 Good morning class. Last class we concluded with the schematic representation of the fundamental equation that governs the double entry bookkeeping. This accounting equation was assets is equal to liabilities plus owners equity and I explained how the basic rules were conceptualized and giving you some inputs on what debit is credit is, when is a transaction, a particular transaction under a particular title is entered in the debit side and on the credit side. For that as a quick way to understand I had explained that every account is characterized by a T account entry which on the left hand side will have a debit and on the right hand side will have a credit and I advise the class not to get confused with the grammatical or the English meaning of debit or credit that debit is not good credit is good so do not get confused with those literal English meanings. For the purpose of accounting debit means just the left hand side and credit means just the right hand side and an asset increase arbitrarily has to be recorded on the left hand side. So while that gets fixed the rest falls in place which means any asset decrease will be on the right hand side, any liability increase will be on the left hand side and increase in liability will be on the right hand side shows the case with owners equity where any decrease in owners equity is on the left hand side and any increases on the right hand side. So this forms the fundamental schematic based on which all the accounts are being recorded under each of their T account categories and it is the aggregation the assimilation of all these individual entries of each of the account falls in perfect place when we finally create the balance sheet and income statement. How to understand how we create the balance sheet and income statement we must understand how these individual transactions are recorded after all the balance sheet and income statement as I told you before is an aggregation of all these individual transactions. So you can best understand this through an example where I will be explaining to you the various transactions day to day transactions or frequent transactions that will happen in an entity any entity for that matter and how each of these transactions are identified measured and communicated all in accordance to this fundamental accounting equation. So I will take a quick example and let us run through a series of transactions and then you will be able to understand why these entries are being made in a particular fashion. Now let us say this transaction is for a particular month let us say I the entity is in the business of running a restaurant. So this accounting entity is trying to record its transactions for a given particular month and let us say it is just starting its business. So the entity itself is getting created during this particular month and the owner of the entity decides to start this business by investing let us say 5000 rupees of the owner's money in this business. So the first transaction is let us say this is happening in the we are in the month let us say we are in the month of April. So it is on 1, 4, 2012 that the owner decides to invest 5000 rupees in the business. Now how would I record this transaction? Now every time when you come across these transactions my advice is to first read the transaction once and understand what the transaction is all about. Now if you read this transaction that is on April 1st the owner decides to invest 5000 rupees in the business. Now immediately the quick reaction would be to assume that the owner has invested 5000 rupees in the business but it is an accounting mind that will actually read this transaction very carefully and then understand that the owner has not yet invested the money but just has decided to put his money into this business. So there is a very fine line of difference between desiring to do something and then doing that thing. So if somebody decides to do something that never gets recorded as an accounting transaction because the event has not happened and for the purpose of accounting we are interested in recording transactions that have happened. So to decide that I am going to invest in an entity is in the business sense an important event but from an accounting perspective it does not alter the T account of the related transaction of the balance sheet of the income statement in any way because it is just a decision taken. Now let us assume that after the decision that he invests as well. So the owner invests rupees 5000 in the business this is the first transaction. Now how do I record this transaction? I told you in last class that a transaction will have a dual impact that it will have a minimum of one entry on the debit side and a credit side and does not compromise on the integrity of this equation as a result of which the debit will be equal to the credit. Now which means for this transaction that definitely has to be one entry on the debit side and one entry on the credit side and that each entry has to have an accounting an account under which this entry is being made. Now the first thing that we have to do is to see what account gets affected by this particular transaction. Now this is a very straight forward transaction where the owner has decided to invest 5000 and let us say that 5000 in the business is in cash and it is the owner's own money. So at the very face of this transaction we can easily make out that one account that will get impacted is cash. So cash is one account that will get impacted because the investment comes into the entity by way of cash. So how do we record this transaction? And I told you that every account is characterized by a T and in this case it is the cash. Now what has happened to cash because of this transaction? The entity before this transaction had no cash in it and now that the owner has put 5000 rupees into this business, the cash has increased from 0 to 5000 which means cash as an asset has increased from 0 to 5000. And have this fundamental equation accounts is equal to liabilities plus owner's equity and that any increase in asset is debit, any decrease in asset is credit, any decrease in liability is debit, any increase in liability is credit, any