Welcome to Learn Accounting Finance. In the next one and a half hour, you will learn the basics of accounting. So that if you have zero knowledge of accounting, by the end of this video, you will be able to prepare financial statements such as balance sheet, income statement, and cash flow, as well as be able to explain how those financial statements are prepared and what is the meaning of each.

If you are interested in an accounting career or finding a job in the field of accounting, I recommend that you watch this video till the end. Subscribe to my channel and like the video so that you can always come back to this video in case you need to refresh your memory. If you understand the basics I share in this video, you are pretty much ready to start a job as an accountant. Or maybe you already have a job as an accountant and you want to clarify the concepts in your day-to-day work. Go ahead, watch the video till the end and let me know if you found this information helpful. Do you have any additional questions and whether or not you find accounting boring or interesting? Let me know in the comments and let's get right into accounting.

Accounting is the language of business. Why is it called the language of business? Well, it records every business transaction. For example, if there is a buyer and a seller, let's say the seller sells a mobile phone to the buyer. This is a business transaction, and there are certain rules and methods to record this transaction in the books of the seller's business. Similarly, the buyer, if the buyer is also a business, they will record a transaction which records the buying or the purchase of the mobile phone. Accounting defines the rules, procedures, and principles to record those transactions in the books of the business. That's why it's also known as bookkeeping.

Let's take a look at a few examples of business financial transactions. A fast food restaurant purchases buns for $300. So they produce burgers and they purchase buns that make the burgers. Another example is the fast food restaurant pays $100 for electricity. It also buys a computer for $1,000. So these are three simple examples of business transactions. Note that all of them involve money, and as per the rules of accounting, there is a specific method to record these transactions. Each of these transactions will be recorded in the language of accounting.

Every transaction in accounting will always have two consequences. This is one important thing to remember. All transactions have two consequences. In the language of accounting, we call them debit and credit. So, one of them is debit. There's always a debit, and there is always a credit in all accounting entries. There are no exceptions. Every transaction will always have a debit entry and a credit entry.

So let's take a look. So the first example of purchasing of buns. How will we record it? Well, a non-accounting entry, which is also sometimes called single entry, will be, for example, cost of buns $300. So if you're not an accountant and you are recording this transaction, you have this business, you would just be recording a single line showing the cost of buns. However, an accountant will record it as a double entry with debit and credit. And the entry will look something like: Debit buns inventory, which is an asset of $300, and credit cash paid, which is also an asset of $300. Note that there is a debit and a credit. The total of the amounts is exactly the same. So the debit always equals credit. And in this case, we have an increase in asset, which is inventory, and we also have a decrease in another asset, which is cash.

We will discuss what are assets, liabilities, equity, income, and expenses in detail. The key in accounting is to start thinking about each transaction in terms of the two consequences or results. Each transaction results in either an increase or decrease in assets, liabilities, expenses, income, and equity. That's pretty much it in a nutshell. All of the transactions that an accountant will record related to a business will always impact one or more of these five categories, which are assets, liabilities, expenses, income, and equity.

Now let's look at the second example, which was payment of the electricity bill. So again, a non-accountant will record it, record a single line showing cost of electricity $100. But an accountant will record as: Debit electricity, which is an expense, $100, and credit cash, because cash is paid out, so there is a decrease in cash, so credit $100 as well.

The example of purchase of computer is very similar. Non-accounting entry: cost of computer $1,000. And accounting entry would be: Debit computer, which is an asset. So you now have an asset physically available in the business. In accounting, we record that separately as an asset. And then credit cash, because cash was paid out. So whatever cash the business had at that point, there is a reduction of $1,000, and that is shown through the credit entry.

Let's look at the rules of debit and credit. So this is an important slide. This is, these are the rules which, as I mentioned, there are no exceptions. So you can always count on these rules. The rules say that you will debit assets when there is an increase, and you will credit assets when there is a decrease in asset. Okay. So in the previous example, we saw that when we purchased a computer, there was an increase in our computer assets. So let's say the restaurant already had one computer and they purchased another one. So now they have two. So that's an increase in assets. On the other hand, we saw cash being decreased. So when we paid out cash for electricity, we paid out cash for the computer, in those cases, we have a decrease in cash. So let's say if the company already had $2,000 and they paid $1,000 for the computer, now the balance has decreased by $1,000, and that decrease of $1,000 is recorded as a credit to the asset.

