was the inventory 240 240 units purchased for 2140. So, the average cost per unit is 8.917 and if I sell 150 units the cost of goods sold is 150 times this. If I sell 120 the cost of goods sold is 120 times this then the remaining value is in this case if it is 90 units that is remaining 90 times this. So, this settles the issue what is the value and whether this is the right value I would say yes why because I adopted in my opinion a very fair method of using the average cost per unit to calculate the cost of goods sold or the ending inventory value. Now, let us say again that I am not convinced with these two methods neither is this specific identification method practical nor is this average cost method acceptable. Both will have their inherent limitation because it does not capture in the average cost method the true value of the inventory it is just average and a specific identification method is practical and I do not have the resources to calculate the value of the inventory and the cost of goods sold till the last mile then are there better method to do this. Yes there are the LIFO method and the FIFO method the name suggests LIFO is your last in first out FIFO is your first in first out method. Now, the FIFO method assumes that the inventory that was purchased or the oldest inventory gets sold first in as inventory gets sold first out as against the LIFO method which assumes that the most recently purchased inventory is what that gets sold first lost in first out and this is as simple as it is explained that in FIFO method it was inventory that came in first to the entity that got processed and sold out first as against the LIFO method it is the inventory that came in last that got processed and sold first. And if this is the qualitative explanation that is required it is just simple to understand but then we are not interested in the qualitative explanation. Now, how is this FIFO method and LIFO method used to capture the correct cost of goods sold and the value of the ending inventory is the real question that we are interested in. Now, let us say I take the FIFO method first the FIFO method says that I have to assume that the inventory that I purchase the oldest gets processed and sold first. So, under that assumption for the same example that I am going to sell 150 units let us see how cost of goods sold is calculated which means from the beginning inventory I consume I am totally selling 150 units. So, from the beginning inventory I already have 100 then from the June 1 inventory inventory from June 1 purchase I consume 150. Now, what was the cost of purchase it was 8 and 9. So, the total cost is 800 and so this is my cost of goods sold. So, what will be my ending inventory I have 10 units balance from the inventory that I purchased in June 1. So, ending inventory from June 1 purchase I still have 10 units from October 1 purchase you know I purchased 80 units. Now, this still is at value 9 this is 10. So, what is cost of goods sold plus inventory still 2140 this does not alter that 2140 that we saw in the previous two cases also. But in this case the cost of goods sold that gets recorded is 1250 and the value of the ending inventory is 890. Suppose I would have used a average cost method then the cost of goods sold that gets recorded is 1338 this case it is 802 whereas, in this case it is 1250 and 890. So, it is only the way in which I recorded the value of the cost of goods sold in inventory that changed and hence both the examples that we saw the average cost and in the P4 you find different values for cost of goods sold and ending inventory. Let us again do a similar calculation if I assume that I am going to adopt the last in first out method to do this. So, to calculate cost of goods sold same thing the last in first out means that what I purchased the most recent now gets used first which means the October first inventory all the 80 units gets consumed then June 1 inventory how many how many units did I purchase 60. So, all the 60 units get consumed then what I had initially January 1 inventory the same 150 units and hence I need only 10 units from that. So, the unit cost is 10 here 9 here 8 unit cost units total cost. So, 800 540 80. So, the total cost of goods sold is 1420. Now, what remains as ending inventory is the balance 90 units that I had in January when I began the transaction 8 720. So, what is my cost of goods sold plus ending inventory is it same as this 2140 here yes, but is it same as the cost of goods sold an inventory that I got when I calculated using the P4 method no it was 1250 and 890 here, but in this case it is 1420 and 720 here. So, now you can understand that leaving the specific identification method which is the most exact that gives you the exact value of the inventory and cost of goods sold, but a little impractical amongst these three methods the average cost the leaf or the fee for the total cost did not change the total cost of goods that was available for sale did not change, but what change between these three methods is the value of the cost of goods sold and the inventory for the same transaction in which 150 units were sold. So, that 150 units that got sold the cost of those 150 units that got sold differed in these three methods and also the value of the ending inventory the 90 units also differed in these three methods and what cost the difference is the method that we adopted to record the value of the cost of goods sold and the value of the inventory why this difference because the cost of acquisition of the inventory itself changed during the accounting period. If the cost of acquisition of the inventory had been same throughout this accounting period then there is no scope for any of these different values. So, time becomes immaterial whether you are going to consume the inventory that was bought first or bought during the interim I mean bought during the middle or during the ending it does not make a difference because the cost of acquiring that inventory is same, but it is very unlikely that that will happen since the cost of acquisition of inventory changes and since we are more interested in calculating the exact value of the cost of goods sold and the ending inventory we have to have some fair method that captures this exact value and these three methods and actually people use the first in first out that is the most popular method. Now, what is the logic behind using this why not last in first out last in first out is also accepted it also has its own strong reasons as to why that should be the accepted method. So, next class we will begin with just giving you I will just give you some arguments favoring first in first out some that favors last in first out then we will see a little bit about depreciation. So, we will see next class. Thank you.