decrease in owner's equity is debit, any increase in owner's equity is credit. Now this fundamental equation needs to be embedded in your mind. As and when we encounter transactions of this type you understand what the transaction is all about, identify these relevant accounts and then this equation should be at the top of your mind. Now with this equation at the top of your mind and I told you that cash was 0 and now because of this transaction cash is increased to 500 and that cash is an asset item, I explained to you last class, a few classes back in the balance sheet cash is in the asset side, most specifically under the current asset side. So an asset has increased and as per our rule any increase in asset has to be debit. So what we do here is write 5000, so this 5000 is on the debit side. I am not writing debit or credit here because it is taken for granted that debit means left hand side and credit means right hand side. Now this transaction has increased the asset item cash and hence it is debit. Now what would be the corresponding second entry for this transaction that ensures that the debit is equal to credit. Now by default I can put this entry here and I know that this is the owner's money and the corresponding entry can be the owner's capital, in this case the owner's own capital, the paid in capital. So one way of understanding why this is entered in the right hand side is because cash was on the left hand side and hence this has to be on the right hand side that is one way of understanding it. But the second way of understanding why I put this 5000 in this credit side is to again look into that fundamental equation. Now what is owner's capital? Owner's capital is a part of the total liabilities on the right hand side. Your liabilities are split into liabilities plus owner's equity and this is an activity that increases the retained earnings of the entity. Now any activity that increases the retained earnings or the owner's equity is on the credit side. So that is why this 5000 I am marking it as credit. And for easy identification purpose, since this is the first transaction I also number each of these transactions so that when we actually revisit to create the trial balance and balance sheet this type of numbering will be really helpful. Now this paid in capital increase which is a credit entry is now recorded in the credit side that is the right hand side. Now I do not know this is not erasing. Anyway let us say we started the business I put in 5000 in this business and the business is started in a rented place and today that is on 1st April 2012 I pay rent worth Rs 750 for this month. There are different ways of treating this transaction but I will just adopt one particular method for you to understand a bigger concept related to it. Now I pay cash of Rs 750 for this month. What would be the transaction? As I said before the immediate account that can be identified because of the immediate impact it has created is the cash account because I have paid cash. Now I pay cash of Rs 750 for this month now contrary to the previous example what has happened in this transaction? In this transaction a cash of Rs 750 has been paid which means cash has left out from the entity cash has gone out from the entity. Now in the previous transaction the cash increase from 0 to 5000 and in this transaction from 5000 it has gone down to by 750 I mean it has gone not interested in what the final amount is but the understanding that the cash has reduced is important. Now cash is an asset item and because of this transaction this has reduced what does it mean? Again your accounting equation comes to your mind and then cash is an asset any asset decrease is on the right hand side so that is a credit of 750. This is number 2 this numbering is not really essential but just for the sake of convenience I am just numbering it and as I told you immediate entry would be 750 on the debit side why because the first entry was 750 on the credit account of cash that is one way of looking at it but then we are more interested in the concept behind this. Now I am going to write this title this as prepaid expense and I will tell the class that these account titles that you are giving you can form as many titles as you want as long as there is some reasonability in creating new accounts. Now in this case I am going to call this as a prepaid expense because this prepaid expense is to me an short term asset reason I have paid it they paid the rent at the beginning of the month as a result of which I have the benefit of using this space for this entire month which I consider it as an asset and hence I am just classifying that as a prepaid expense. Now again look at it from the accounting equation point of view this is an asset and end of the month of July I did not have the right to use this particular space I am sorry end of March then first April I paid 750 as a result of which I get the right to use this space and this right I think is my asset which I did not have before and now it has increased as a result of which any asset increase is on the left hand side debit. Now look at one more interesting observation in this transaction it is not that for every transaction that an asset item has to be affected and a liability item has to be affected for every transaction it is essential that the debit is equal to credit but then the debit can happen amongst asset items and the credit can also happen amongst asset items likewise the vice versa also. So it is not necessary that if there is a debit entry in asset necessarily there has to be a credit entry in the liability in this case it is not because both the debit and credit entry affect accounts which are asset type accounts namely cash and prepaid expense this is another interesting thing that you will have to observe and then at the end of this month what will happen will this prepaid expense continue to be an asset that is a question that I will ask probably sometime later when we actually do those adjusting entries but please have this at the corner of your mind that this prepaid expense of 750 is an asset at the beginning of this month which gives me a right to use this office space. Now what happens