Liability, equity, and income, they are actually opposite of assets and expenses. So in case of liability, when the liability increases, or equity, or income increases, there is a credit. And when they decrease, there is a debit. And expense actually follows the same logic as assets. So assets and expense have similar debit and credit response. While liability, equity, and income also have similar, but opposite to asset and expense.

A point to note that out of these five categories, assets, liabilities, equity, income, and expense, asset, liability, and equity are part of the balance sheet, which is a financial statement. And if you're not aware of this, we will discuss that in detail. And income and expenses are part of another financial statement, which is called the income statement, sometimes also known as profit and loss statement or P&L statement.

As we noted, assets and expenses have similar response or follow the similar principle of debit when increased, credit when decreased. Liability, equity, and income, credit when increased, debit when decreased. If you wanted to make it easy to remember, you could think about only assets and expenses. Debit when increased. And everything else is opposite. Right. So if I focus on this alone, assets and expenses, debit when increased, I can make an abbreviation of AEDI. Now, AEDI is a little hard to remember because it doesn't make any word. So do you have any ideas if we shuffle the letters around, can we make a word? How about IDEA itself? Now, if I use this abbreviation of IDEA, it will sound something like: Increase will debit expense and assets. So although these are very few rules, you can remember them even without an abbreviation. But if you had to use one, this is one suggestion. So any increase in expense and assets will result in a debit, and everything else is opposite to it. So if there is an increase in a liability, equity, or income, it will not be debit, it will be credit. And similarly, if there is actually a decrease, not an increase, in assets and expenses, then it will be a credit.

We will actually practice some examples. Don't worry if this is still confusing. Because of the rules that we just discussed, there are default or common balance positions. So assets and expenses, you will usually see a debit balance. You can also see a credit balance, but usually for most accounts, you will see a debit balance in the books or trial balance. And for liabilities, income, and equity, you will usually see a credit balance.

So we'll get back to the rules of debiting. But first, we have to explain what are assets, liabilities, equity, income, and expenses.

What is an asset? What comes to your mind when you think about an asset? Maybe you're thinking about your house, especially if it is paid for and you don't have to pay any money as far as loan or mortgage is concerned. You can live in the house. You could also be thinking about the money you have in the bank. That is money that you can use to buy stuff. It can buy you things. It can buy you happiness, maybe. And you could also be thinking about your car or the bike that you have that you ride and can go to places. You can also go to work using the car or the bike, which will result in money flowing in in the form of salary or wages.

So an asset is something you own or you possess and expect to use or have some benefit from it in the future. So let's look at the definition of assets according to International Financial Reporting Standards. We'll talk about International Financial Reporting Standards in a moment. The definition of assets is: "A present economic resource controlled by the entity as a result of past events." And an economic resource is "a right that has the potential to produce economic benefits."

So we'll get back to the definition of the assets according to IFRS in a moment. But first, what are IFRS? A quick introduction about them. IFRS on International Financial Reporting Standards are accounting standards that are developed so that business entities, corporations, companies across the globe, all over the world, follow similar accounting standards. And the real purpose is that you have internationally comparable financial statements. So, for example, if investors or decision-makers are considering buying a business in Canada, but they're also looking at a similar business in, say, the UK. Take a look at their financial statements and try to compare which one is a better option, right? And if both of those companies are using International Financial Reporting Standards, it means that the investors or decision-makers can be assured that similar accounting policies are being formed. So they can really rely on the information that is presented on the financials to compare the two. If both these companies were using different accounting standards, it would be hard for them to make a decision because they don't really know, for example, what are the basis of arriving at the profitability for one company compared to the other one, and there could be misleading results. So the purpose of International Financial Reporting Standards is to have global comparability, to have consistent principles that are applied to financial reporting.

Currently, the IFRS are required to be applied in more than 100 countries, and a few more permit them. But not all countries require the application of IFRS. Notably, there is not a requirement to apply IFRS in the United States, and the same for India. So we can take a look at the geographies where IFRS are required to be applied or permitted.

