 Good morning class. In the last class we had completed almost the substantive portion of financial accounting and when we began this course I had clearly mentioned that there will be two parts in accounting that I will be handling. One is financial accounting and the next one is management accounting. So we would be entering into sessions related to management accounting and before I venture to do that I would like to quickly summarize and give you a snapshot that will capture the basic essence of financial accounting for the benefit of those who could not attend to some of the previous sessions. And also I had already told you that the purpose of this entire course is to enable you to intellectually engage in a conversation that has got something to do with financial accounting in some form whether it is a balance sheet or an income statement or some terminology is used in financial accounting. With that perspective also before I spend some time on management accounting I thought I will quickly provide a quick summary of all those important topics that we dealt in financial accounting. The very purpose of accounting as I said before was to collect information and for collecting the information we have to identify what type of information is relevant record that information and communicate in a way that it is best understood by the end user group. The financial accounting is one form of accounting where we identify, measure and communicate all sets of activities that happen within any entity and in the process try to create financial statements, a balance sheet, an income statement and a cash flow statement all three independently conveying some sense on the way in which the organization is functioning. And the reason that we do this is essentially to capture information because the purpose of accounting by enlarge is to capture information and communicate it in a way that it is understood uniformly by any end user for various decision making. So I had already explained the two major forms of accounting and we will be spending some time on understanding the difference between these two types of accounting namely the financial and management accounting. As I said before I will be just quickly providing you a summary of what financial accounting is all about. Financial accounting is as I told you before it tries to identify, measure and communicate in monetary terms all relevant activities of an entity and hence it becomes the language of business. And since it is identified as the language of business there must be some syntax, some nomenclature that makes it uniform as a result of which a balance sheet is interpreted the same way given all things being equal in India or in the US or in Europe wherever you are. Geography is disappearing there is a common syntax that is followed for the purpose of understanding these financial statement as a result of which financial accounting is popularly called the language of business. Now when it comes to following a uniform syntax it means that there must be some set of principles which form the underlying basis on which these three requirements of identifying, measuring and communicating in monetary terms these activities have to be done. So the language of business or financial accounting has basically eleven accounting principles and these principles form the underlying basis on which the entire accounting concept rests. The first one would be the money measurement concept, principles or concepts I would rather use the word concepts. The money measurement concept is the fundamental requirement that governs accounting principles which means that all the activities that happen within a given entity that needs to be recorded has to be expressed in some monetary terms. It does not make sense to record that an entity has 3 tons of inventory, 20,000 square feet of building and that does not show up as 20,000 square feet and 3 tons of inventory in your balance sheet and even if it shows up it does not really make any financial sense it makes some sense but then for the purpose of balance sheet it does not make any sense. Now the money measurement concept is one that enables or necessitates that all the activities that are required to be communicated needs to be expressed in monetary terms and the type of activity that happens in an organization is very diverse. So for all these heterogeneous activities you need one homogenous identity and this homogenous identity is the expression of all these activities in monetary terms. In short all these heterogeneous activities need to be identified in monetary terms, it has to be monetized. So a 20,000 square feet of building needs to be expressed as 2 crore rupees in value. 3 tons of inventory needs to be expressed as some value in rupees and only when all these activities get monetized and expressed in monetary terms it makes financial sense when these sit either in the balance sheet or the income statement. So that is the first fundamental concept based on which the accounting principles are framed. The second one is the entity concept. The entity concept clearly draws a line differentiating the owner or the individual who run the company as against the entity itself and I gave you a very simple example when as a owner if I take some money from the entity it does not mean that I have to be oblivious to this activity. Though I am the owner the fact that I take money from the entity needs to be recorded as an accounting information because the owner is different from the entity. So the entity concept clearly differentiates the owner of the firm from the firm itself and you need to appreciate that because at times people think that the owners and the firms are one and the same but from an accounting perspective they are entirely two different entities. One is the firm the other is the owner of the firm which is who is totally different from the