to the firm let us say the firm decides to borrow money from the bank so borrow not decides I have borrowed I have borrowed 4000 rupees 4000 from the bank 12 percent interest how do I record this transaction again the immediate accounting entity in this case the account that is that gets affected is the cash because I have borrowed 4000 from the bank what does it mean that the bank has given me 4000 so whatever be the cash balance before this transaction it has increased from that by 4000 so any increase in asset is credit sorry debit and this is account number 3 transaction number 3 and you can blindly put 4000 here but then as I told you before I am interested in understanding why it is on the credit side now why is it on the credit side I know that I got cash what is the source for this cash it was not my money so it is not the owners equity it is not the owners capital it is from a bank as a result of which the liability has increased which means I owed the bank I owed the bank nothing and because of this transaction now I owe the bank 4000 which means my liability which was 0 is now increased to 4000 now again your accounting equation comes to your mind what happens when liability increases so any increase in liability is on the credit side now what is this liability this is you know bank loans payable or assume this is you have many banks and you intend to borrow money from many banks so to make the account more specific you can also say this as bank X loan payable as I told you before all these titles to the account is entirely your choice as long as it conveys some reasonable meaning it is not a significant thing to worry about now this transaction is recorded this way now let us say the fourth transaction and I told you before this is a restaurant business that I am starting so I put my money I have got the space I borrowed money from the bank so the next thing that I do is to buy some equipment for me to start the business so I purchase equipment equipment worth 7200 now what is this transaction I purchase equipment worth 7200 equipment worth 7200 purchased this is the transaction how do I record this it is very clear that the cost of the equipment that I purchased is 7200 I did not have any equipment before this transaction now I have an equipment so something has increased in the asset side because this equipment is an asset and then what would be the corresponding second entry on the credit side now before we get to understand that the accounting mine should ask this question yes you purchase this equipment but did you pay the amount while you purchased or you deferred the amount that you had to pay now that is the question then let me also give an answer that I purchased at cash purchased paying cash right so there are two accounts that will be created which is equipment and in this case I paid cash cash is an account that can be easily identifiable so I say it is cash now let us begin this way let me let us make the credit entry first now that cash is left the entity so cash is an asset item any decrease in cash is credit and because cash is here as credit the corresponding entry on debit will be 7200 this is one way of doing or the other way is I did not have any equipment before this transaction now I purchased equipment whose value the cost of acquisition is 7200 as a result of which my asset has increased from 0 to 7200 and this I debit equipment 7200 and what is our accounting principle of cost it says record transactions at the cost of acquisition so I am recording it at it is full cost of acquisition which is 7200 now note again that both these accounts are asset accounts equipment as well as cash now I am blindly putting 7200 here and 7200 here that does not mean that for every transaction only one account gets affected on the credit and debit side no there are examples where more than one accounts get affected on the credit side and debit side the fundamental is a minimum of one debit and credit entry has to be made which means more than one debit or credit entry can be made for a particular transaction because two different accounts can get affected for example in this transaction if I decided that I purchase the equipment and that I decided to pay only 50% in cash and the remaining 50% after one month now in this case what would have happened is the transaction equipment 7200 debit does not change but then the corresponding dual entry cash would have been only 3600 because I paid only 50% so only 3600 would be cash and then what would be the corresponding second entry the credit entry for this particular transaction would be it would be probably accounts payable because I am yet to pay the remaining 50% another 3600 and since account payable is a liability it has increased so any increase in liability is on the credit side so you would have had cash 3600 and then accounts payable another 3600 and put together it is 7200 and that matches with your first debit entry of 7200 so here again another quick clarification is that you need a minimum of one entry on the debit side and credit side so that the integrity of the equation accounts is equal to liability so owner's equity is not compromised at any stage now let us say the equipment is arrived it is all installed and now we are going to start business and to start business we need to purchase some inventory and start doing starting our activities now let us say an initial inventory worth 800 was purchased on credit which means I purchased some inventory but I have not paid for it I am going to pay for it later now what do I do the account that gets affected here is inventory I told you inventory is a balance sheet entity asset entity in this case I it is raw materials it is raw material inventory which I purchase to process to conduct business what is the value of the inventory that I purchase is 800 should it be debit or credit this is inventory I had no inventory before now I have purchased some inventory whose value is 800 so before it was 0 now it is 800 is increased any increase on the asset side is debit and I am going to purchase it on credit so blindly I put it as 800 here but then I wanted to understand why I did that so I call this as accounts