The first one is Africa and the Middle East. You can see a lot of the countries highlighted as red require IFRS standards for reporting or financial presentation, especially for listed companies. And then you can also see a few countries where IFRS are permitted. If you look at Asia, you see again quite a few countries. But you can see India and China currently do not require IFRS. But you see countries like Pakistan, Australia, requiring IFRS. In Europe, IFRS is heavily adopted, and you can see a lot of countries in Europe currently require IFRS. And then finally, Americas. On the left side, you have North America, and on the right side, you have South America. So you can see a lot of countries in South America currently have adopted IFRS. In North America, you can see the United States has currently not adopted IFRS.

So if you want to check the profile of your own country wherever you live in, you can go to this website here at the bottom. And when you go to this website, you can select your country, and it can show you some information like this. Where, for example, I selected the United States, and it shows the extent of IFRS application. In this case, you can see that IFRS are not required for domestic public companies. In fact, U.S. GAAP is the requirement. However, IFRS standards are allowed or permitted for listings of foreign companies. Right. So, and also currently more than 500 foreign companies registered on the SEC are applying IFRS. Similarly, for India, you can see there's no application requirement for IFRS. In fact, India has its own Accounting Standards, which are required, but they are substantially converged with IFRS standards. So, there are a lot of similarities.

So I chose to use the definition from IFRS because it's a good, different definition that can be applied to understand what are assets. But as I mentioned, different standards that are applied in different countries, the understanding around the key elements of financial statements, which are assets, liabilities, equity, income, and expense, are very similar. Usually, you don't see many deviations from the treatment of assets, liabilities, equity, or the classification of assets, liabilities, equity, income, and expenses.

So going back to the definition: "A present economic resource controlled by the entity as a result of past events." And the definition also explains what an economic resource is: "it's a right that has the potential to produce economic benefits." It's similar to what we just discussed. And as it is something that you own or control that has a potential of providing you future economic benefits. So key points are: it is an economic resource, so there is some economic benefit, right, financial benefit. The entity, the organization, controls that asset. And then that economic resource means there will be a potential to produce economic benefits. So that's looking in the future, right? So it's not any benefit that you've already received is not considered as an asset. It's only an asset when there is a potential in the future that you will receive economic benefits. This will be really clear when we look at the examples.

This list that you see, this is pretty much majority of the assets that you will encounter in accounting or when you are working as an accountant. This list pretty much covers everything. So let's go through the list one by one.

The first one is cash at hand or bank. The cash or money in the bank or physically available at the business premises is an asset because, of course, it's something that the business controls or owns. And then the business can utilize this money to receive benefits in the future, right? So the company can buy stock, the company can pay for rent, pay for utilities for the business. So the business will definitely get benefit from the cash. Cash, in a way, is the ultimate asset. A lot of the other assets ultimately convert into cash.

Second one is building or office. So the building where the business is located is also an asset.

Computer hardware. So it's all the computer equipment asset.

Furniture inside the building where the employees come and work, the office desk, office chair, office equipment is also an asset.

So the next one is inventory. Inventory is really the stock, the goods, the products that the company sells. As long as they are with the company premises, not sold yet, they are also considered an asset because they will be sold in the future and bring money to the business.

Similarly, vehicles in which the business conducts its business or it helps in bringing the employees to office to customer locations and perform business, they're also an asset.

Any machinery that the company has, especially if it's a manufacturing organization, all the machinery is also an asset.

Land or property that the company owns is on certain asset accounts.

Accounts receivable. This is the amount of money that is receivable or due from the customer. So if the company sells on credit and gives the customers a time, some time to pay, at that point, the company records accounts receivable. And this account receivable is an asset because, of course, this will convert into cash when the customers settle the amount.

Similarly, prepayments. Prepayments are the amounts that are paid by the company in advance, but the service or product that they expect to receive has not been received yet. So again, in the future, there's a benefit of that product or service. So prepayments are also an asset.

Investments. So if the company has invested in other companies, the shares, or invested in bank, or invested in metals such as gold, silver, all of those investments are also assets because they will convert into money or cash.

