 Last class we ended the discussion with the current liabilities in the balance sheet and to be more specific it was on the issue of deferred revenues that I ended the class. There was a question to further elaborate on what deferred revenue is with a good example. Let us say I am a magazine subscription company so the entity that we are talking about is a magazine subscription company and that I have collected cash, I have collected money with a promise that I am going to for the next 12 months provide you with the monthly issues of the magazine. Now from the entity's perspective from the subscription company's perspective the balance sheet would show the amount that I have collected as a deferred revenue. On one hand on the assets it would have recorded the cash that I have received for this and on the other hand I would record because the principle of duality the other entry corresponding to this cash should be the deferred revenue and why is this a current liability? Because this represents the liability that arises from the fact that as an entity I have received money I am bound to provide these magazines every month for the next one year. Now what happens when I start doing this? Let us say the first month I deliver the first issue so one 12th of the money that I received will be recognized as a sale so at that point of time one 12th of the amount would be recognized as sales and I would not add cash because I have already received this money so that one 12th would be reduced from the deferred revenue liability so that would be the corresponding second entry one month later after I have supplied this magazine. We will talk about this more when we are talking on concepts like recognizing and realizing revenues but for the purpose of understanding why deferred revenue is a liability? This is a very good example so that you will appreciate that this represents a liability of an entity to provide a service for which it has already received an advance payment. Now getting a little further just as we have current assets and fixed assets we have current liabilities and long term liabilities, long term liabilities are predominantly long term debt or the company's own bonds that they issue so which means I borrow money from the bank repayment period is 8 years 10 years since it is long term this stands as a long term debt or raise money by selling corporate bonds the period the duration of the bonds 5 years 10 years whatever the case may be these are long term debts and I already told you that the fundamental equation is assets is equal to liabilities plus owner's equity we have seen what assets categories are what liability categories are now let us see what the owner's equity categories are what is owner's equity now owner's equity is the extent to which an owner's investment in an entity is expressed usually we see that this gets reflected from the fact that you know a owner or a group of owners owns certain percentage of shares in the incorporated entity so the extent to which he owns the shares determines the extent to which he owns the entity. So that is why you often see that this owner's equity terminology itself can is substituted with this terminology called shareholder's equity the extent to which I own the shares of a particular firm so the shareholder's equity has two parts in it the first part is the paid in capital and the second part is the retained earnings now what is paid in capital the paid in capital part of the shareholder's equity is the amount that the owners have directly contributed in creating this entity so this is the amount that they have directly invested in the business the extent to which their contribution is represented in the direct investment that is being made is the extent to which they own this entity now again this paid in capital which is the direct investment direct owner investment has two parts the capital stock and additional paid in capital what is the difference I told you before that you know shares are issued by companies and the extent to which somebody owns a share determines the extent to which he or she owns the entity let us say that an entity has one million shares outstanding and when we talk about share every share has a par value the value that appears on the share certificate let us say this one million shares that is outstanding has a par value of rupee one and as investors paid rupees five to own one share does it make sense can you appreciate difference between capital stock and additional paid in capital the share that is sold to an investor for rupees five has a capital stock component which is represented by its par value of rupees one and an additional paid in component which is the differential of rupees four and since we have one million shares outstanding how was this expressed so your paid in capital gets modified paid in capital is now represented this is for the entire one million shares so it is usually represented in your balance sheet if you look it will say common stock at par that is your one million and additional paid in capital your additional paid in capital is your four million so your total paid in capital is five million so this excess over par is your additional paid in capital now your shareholder's equity as I told you before has two components your paid in capital and your retained earnings and we just saw what paid in capital is then what is retained earnings now retained earnings is the second category of shareholder's equity see the owner's equity in a business increases if the earnings of the business increases what do I mean by earnings of the business I make a sale there is income there is lot of expenses associated with the sale that I made so after meeting all those expenses taxes I have some net income that is available to the owner which means after meeting all the expense related items there is a free income that is available to the owner and let us say this is the earnings that is available to the owner so the owner's equity gets increased because of this increased in earnings now suppose from the earnings the board decides to disperse dividends which means it goes to the shareholders also the principal owner's equity gets