entity itself. The third assumption is the going concern concept. The third concept is the going concern concept. As the name suggests the going concern concept is one that believes that any entity for which we are recording all this information is assumed to exist for a perpetual period of time. Now this is a fundamental assumption that is reasonably valid because we are trying to understand the principles of accounting for entities that are assumed to exist forever. So a going concern concept justifiably assumes that any entity exists for a perpetual period of time. It is not that it is going to start today and going to wind up business in two months from now but of course there are some operations which have shorter durations and still these concepts are applicable for those but then we will deal it in a different way. A majority of the accounting information that is collated for various entities however assumes that such entities exist for a perpetual period of time. The fourth concept is the cost concept which we discussed at length when we actually had discussions on balance sheet depreciation when activities relating to acquiring new assets were discussed. The fundamental assumption is that the cost concept records the cost of an entity the economic resource of an entity is always recorded at its cost of acquisition and thereby there is no room scope for any subjectivity in the recording. Now suppose you look at the balance sheet and you buy some land at some point of time for 10 million rupees it gets recorded at the cost of acquisition and the land stays with the entity 5 years, 10 years and at the 10th year if you look at the balance sheet still the cost of the land will be recorded. The value of the land will be recorded in your balance sheet at the cost of its acquisition which is 10 million, 10 years back. We do not record the value of that particular asset any economic resource for that matter at its future value or at its expected value because then that gives room for a lot of subjectivity because different people have different valuation models as a result of which there might be different values for the same underlying asset. Now to make sure that there is no room for such subjectivity the cost concept assumes that all economic resources of any entity needs to be recorded at its cost of acquisition and as and when an asset gets used if that asset needs to be depreciated it is the annual depreciation that gets reduced from the value of the economic resource. The fifth concept is the dual aspect concept in which we saw that the fundamental equation when we discuss about the balance sheet is that the assets will be equal to the liabilities plus owner's equity and any activity that happens within an organization within an entity will impact the accounting records in such a way that this fundamental equation assets is equal to liabilities and owner's equity is not compromised. So there is a dual impact to ensure that on one side the asset and on the other side the liabilities the owner's equity remains equal and that in every transaction happens each transaction has a dual impact that does not compromise the integrity of this fundamental accounting equation. Remember this is the fundamental accounting equation assets is equal to liabilities plus owner's equity and we will also understand how this is recorded when we actually get into the double entry book keeping. The sixth accounting principle is the principle of conservatism the previous five concepts are in a way related to activities that has a huge impact on the balance sheet and the remaining that we will be discussing are the ones that not all the remaining but the most of the remaining concepts will be the concepts that will have an impact on the income statement. The conservatism concept is about the principle regarding revenue recognition and this is where I had re-iterated and I would like to reinforce now that it follows the concept that revenue will be recognized if it is reasonably certain and expenses if it is reasonably possible and a classic example is always when I walk into a automobile dealer showroom and say that I need a car the dealer should not record that as a revenue though I would end up purchasing the car two months three months from now but suppose the same dealer loses or a car gets stolen then it has to be recorded as some bad expense though the dealer believes that three months four months down the line there is every possibility that the car will be recovered. You will understand that when it comes to recognizing revenues it has to be recognized only if it is reasonably certain that the revenue can be generated and contrary to that expenses have to be recognized when actually there is some possibility that it would be incurred and this is the principle the concept of conservatism. So conservatism is about the timing and the next concept is the realization concept which is more about the amount. Conservation is about timing the realization concept is about the amount and based on historical experience if you make a sale on credit to what extent will you be able to get the entire collections for the sale that depends on the type of customer the historical record that the customer has got with the entity. So based on that to that extent you will realize the extent of revenue that will be recognized. The next concept is the matching concept the matching concept is the fundamental to the matching concept is that given an accounting period all the revenues and it is related expenses need to be recorded within the same accounting period. So if you are recognizing revenue within an accounting period the expenses related to that revenue within that accounting period needs to be matched to it. So this is the matching concept and only if we are able to follow this matching concept will your financial statement actually be accurate because