Computer software is going to be utilized by the business. So an example would be the implementation of ERP, for example, SAP or Oracle Financials. Any ERP, any computer software that the company purchases can also be considered as an asset.

And then we have some other categories of assets. Goodwill on the purchase of business. If a company acquires another business, the goodwill that that other business has will result in positive profit or cash flows for the company. And there is usually a value determined or assigned for the amount of goodwill, which can also be recorded as an asset in the books of the company.

Trademarks, patents, and copyrights purchased were also considered an asset.

So this is a list of assets which pretty much covers most of the assets that you will encounter in real life.

Let's look at types of assets. So broadly, there are three categories of assets. Two of them are based on time, whether the assets are expected to be realized in short, in a short term or a long term. And the third one is whether the assets are touchable, tangible or not, right? So let's go through them one by one.

Current assets. All cash and cash equivalents are considered as current assets. And cash equivalents are really not cash, but very short-term investments or any assets that can be quickly converted into cash if required. Current assets are also expected to be converted into cash or cash equivalents within 12 months. And similarly, any assets that are expected to be sold or consumed within the normal operating cycle of the business. So normal operating cycle is really the business cycle, you know, when a company buys and sells. So the average time it takes from buying something, buying a product, and then selling it and receiving cash for it is called a normal operating cycle. And if any asset is usually expected to be sold or consumed within the normal operating cycle, and really this refers mainly to inventory, the stock, because it is converted in the normal conversion cycle. Or it is also referred to referring to accounts receivable, the amount that is due on amounts sold to customers. This is usually already converted into cash in a normal operating cycle. So this represents cash and cash equivalents.

Let's take a look at the examples. So if we go back to our list of assets, and if we had to highlight current assets, the current assets would be: cash at hand or bank, the inventory, as we discussed, normal operating cycle, accounts receivable, again, normal operating cycle, prepayments. And some prepayments could be long term as well. It depends on the time within which that asset is expected to be realized. But usually, we see prepayments are mostly short term. And then investments could also be both short term or current and long term. So again, it depends on the maturity of the investments. Some investments you will see as current or short term, and some will be classified as long term.

Now, in which financial statement do we find assets? You should know it by now. Yes, it's the balance sheet. So here is an example of Nike. This is their consolidated balance sheet for the year ended May 31, 2022. And if you're thinking why it is May 31 and not December 31, well, December 31 is the calendar year end. But many organizations do not necessarily have the same year end as the calendar. So their 12 months period, their fiscal year, or their financial year could be any other month during the year, depends on what is the year that they choose. So in the case of Nike, they have chosen that May 31st is the year end.

So this is the balance sheet with balance sheet line items. And we're looking at the asset side of the balance sheet. This is not the complete balance sheet. There is, of course, liabilities and equity. But we will see. But the asset side has current assets with their amounts listed. And in this section, you see the top part is actually the list of current assets with the respective amounts here. And the bottom part is non-current assets.

So what are non-current assets? Really, all the assets that are not current assets, all the assets other than current assets are non-current assets. But they are also expected to be utilized or converted to cash over more than 12 months. Let's take a look at examples. So going back to our full asset list, if we had to identify the non-current assets, there are quite a few in there. Here you can see building and office is a long-term asset. So you will see that the expected time of realization of their benefit is more than 12 months, right? So buildings, computer hardware, we know they are used for longer than 12 months. Furniture and equipment could be very long, 15, 20, 25 years. Then you have vehicles, of course, more than a year. Machinery, land or property. Well, land could be forever. Investments, yes, if these are long-term investments, then they are considered as non-current assets. Computer software, goodwill, trademarks, patents, and copyrights, all of them are considered as non-current assets.

Again, where do we find them in the financial statements? Just saw that in the balance sheet. And here, in the case of Nike, you can see at the bottom, the non-current assets are listed here with the amounts of balances in the balance sheet.