reduced because of this disperse disperse sale of dividends otherwise the earnings would have entirely come to me or to the firm now it is disbursed as dividends and after dividends whatever is the remaining part of the earnings that is available gets into the firm as retained earnings so retained earnings can be expressed as the total earnings minus the total dividends disbursed when because in your balance sheet the retained earnings will be one number it is the difference between the total earnings of the entity from the time of its inception to the balance sheet date and the total amount paid as dividends out of the earnings right from the time of its inception up to the balance sheet date that is the retained earnings component or to put it in a better perspective for you to understand it is that earnings that gets reinvested into the business the money after even the dividends are distributed that gets retained by the business for its own internal investments is your retained earnings but a caution here is that you shouldn't confuse retained earnings with cash retained earnings is not equal to cash you look at the sample balance sheet you will find that retained earnings is an amount while cash is a different amount now what is retained earnings it is the aggregate of all the earnings from the time of inception up to the balance sheet date minus all the dividends disperse during this period and what is cash cash is the ending cash as on that particular date both will not be equal very often people misunderstand cash with retained earnings just as they also misunderstand income with cash I will explain that there is also a difference between income and cash when we actually talk about income statement but retained earnings is not cash now why is this part of shareholder's equity retained earnings is part of shareholder's equity because the earnings that the entity earns after it has met all the liabilities whose the principal beneficiary of this earnings it is a shareholder but I the shareholder decided that I am not going to take the money for me but I am going to reinvest into the business retain it for the purpose of business investment I call it as a retained earnings and it is a money that a shareholder decided that I do not need it now but would rather invest in the business and hence it is a shareholder's money that just got into the business as retained earnings it is part of shareholder's equity so it is not just the paid in capital or the direct investment in capital that alone represents shareholder's equity it is also the extent to which the shareholder has continuously contributed by way of retained earnings over a period of time that also represents the shareholder's equity now I can understand this if my business is incorporated because I have share I have stocks the extent to which I own the share determines the extent to which I own the business but that does not mean for unincorporated business there is no shareholder's equity or I am not able to express shareholder's equity for unincorporated business namely a proprietorship firm or a partnership firm still you can express the capital portion let us say in a partnership a partnership is an unincorporated business it is owned jointly by several persons now let us say there are two people who own this business and the total capital the business is 30,000 so X X's capital let us say they are equal partners 50,000 Y's capital 15,000 total partners equity 30,000 partners equity will also increase or decrease based on his or her share of the entities earnings during that period let us say X capital beginning was 80,000 and the entity the entities earnings from the entities earnings the portion that X should get is 35,000 add X's earnings and the partner also had some drawings during this period so partners for X's drawing anything within parenthesis means it is minus so what is this 91,000 it is X's capital as on a particular date that we are studying now so the capital part the equity part can also be expressed even for unincorporated entities now let us see whether with this input we can still expand our fundamental equation which is assets is equal to liabilities plus now your owner's equity gets split into two parts paid in capital plus retained earnings now with this definition and the five concepts that we saw earlier you can begin to appreciate changes that can happen in a balance sheet based on events that occur the numbers keep changing in the balance sheet that we start creating and as and when an accountant records these events it gets meticulously recorded and then the changes get reflected in the balance sheet and at each stage since balance sheet is a status report each stage of the balance sheet reports the financial condition of the entity on that particular date it was prepared it is a practice that a balance sheet is prepared at specific intervals but for the purpose of appreciating these accounting concepts I would just try to record some entries and create mini balance sheets so that you will appreciate how these entries are being recorded at a balance sheet level and how a balance sheet at the end of the day balances just for the sake of appreciation let us just quickly work some examples quick examples of the effect of a few transactions on the balance sheet of an entity firm I just give you a few examples now let us say a person is going to start a music store it is a firm the entity is a music store now he starts this business by depositing 25,000 rupees of his own money and he puts this money into the business and in return he just gets some stock certificates worth 25,000 that says that this person is the owner of the business so let us say I name this music store as let us say music mart that is the name of the entity this is how a balance sheet is prepared then what type of a financial statement are we discussing we are talking about a balance sheet and let us say it is on January 1st that I put 25,000 of my money to start the business so January 1, 2012 I started this business so this is a balance sheet now assume that this is the only entry can I have a balance sheet yes I can have the balance sheet will look simple that is