payable it is a generic account any outstanding to a vendor supplier you can categorize it as accounts payable but if you want to be very specific and you want to know how much outstanding to each of the vendor you could still qualify this account by saying accounts payable to X Y Z A B C whatever you can create as many account categories titles as you want finally your accounts payable will be the summation of all the individual accounts payable entities that you have created so in this case accounts payable to a particular vendor X there was no liability before this transaction and now because this transaction has happened I owe this particular vendor X a sum of rupees 800 so any liability that is increased is on the credit side the right hand side so this explains why the 800 is of the right hand side now let us say inventory is there its process finished goods available it was ready for sale and then we started making sales so the entity has started to make sale sales worth rupees 12,000 again that is what I wanted to understand a quick accounting question is was the entire sales in cash did we receive the entire 12,000 in cash yes then cash gets increased by 12,000 no part of it was cash then the customer said I will pay it later then whatever part is in cash gets recorded as cash and the remaining unrealized portion is accounts receivable we will get into those special types a little later but then this is for the purpose of understanding there is an accounting mind you will have to quickly ask this question whether this entire sales was in cash and for the sake of simplicity let me say it is all in cash so what is happened now because of this cash because of the sales my cash has increased from whatever it was before by an amount 12,000 corresponding entry is 12,000 credit what is the account title this is sales so I can write it as sales or revenue or sales revenue together it all makes sense but why is that this is credit 12,000 it is credit 12,000 because it was debit cash 12,000 that is one way of understanding but I do not want you to understand that way what happens when an entity recognizes sales when sales revenue is recognized we saw last class in an income statement the top line is sales revenue sales revenue minus all expenses finally you get net income then dividends and then is your return earnings and we are interested in knowing what type of transactions increase or decrease the retained earnings and if it increases or decreases how it has to be recorded whether it is on the debit side or the credit side and then again your fundamental equation that comes to the top of your mind tells you that any transaction that increases the retained earnings retained earnings is owner's equity it is owner's that has to be credit the right hand side now as this question here sales revenue if I am realizing sales that increases the retained earnings any incremental sale will create an incremental proportionate increase in the retained earnings so sales increases retained earnings any increase in retained earnings is credit right hand side and hence I put this 12,000 on the right hand side then employees where paid salary how much 3000 did I say employees no salary or I will pay later no no I said they are paid salaries I still I can say that I am going to pay you salaries only next month which means it becomes an liability for me for which the transaction gets recorded a different way but let us assume for the sake of simplicity I paid my employees a salary worth 3000 as a result of which my cash gets reduced by 3000 the corresponding entry here is 3000 it is a salary expense now here again you need to understand why is an expense item recorded in the debit side the left hand side now what is an expense again go back to your income statement it started with revenue and then you had all the expenses before your net income and retained earnings were calculated so think about this what happens if your expense keep on increasing if your expense increases then your retained earnings will decrease so any decrease in retained earnings again the equation says that will reduce the owner's equity and any deduction in the owner's equity has to be on the debit side that is your left hand side now in this case a salary expense whatever be the amount will reduce the retained earnings as a result of which your owner's equity is reduced and because your owner's equity is reduced your salary expense 3000 is on the left hand side let us say the next entry as inventory purchase of worth 5750 on credit it is similar to your fifth entry so no explanations needed it is just that additional inventory worth 5750 was purchase 48 and then accounts payable is 5750 here again it is on credit now before I go to further entries I just thought not sure whether I was making the class understand on this entry owner's capital why is this on the right hand side owner's capital is on the right hand side because your fundamental equation says any increase in owner's capital is on the right hand side here in this case this is the owner's equity owner's own money I always link this with the return earnings owner's equity see retained earnings is the net earnings available after dividend disbursement that gets back into the firm gets reinvested into the firm if it is not reinvested whose money it is it is the owner's money why because it is the money which has resulted after meeting all the liabilities a bank interest all other expenses your income tax then paying all the dividends and finally the owner's money so please understand that any that is why any increase in retained earnings can be directly linked to increase in owner's equity because retained earnings is anonymous with owner's equity so that is why any increase in sales increases retained earnings any increase in expenses will decrease the retained earnings and vice versa will affect the owner's equity as a result of which you credit or debit that is the understanding now the next transaction now let us say the sales that I made before consumed some of the inventory so sales consumed 6000 worth inventory so what does this mean it means that you know I had an inventory and because of the sale the value