Let's look at intangible assets. So depends on whether the assets by nature are physical or not. These assets can be created or acquired. However, created intangible assets have no book value. Intangible assets can be definite or indefinite, which means that they could have a fixed or defined period. They could also have an indefinite or undefined period. Going back to our list of assets again, the examples of intangible assets are computer software, goodwill, trademarks, patents, and copyrights. And as you can see, all of them are pretty much non-physical in nature. That's why they are considered intangible assets.

So the current and non-current distinction will really become important when we look at financial ratios. It really helps to understand which of the assets, and on the same note, which liabilities are going to be settled in less than 12 months or in the short term versus the assets that are long term. And on the same note, this applies to liabilities as well, which liabilities are due for settlement in the short term versus long term. Because this really helps us understand the current balance position of a company. So this distinction between current and non-current is important, and we'll see that once we start analyzing the financial ratios.

In the case of Nike's balance sheet, we can see that they also have a couple of intangible assets that are listed on the balance sheet.

Let's look at what is a liability. So again, the IFRS definition for liability is: "A liability is a present obligation of the entity to transfer economic resource as a result of past events." So the important points being: it's a present obligation, it's something that is due now, and it arose as a result of a past event. So event arising in an obligation was a past event, and the liability is due now. So it cannot be any future events that have not taken place yet, that have not happened yet. We cannot consider them as liability yet. Although in future, we may need to record them as liability.

So let's take a look at examples. Here are majority of the examples that you will see for liabilities. The first one being accounts payable, which is kind of the opposite of accounts receivable. In accounts payable, these are the amounts that are due to be paid by the company to its vendors or suppliers. So if the vendor or supplier has offered credit to the company to make payments, the company purchased something from the vendor, and the vendor has allowed them some time to pay the amount, then this is recorded as accounts payable.

Accrued liabilities are recorded in accordance with the accrual concept, and we will go through the accounting principles, accounting concepts in a future video. But this represents expenses that have incurred, but we have not received invoices or bills yet. So a good accounting practice is to record those expenses in the period. For example, if the company has used electricity for the month of January, and the bill has not been received at the end of January, and the company is closing the period of January, they will record an accrued electricity expense. So there will be a debit to expense and credit to accrued liabilities in anticipation that the bill will be received in future, but the service, which is electricity, has already been received. The same applies for accrued salaries and wages. So a company may be paying its employees every 30 days or every month. Can also be paying every week or every two weeks. But at the end of the month, if there are wages or salaries that have incurred, so the employees have already done the work, but because the pay cycle is not there yet, the company has not paid. Let's say at the end of January, January 31st, there is 10 days worth of salary that has not been paid, although work has been done. And those 10 days will be paid, let's say on the 4th of Feb. Let's say the company is paying in two weeks' time. So there is this 10 days that need to be accrued for the month of January to truly reflect the cost of salaries and wages in the month of January.

Similarly, any taxes payable to authorities are a liability.

Long-term debt. Long-term loans that the company have. Any current portion of the long-term debt. So, you know, how if the company acquires a loan, there is a payment schedule. So it could be that every month the company has to pay off some amount, every quarter. That portion becomes current. Usually, the amount of debt that has to be paid within the next 12 months is considered as current. So that is also a liability.

Then we have deferred revenue. This is the amount received from customers in advance, but the service that the company needs to provide has not been provided yet. So it is considered as deferred revenue because the company needs to settle this through providing the service or product that it promised. And similarly, bank overdrafts. Any overdraft money facility received from bank is a liability because it needs to be settled. And again, any short-term debts, similar to long-term debts, are considered liabilities.

So if you look at the balance sheet of Nike again, now we are looking at the liabilities and the equity section. So here you can see the top section shows all the liabilities that the company had for the year ended May 31st, 2022, with the respective amounts shown in dollars.

Types of liabilities. Similar to assets, there is a current or short-term liability, and then there is non-current or long-term liability. And there is another category which is the contingent liabilities. If we look at our list and if we need to identify the current liabilities, the current liabilities would be all the accounts payable, accrued liabilities, accrued salaries and wages, taxes payable, usually the current portion of long-term loan, bank overdrafts, and short-term debt. And then if we want to look at non-current liabilities, deferred revenue is one non-current liability, and then a long-term debt, of course, is a long-term liability.