all but still it is a balance sheet so how simple will that balance sheet look it will be as simple as this assets the firm got cash how much 25,000 why did I say assets cash 25,000 because the firm received 25,000 from the owner so cash 25,000 what is the resource and claim view of a balance sheet if you have an asset of 25,000 then there must be a corresponding liability item which has a claim against this asset now in this case who has a claim against this asset of 25,000 it is the owner so where will I record this under the liability the owners equity section paid in capital paid in capital 25,000 this is the balance sheet yes it is a balance sheet why is it a balance sheet because it represents assets and liabilities of the entity and 25,000 is the asset 25,000 is the liability it is a balance sheet it is the most simplest form of a balance sheet now suppose after some time that the firm decides to borrow some money from a bank and let us say the amount that I borrow is around 12,500 now what happens when I borrow money from the bank what is the effect on the balance sheet now the first entity the first balance sheet that we created was during the creation of the firm now the second one is the bank loan the music mark balance sheet remains the same except that the date changes so assume that before January let us I did this on January 10th so you will have balance sheet you will have music mark here assets cash now I borrow 12,500 which means the cash that I have now will be 37,500 now on this side liabilities plus owners equity what will be the corresponding entry one thing that has not changed is my paid in capital right 25,000 now the fact that I owe the bank 12,500 has to be recorded as a liability so I say loans payable 12,500 so total 37,500 equals so what is the balance sheet of this firm as on January 10, 2012 this is the balance sheet of the firm a simple balance sheet except that the first 10 days we had only two transactions but still it qualifies to be a balance sheet now suppose I started business I purchase some inventory worth rupees 5000 and how do I purchase the inventory there are two ways I could have done it I purchase the inventory worth 5000 and say that I am going to pay this 5000 later or I purchase this inventory 5000 I said okay I pay 5000 right away let us assume that I did the second option so I purchase inventory and paid 5000 rupees and when did I do this let us say I did this on January 15 so balance sheet 15,1, 2012 so what will happen to my assets there will be two entries now what will be the two entries one is that I have paid 5000 rupees now where did I paid from because I already have a cash of 5000 so my cash gets reduced by 5000 now what is the principle of duality there should be a dual impact where is the second impact because I paid this cash I got inventory worth 5000 now has this transaction altered my liabilities plus owner's equity no my loans payable paid in capital remains unaltered as a result of which the total is 37,500 here also 37,500 I said I can do this transaction in two ways except that I chose to pay it now had I chose chosen to pay this a little later the balance sheet would have been assets 37,500 my liability would have also increased because I have not paid this inventory so what would have happened to the balance sheet balance sheet amount would have been just I just want to spend a little time here suppose at this stage this is where I purchased the inventory I said I purchased the inventory because I paid I removed 5000 from cash here but if I have not done that and I said I am going to pay it later this 37,500 would have remained there I would have added inventory so 37,500 plus 5000 would have been 42,500 the dual impact the second impact would have been on the liability side where I had added one more entry called accounts payable 5000 as a result of it this total would have changed to 42,500 so that also is a balance sheet that also is a correct balance sheet for the same firm except that the way in which I transacted deferred now let us say for I began I began selling so I sold something let us say for 750 rupees I sold some merchandise that was costing only 500 rupees now what will happen this gets a little interesting I sold merchandise costing 500 for 750 rupees this is the transaction how do I record this cash increases because I sold something and in return I got cash how much did I sell it for sold it for 750 rupees so what would be the total cash it will be 33,250 what would be the value of the inventory now I did not sell an item from thin air I consumed some inventory what is the value of the inventory that I consumed it is 500 so from that 5000 that was existing before I sold 500 worth merchandise so what will be the total here so this is on the asset side now how do we record this in the liabilities and owners equity as a fact that I have sold inventory worth 500 for 750 rupees changed by equation with the bank no because I still owe the bank so my loans payable does not change my paid in capital also does not change what is the paid in capital remains as 25,000 where do we accommodate this difference here it is 37,500 here it is 37,750 where do I accommodate this difference of 250 it gets into the retained earnings component why because this 250 is the profit of the same and this entirely belongs that there is as on date there is no other liability it entirely belongs to the owner's equity so the owner's equity has to increase by 250 and which part of the owner's equity increases by 250 not the capital because it did not go into the capital it is the retained earnings part that got increased by 250 remember I told you before that retained earnings is not cash look at this balance sheet you have a cash of 33,250 you have a retained earnings of 250 only means that retained earnings is not equal to cash now at this point if you are not able to understand some of the concepts there is no reason to get alarm because in the subsequent sections we are going to considerably expand on some of the concepts some of the categorizations that I have made and we will describe in detail how the behavior of these account categories change under different