of the inventory that was consumed is 6000 and inventory is an asset item any reduction in asset is credit entry now resources that get consumed to generate sales is a I have told you in class last time that I call them as the cost of goods sold because these are resources directly identifiable that have been consumed to generate the sales cost of goods sold usually we call this as COGS and some forms actually had a court this separately but for some accounting entities it is difficult to actually record cost of goods sold so you would not even see cost of goods sold in some of the income statements and hence cross margin is difficult to calculate this is start with sales and then write all those expenses to finally calculate the operating margin and the net margin but at least for understanding let us assume that we are able to identify these inventory that gets directly consumed to generate the sales and the value of the inventory that got consumed is 6000 and what is cost of goods sold it is one form of an expense and now that expense has reduced the retained earnings reduction in retained earnings is reduction in owner's equity reduction in owner's equity is an entry that needs to be recorded in the left hand side that is the debit side and hence cost of goods sold is debit 6000 now I need to pay some expenses for the utilities for this particular month so let us say we are at the end of this month and I have to pay for utilities and the utility expense was let us say 450 rupees this is again a straight forward transaction where you see cash is what I pay and that cash has went out cash is an asset it has reduced the cash credit 10,000 easy accounting an account title called utility expense which is 450 why is it debit because utility expense reduces retained earnings as a result of which the owner's equity gets reduced so let us just pause here now you should have a very firm understanding on why certain type of transactions are being recorded at the first place they are identified and given a proper account name for easy retrieval later and then after naming each of these accounts and I told you that you can create as many accounts as you want and the more and more accounts that you create the more and more specific you are getting down to understand the transaction at various levels and then each of these accounts you are trying to see what gets affected what relevant account gets affected and then identify those accounts and record the monetary value of these transactions based on the nature of the transaction it could affect cash to affect accounts payable inventory sales so you have a host of such accounts that you can create now let us say the next transaction is about an activity that has happened in the past and now that we are trying to handle that activity now let us say I paid some amount of accounts payable that I owed in the past let us say the accounts payable worth 4800 paid in cash now I do not have to go back to the original entry where we made some accounts payable 5750 and right here less 4800 the very purpose of doing this is to individually characterize each of these transactions and then aggregate them together later so this particular account though it is linked to a previous activity that has happened gets identified as a separate activity by way of a T account entry this is something that we have to understand because this is what makes the aggregation easy for you later when we are actually going to consolidate each of these individual accounts now what did I do here accounts payable worth some 4800 was paid in cash which means cash 4800 I paid accounts payable 4800 why is it debit because now my accounts payable is no longer that 5750 that we entered previously I have paid 4800 now this transaction has reduced my liabilities any reduction in liability is a debit entry a right hand side entry so an accounts payable paid in cash you understand now cash gets recorded in the right hand side because it has gone out as a result of which the asset has reduced to that extent now let us stop with this transaction let us say I entertained one of the customers who happens to be I meaning the firm okay so you will have to understand the difference between I and the firm they are two distinct separate entity so the firm entertained the customer who happens to be the friend of the owner of the firm so let us say the sales because of that was rupees 2000 and since he happens to be the friend of the owner the owner decided I will collect this 200 rupees later now how do I record this transaction two things that you should ask yourself or I will do one thing I will just record this transaction and then probably get into a little complicated issue as to how the sale is getting realized so sales 2000 debit or credit it is credit why because sales increases your return earnings any increase in the return earnings increases owner's equity any increase in owner's credit now what do I do here did I receive cash for the sales no happens to be my friend we said accounts receivable what is accounts receivable it is a current asset account I had no accounts receivable it was 0 and because of this sale transaction it means that at some point of time I will be getting this 200 later so it is not cash because I have not got it I will be getting it sometime in the future so I record that as a current asset item because accounts receivable is a current asset in this case it was 0 before and now it has increased by 2000 and increase in the asset is hence recorded as the left hand side let me stop here and then begin next class with the same transaction as to first why did you record this 200 as a sales revenue are there any other circumstances where you would not have recorded this despite the fact that the sale has happened you would also end up not even recording this 200 as a sales revenue quite possible and then we will have to revisit our concept of principle of conservatism and the realization and recognition of sales revenue so let me stop here and when we meet next class I will start with this principle of conservatism and then we see various other transactions before we end up doing a trial balance thank you very much.