Contingent liabilities. So contingent liabilities are liabilities which are dependent on an uncertain future event. So a good example is lawsuits. So, for example, a lawsuit has been filed against a company, but the decision is pending. So the company does not know exactly what the decision will be and how much amount they need to pay. Such liabilities are considered contingent liabilities. So they are recorded in the financials depending on whether the amount can be measured reliably or how probable it is that the amount will actually be settled. Another example is product warranties. So any warranties that the company has offered to its customers, this is a contingent liability because at the time of sales, it's not clear how much will need to be settled in the form of warranties. For example, if a company sells mobile phones and it offers a warranty period of 12 months, then in that 12 months, how many customers will come back and ask for their warranties because of defective product or issues with the mobile phone, right? So this is again an example of contingent liability. And another example is bank guarantee.

Okay, so by now we have looked at assets and liabilities, two elements of balance sheet. And now we are looking at the final element, which is equity. So what is equity? Let's look at the IFRS definition first. "Equity is the residual interest in the assets of the entity after deducting all its liabilities." Equity represents ownership. If you think about a company, assume for a moment that the company only has assets and no liabilities, right? So in that case, all of those assets that the company has belong to the company. So we talked about buildings, we talked about computer hardware, any land or property, we talked about the accounts receivable, the amounts that are receivable from customers. If the company only had assets, all of those assets would actually equal equity because this is the ownership, the owners of the business own these assets, right? However, in most cases, companies also have liabilities. So these are the amounts that the company has to pay, that actually belong not to the owners, but to outsiders, right? That's why equity is assets minus liabilities. So you look at the assets which the company owns or the owners own, but to deduct liabilities from the assets, and that gives you equity. Equity usually represents ordinary shareholders of a company. They own shares, and the value of those shares represented under equity could also be preference shares and any accumulated retained earnings, which means that every year that the company earns profit or even loss, the owners or the equity holders own that, right? So again, it goes into equity. And we will see that when we go through the financial statements, such as P&L and balance sheet, where accumulated retained earnings come into play. So accumulated retained earnings really show the accumulated profits over the years. Since the company has been in business for 10 years, over the period of 10 years, all the profits that the company has earned will be reflected as accumulated retained earnings.

Now, this brings us to a very important point, which is the balance sheet equation. So while understanding assets, liabilities, and equity, we could see that equity is equal to assets minus liabilities. We just discussed that. Or we could also say that assets equal to liability plus equity. Just a little bit of shuffling of the equation shows that assets are equal to liabilities plus equity.

So we're looking at the balance sheet of Nike again. So this is the asset side, and you can see the total assets are $40.3 billion. And if you look at this other side, which is liability and equity, these all these lines are liability. And from here, you see shareholders' equity. This is the section of equity. You can also see retained earnings in there. So the total of liabilities and equity is $40.3 billion. If you look at the prior year, the balance sheet was $37.7 billion for equities and liability. And if I go back to the assets, you see assets were also $37.7 billion. So the equation will always balance. The assets will always equal liability and equity.

Here you can see again the numbers as we just saw on the financial statements of Nike. So as mentioned, you can find equity in the balance sheet, usually in the liabilities and equity section. You see here total liabilities and shareholders' equity. And these are the line items for the equity represented in the balance sheet.

If you have looked at the balance sheet items, assets, liabilities, and equity, now it's time to look at the income statement items, income and expenses. Let's look at the definition first. So income is "increasing assets or decrease in liabilities that result in increases in equity." Right? So we have already learned about assets, liabilities, and equity. And income is simply an increase in assets. So it could either be an increase in assets or a decrease in liabilities, but it results as always positively in increasing in equity. We have to exclude any increase in equity directly done by shareholders or owners of equity. For example, if they provide additional funding to the business in the form of ownership shares, that will not be considered income. But other than that, all the business transactions that result in an increase in equity, and practically speaking, this is really increased in profits, this will be considered as income.

Expenses on the other hand are the opposite of income. They are "decrease in asset or increase in liabilities that results negatively or decreases in equity other than the equity holders' contributions." So the key points for income and expenses: income will result in an increase in equity or increase in profits, and expenses will result in a decrease in equity or decrease in profits.