context but it is essential that you understand that the fundamental equation that always remains uncompromises that assets is equal to liabilities plus your retained earnings and that when you record these transactions that you will be following a set of concepts only five concepts that we have already covered quick recap of them the money measurement concept that says that all accounting transactions need to be monetized the entity concept that says that the individual is different from the firm the going concern which assumes that the entity or exists forever the cost concept which says that the asset is recorded at the cost of its acquisition and the dual aspect which says that every transaction affects at least two items and preserves the fundamental equation liability plus owner CQT is equal to assets and that we also saw what a balance sheet is all about now what we will be doing in the next class is to also understand what income statement is and what the remaining six concepts based on which the accounting principles are being framed now before I go that you should understand how an income statement is different from a balance sheet see the entity for which we are creating this financial statement I said can be expressed in two ways one if you look at the balance sheet it gives you a status report so that tells you the financial strength at a given point of time and hence it is called a status report or a stock report as against an income statement which I said in the previous class is a flow report which measures the flow over a period of time for people who understand physics or engineering you know it is difficult to predict the position as well as velocity at the same point of time so either I look at the balance sheet and understand the financial position at that point of time or look at the income statement to understand the performance over a period of time so an income statement is not a snapshot a balance sheet is not a motion picture a balance sheet is a snapshot an income statement is a motion picture now what is that in an income statement that we are trying to cover some continuous flow what is that continuous flow in a business cycle any business cycle if you look at it any business cycle will have cash and with cash what will you do you purchase you purchase inventory or you manufacture goods as a result of which you have some inventory and what you do with the inventory you engage in some earning activities that results in sales and accounts receivables as well how does account receivable get converted to cash because you have some collection activities so you get cash by sales or accounts receivable converted to cash because of collection activities then you use the cash to purchase inventories and when you purchase inventories you manufacture goods and then you have finished inventory that needs to be sold and the time between selling the inventory again collecting cash or reaching the accounts receivable period you engage in earning activities which actually converts the finished inventory into sale now we are interested in seeing the behavior of these earning activities from finished goods that is been sold what price it is sold what is the charge that is a portion to the revenue that is generated what is the expense against the revenue that is generated is the sale mean made profitable so between this period of inventory to cash at sale or accounts receivable for later being collected as cash is your earning activities and an income statement focuses on earning activities and the related expenses associated with these earning activities which means for an identified revenue you will have identified set of expenses and if you are able to record both these then you can say that this is the net income and so on so an income statement is based on focusing these earning activities. But then the question is how do we know whether we have made a sale or not another question is I know I have made a sale but I do not know whether I will collect the entire amount or I will just receive some amount another question is I have made sales there is a revenue but I do not know what portion of the expense can be a portion to this particular revenue so questions get a little complicated how do I recognize sale first how do I realize sale the extent to which a sale is made and how is that I am able to match corresponding expenses with corresponding revenue for that you need to understand the other six principles of accounting out of which the first three is related to what I was talking now recognition realization and matching expenses to revenues and then other three standard accounting concepts which I will be explaining in next class the remaining six concepts based on which the accounting principles are evolved. So at the end of this class I am sure you would have understood those five concepts and the balance sheet of an entity and what a balance sheet conveys looking at the balance sheet you can see how financially well off is a particular firm next class I will give you introduction to an income statement and we will also be covering the remaining six accounting concepts and then when you begin to look at both the balance sheet and income statement together with these accounting concepts forming the background then you will begin to appreciate that a balance sheet and an income statement so finally interwoven gives more information about the firm than each of them look independently. After which we actually would be getting into the real double entry bookkeeping concepts the concepts of debate credit how do we identify measure and communicate these transactions in a form that is universally understood in the same way that we will be covering in the subsequent classes. So next class we prepared to understand what an income statement is and what the six remaining principles talk about and as I had assured you I will also bring during my next class the sample balance sheet and income statement that I will also put it as part of this lecture so that you can revisit the sample balance sheet and income statement when you actually go through these lecture notes. So thank you very much I will see you next class.