it is only the expenses relevant to the revenue and both of them when captured within the same accounting period makes more financial sense. So that is the fundamental to the matching concept. The next is the consistency concept now consistency concept assumes the need for following the same procedure methodology for recording activities in a given particular way and as long as you follow the same methodology and you do not change methodologies frequently then your financial statement the resultant financial statement is in perfect order that does not mean that you cannot change the way in which you record transactions. But consistency concept only requires that such changes are infrequently done for example you might change the way in which you would like to depreciate an asset it is possible except that you do not do it straight line this year then the next year accelerated then again the next year straight line. So such types of frequent change the way in which you record this transaction do not happen and if at all when you actually change the way in which you do this you would see at as a footnote in these financial statements that they would record that till last year we followed this principle and from this this year we are actually changing the way in which we have recorded these transactions. But by and large there is a consistent way in which such transactions are being recorded and this concept ensures that there is not inconsistency in the way in which these transactions are recorded. The next concept is the accounting period concept now every day in a given entity has a set of activity and technically every day you can end every day by creating an income statement and balance sheet for each day but that is not the purpose we are interested in understanding these financial statements over a longer accounting period and typically for the sake of uniformity and convenience in understanding an accounting period that is why you would see you would find the annual reports that talks about the balance sheet and income statement for a given particular year and across the globe the standard accounting period is assumed to be one year but at the same time we also need to meet the regulation set by various you know stock exchanges I am talking about companies that are listed in exchanges where you will have to file information every quarter so that is why you would see companies also filing quarterly returns that talks about the balance sheet and income statement for a given quarter so that is why you would see quarterly balance sheet and income statement and the aggregate of these four quarters is your annual report that you see at the end of every financial year. So by and large the accounting period is assumed to be one year and at the end of every year you would see annual reports publishing these balance sheets and income statement the 11th principle is the concept is the materiality concept now materiality concept the fundamental understanding a given is that I am interested in monetizing in expressing in monetary terms evens that have a significant material impact so I am interested in only recording such transactions and the classic example that I usually give to a class is that the fact that I purchase one box of stapler pins does not mean that the entity owns an asset though it is an asset I do not record it as an asset in a balance sheet item in the balance sheet I do not record the stapler pin as an asset rather the money that I spend to buy a stapler pin I would rather treat it as an expense a stationary expense and that gets reflected in my income statement. So the materiality concept is one that assumes that only activities that have significant material impact needs to be recorded appropriately that does not mean that activities which are not significant need not be recorded but then has to be dealt based on its significance that is the materiality concept. So if you find all these 11 concepts and if you are able to understand these 11 concepts then you will know that these 11 concepts actually form the very foundation on which accounting principles are evolved now with these 11 concepts how do we actually record these activities in an organization and for that the standard methodology that is followed world over is the double entry book keeping and what is it I told you that the fundamental equation is assets is equal to liabilities plus owners equity. And the double entry book keeping is just one way of recording all these transactions by identifying each of the transactions as a particular account activity and each activity has an account head like cash or inventory or accounts receivable sales asset purchase so each of them is an account and each of these accounts get recorded in a manner appropriate based on what happens to the account as a result of the transactions. And how do we record that we record these transactions in monetary terms by entering one in a debit side and since one of the fundamental concepts of accounting assets double the dual impact there needs to be something called a credit and do not get confused by debit credit add attach some grammatical interpretation the English grammatical interpretation to it in accounting debit simply means the left hand side and credit simply means the right hand side that is it. And when we record each of the transactions and it is impact to a particular account we just use this particular t this is the t the t account and record the impact of the transaction to that particular account. And how do we know what is the impact now this is very important that you need to understand that any increase in asset is debit and the rest simply follows. So, the fundamental assumption non-negotiable is that any increase in asset is debit now if any increase in asset is debit then any decrease in asset is credit then any decrease in liability is debit any