What is income then? Income is money received or receivable from sales, services, or investments. It increases assets, for example, cash. It decreases liability. For example, we discussed about accrued liabilities. So the company records the bill for January in the month of January, but the bill has not arrived yet. It comes in later. Let's say the bill comes in, and it's actually lower than what the company estimated. So that will be a reduction in liability that has already been recorded. So that would be that difference of what was originally recorded as an expense versus now the revised amount will be an income. So income increases equity or profits. And if you remember from the rules of debit and credit, an income is a credit entry when increased, and debit when decreased.

Some examples of income: when a business sells burgers for cash, remember there is an increase in the cash asset, right? So the selling of burger results in an increase in cash, which is an asset. And the accounting entry is: Cash received, debit, and credit sale of burgers. This is the income or revenue. So this section, as you see, this is the recording of income. If you remember, there's always double entry, dual impact. So the asset increases, and income also increases, but in the form of a credit. Just a point to note here, cost of sales will also be recorded in this case in accordance with the matching principle, and we will be discussing accounting principles in a separate section shortly.

Examples of income include sale of goods, service income, dividend income (this is the dividend that is received from any investments that a company has in other companies), interest income, rental income, and gain on sale of assets. So any assets that the company owns, when they sell them, and if there is a profit on that sale, that's also considered income.

Expenses. So expenses are costs incurred in exchange for something. Remember from the definition, it is a decrease in asset, for example, cash. So when you pay for something, that's an expense. The asset cash is reduced. It also can result in increase in liability, for example, accounts payable. So when the company purchases something on credit, it records an accounts payable liability. And it results in decrease in equity or profit. Finally, it's a debit entry when increased, credit when decreased.

An example of expense: when a business pays rent for the building, accounting entry is: Debit rent, this is the expense, and credit asset, which is cash. So here you have the decrease in asset. Some examples: there are many examples of expenses. A few of them are salaries and wages, training costs, meals, rent, cleaning, office supplies, electricity, gas, water, repair, maintenance, taxes, interest paid, depreciation, insurance expenses, leases, rental equipment, and travel expenses. So all of these, you can see, are outflows for the company. These are expenses where the company has to pay. And as a result, the asset is decreased, but also profit is decreased. So it has a negative impact on the equity.

Let's look at Nike's income statement. So here all the income and expenses are listed on the income statement. If you look at this, revenues and other income are the income in an income statement. When you see revenues, and if you see other income, which is a negative number in this case, and in bracket, you can see it shows if it's income, it will be a negative number or shown as in brackets. So these are the two lines for income. And everything else is an expense. So cost of sales, so cost of the products that Nike sells, plus any demand creation expenses, operating expenses, operating is really the business expenses to run the business, interest expense, and then tax expense. All of them are expenses. And finally, you have net income, which is the difference of income and expenses. Income minus expenses is your net income. So for the year end date, so for the 12-month period ending May 31st, 2022, Nike had a net income of $6 billion, roughly.

So now we have looked at all the elements of financial statements from assets, liabilities, equity, income, and expenses. As discussed earlier, assets, liabilities, and equity are part of the balance sheet. And income and expenses are part of the income statement. We'll now look at the accounting principles, and then we will jump back into rules of debit and credit and some accounting entries as a practice.

Okay, now let's look at the accounting principles. These principles are applied when preparing financial statements or preparing accounting entries. So a few principles that we will be discussing are: accrual principle, matching principle, consistency, cost or historical cost principle, going concern, materiality, revenue recognition. These are the principles that we will be discussing. But of course, there are some more accounting principles as well.

Accrual principle. Very important accounting principle. Rule principle states that we need to record transactions in the period when they actually occur, not when related cash is paid or received. This is the opposite of cash basis of accounting. So we discussed a little bit of that earlier. But an example would be, if you pay the electricity bill for the month of January in the month of February, according to the accrual principle, record the expense in January. So if you were not following accrual principle, you would only record the transaction when you receive the invoice or when you receive the bill. But according to accounting principle, you know that the service has been provided, electricity has been provided for the month of January. That is the period when the expense has actually incurred. So we will record this expense in the period, in the month of January. And you could also use an estimate if you don't have the bill and you don't know what the exact amount is, but you want to be able to show the users of financial statements, the people who look at the results, they should be able to understand truly when our expenses taking place. This is one of the key principles to remember.