increase in liability is credit. Likewise any decrease in owner's equity is debit any increase in owner's equity is credit now this fundamental equation and the way in which we record in monetary terms the transactions that impact a given account by following the debit credit double entry book keeping is the heart and soul for this accounting. And it is based on this that we actually create these three financial statements. Now assume that you have to do this for an entity and that one year has passed and that you have recorded all the individual transactions that have impacted various accounts cash inventory accounts receivable accounts payable accounts receivable loans. So, you have various accounts each of them has an account title and the aggregate the summary of all these accounts at the end of a given accounting period is what you find in a balance sheet or an income statement. A balance sheet is a snapshot or a stock statement which provides information regarding the financial strength of the entity and an income statement is a flow statement that provides information on the financial performance of the entity. But then both of them are linked and I have told in class that I would consider an income statement a little subordinate to a balance sheet because the balance sheet is the real statement that gives more information on the financial strength of the entity. And if you look at the balance sheet that is where you would find the assets and liabilities and onos equity on the other side. And do not be surprised that their assets is equal to liabilities with onos equity. It has to be that way only then it is a balance sheet and it will be that way as long as you follow all the concepts and record transactions without compromising on the integrity of the fundamental accounting equation. Where the income statement talks more about the financial performance where you start with sales, the cost of goods sold, the expenses and the net income. And before we actually prepare this balance sheet and income statement we also create a trial balance which is an interim report which we use to ensure that before we advance to a balance sheet and income state preparation it is just a checking mechanism to ensure that all the transactions that we have recorded are recorded correctly. And how do we do this check? I explain that for each of the account you find the closing balance and record them as debit or credit and the summation of all the debits and summation of all the credits will equal. That is a signal that tells you yes if you go ahead and prepare a balance sheet from here your balance sheet will balance. But that does not tell you that all the information or the way in which you have recorded this transaction is correct. You could have made an error on the right side and still your trial balance will show that your debit is equal to credit and if you go ahead still your balance sheet will be balancing. But then it does not provide correct information your balance sheet will balance but then the balance sheet is not correct. So a trial balance is an interim check just to ensure that your debit is equal to credit and if it is not it tells you that there is some mistake somewhere and you have to go and rectify those mistakes. And we also dealt with three special cases, three special cases in these accounting categories, the revenue, the cost of goods sold and depreciation. And revenue this can be elaborated at length but then we restrict it so that we understand that two important requirements is on the realization and recognition. Whether you need to recognize the revenue in this accounting period or postpone it later. In the moment you recognize an activity as revenue generating to what extent would you realize the revenue and this is open to a lot of subjectivity but as long as there is some reasonability in the assumptions that you are making to record revenue transactions then your income statement is correct. The second thing is cost of goods sold, the cost of goods sold at elaborate we discussed on how the cost of goods ready for sale after it gets sold finds itself in two places inventories and cost of goods sold. And what is the value of the cost of goods sold and what is the value of the inventory depends on what type of inventory recording method that you have adopted. It could be a leaf oak last in first out or a first in first out leaf oak or an average inventory costing mechanism or a direct inventory identification where every inventory is tagged and then the cost of acquisition is recorded and as in which as and when an inventory is consumed it gets identified and recorded at specific inventory levels. So specific identification and average leaf oak, leaf oak, leaf oak these were the four methods that we use to record inventory and also find the value of the cost of goods sold. The depreciation also we discussed on how there are two methods straight line and sum of years digit two ways by which an asset can be depreciated. So these are the three special cases that we also discussed at length. And then finally we also discussed about a cash flow statement which is the third important financial statement and this is where that we appreciated the concept that income is not cash. The cash that you see in your balance sheet is not equal to income that you see in your income statement and both are different because the misconception that people who have no accounting sense is that cash and income are one and the same then you will appreciate when you actually get into these concepts that both are different. And that a cash flow statement actually gives you more information on the behavior of cash between two successive accounting periods and you will know how cash got into the firm, how cash left the firm and a resultant of all the activities that have either consumed or generated cash will actually give you an ending cash and that is the cash that you see in your balance sheet. And these activities we found that are predominantly categorized into three types namely the operating activity, financing activity and investing activity and by and large if you are able to categorize all the activities in these three heads and study how each of the activity has influenced the behavior of cash and the summation of all the activities that have influenced cash between two successive accounting periods is what gets recorded as a cash flow statement. And then finally we also saw how a financial statement can be analyzed and we understood that by actually getting into some of the ratios that are popularly being popularly used which fall broadly under four categories namely the liquidity ratio, the activity ratio, leverage ratio, profitability ratio. So these four ratios that talk about the extent of the liquidity of the firm, the efficiency with assets are being used gets captured in the activity ratio, the various sources of capital and the potential of the firm to services debts gets captured in the leverage ratio and the profitability ratio is the one that provides explanation for the extent to which the firm is generating net income, the return on income is expressed in various ratios that come under profitability ratio and also finally we also saw what a due point ratio is and how that return on equity is split into three parts and each of them important. Remember we talked about the net income by sales which is the return on investment that is the profitability ratio and then the asset turnover ratio sales by assets and then assets by equity is the equity multiplier. So these are the three individual components which put together forms is the due point ratio which is your profitability ratio expressed as net income by sales times sales by asset which talks about the activity ratio how efficiently you have used the assets. Assets by equity is more a leverage ratio and equity multiplier and all these three put together is your return on equity which is your net income by equity and this is important because return on equity is another important measure because you will find that many of the entity the main objective is to maximize shareholder value which is actually maximized when your return on equity gets maximized. So this in a nutshell is what financial accounting is all about that we have to follow some concepts that actually govern the generally accepted accounting principles and these are the principles that are uniformly used wherever you are except that there might be some minor changes suiting to the local needs but then if you see an income statement of Ford Motor Company listed in the US and you see that income statement in India you could still make sense from those income statement and balance sheet just as somebody sitting in Europe can make the same sense looking at an income statement of Atada Concentracy Services or any other Indian company and then these accounting principles have to be properly understood and all the transactions that are relevant needs to be identified, measured and communicated by following a set of rules that govern this language of business and if you are able to do that then you would end up preparing a correct balance sheet income statement cash flow statement based on which both internal as well as external users can use this information can analyze how well the entity has performed because you have different ratios that you can calculate from all these statements that you have prepared. So the use of such financial statement is not only for those inside the organization but also for those who are outside namely the shareholders, the bankers, the income tax authorities, the government authorities, the regulators, whoever it is they would be able to make the same sense because the financial statements that you have prepared is one and the same whoever is the end user and as long as you have followed some of the basic principles and you have not compromised on any of those then you have a correct financial statement in place. So in essence the previous sessions I have given you inputs on how to record these transactions and why these concepts are very important and after having understood these concepts then you can take a decision whether these transactions are relevant, the significance of these transactions and how it needs to be identified under particular account category and how such transactions are recorded by following the principles of double entry book keeping and an aggregate of all these transactions will form your balance sheet income statement and cash flow statement. Now this is about financial accounting and I told you that on the other side there is also something called the management accounting. So next class I will be giving you some inputs on the fundamentals of management accounting but we would not be spending a lot of time on management accounting just as we spend a lot of time on financial accounting not that it is not relevant but then it is not that popular because the user of the information that comes out of management accounting is more internal as against financial accounting where the user group could be even external stakeholders but then it is essential from an internal control point of view that we need to understand what management accounting is all about. So next class I will give you some inputs on the need for management accounting the difference between management accounting and financial accounting which relates to the behavior of cost and how cost is the understood the cost structure is understood and the impact of changes in the cost structure on the pricing decision or other financial impact can be best understood when we actually know what management accounting is all about. So next class I will give you some inputs on management accounting. Thank you.