The next one is matching principle. And another very important principle. And it's somewhat similar to the accrual principle. And what it says is, match revenue and expenses or costs and benefits, so that they are recorded in the same period. So an example is, we record cost of sales expense in the same period as when the sales revenue is recorded. So if a company buys some stock to sell, again, let's take the example of mobile phones, right? So the company buys mobile phones, and the company plans to sell them. But let's say they bought 10 mobile phones in the month of January, but they actually sold those mobile phones in the month of Feb. Okay? So in the month of January, we will not record any cost of sales, although we did purchase those mobile phones, and we actually even paid for them. But they will be recorded as inventory, which is not an expense yet. They will be recorded as an asset, an inventory. This is not an expense. And this asset will only be converted into expense when the actual sales happen. And this is in accordance with matching principle because we want to reflect the cost of sales in the same month as the sales is recorded. So as soon as we record the revenue or sales, which is the amount received from customers for those mobile phones, and in that month or in that period, we will record the cost of sales as well. So this is what is matching principle. If we did not do this, then what would happen is, we would be recording cost in the month of January, and sales or revenue or income in the month of February. And this way, there is a mismatch in the timing of when income and expenses are recorded, which may be misleading.

Another example is the recording of depreciation expense in each period for an asset according to its useful life. So when we buy assets with which are long-term or non-current assets, for example, if we purchase furniture, this furniture is going to be used by the company over a long period of time. And usually a useful life is determined by a company for each type of asset. So let's say for furniture, a company has determined the useful life of 10 years as an example. So the cost of furniture originally will be recorded as an asset. The day it is purchased, it's not immediately expensed out, but it will be actually be expensed or recorded as an expense in the income statement over the period of its useful life. So over the period of 10 years, the cost will be allocated as expense. This is a matching principle.

The next one is cost principle, also sometimes called as historical cost principle. And what it states is, we have to record assets at their purchase price and do not adjust for inflation or market value fluctuations. An example would be, if a company purchases a vehicle, a car, so the company will record the cost in the books at the original cost of purchase and depreciate it over use, over its useful life, without considering any market value changes. So if the car, if you look at the market value of the car, it may be fluctuating all the time. And maybe in a year or two, market value of the car has either gone up quite a bit or has decreased quite a bit. But those fluctuations are not to be recorded. The historical cost, the original cost at which the vehicle was purchased at, is what will be recorded in the books for accounting purposes. You have to make a note that this does not apply to all types of assets. For example, if we have short-term investments, the historical cost principle does not apply. The historical cost principle also does not allow recording of assets which were not acquired in a transaction. So we do not have a cost, a reliable cost to measure them. For example, internally generated goodwill or trademark.

The going concern principle. It's also an important principle. What it states is that there is an assumption that the business will remain in operations for the foreseeable future. We do not expect the business to be shut down in the near future. So the business is expected to continue as it is. The business is expected to have sales, have customers, have revenue and profits in the foreseeable future. And we are not shutting down the business. Therefore, as a result, we do not need to write down assets. Because think about it this way, if the business is continuing, all the assets that the business has, that have been recorded at original cost or historical cost, are still valid. It's still considered correct to keep the assets at their net book value, the original cost less depreciation. But if the business is discontinuing, if the business is not going to continue, the management has decided to sell it, then in that case, those assets may not be truly reflecting their value if we keep them at historical cost. So, for example, a business has a very specific machinery that costs a lot originally, but that machinery is not required now by any other businesses. There are no buyers for that machinery. So if the business is shutting down, that asset value is then inflated, it's overstated. Because really, those mutual economic benefits that were expected to be received from this machinery are no longer valid. The only way that machinery was going to provide us those benefits was if we continued business and that machinery continued to produce those products. But now, when we are discontinuing the business, for sure we are not going to use that machine, and nobody else is looking to buy that machine as well. Maybe we can sell that machine as scrap, and that is really the true value of that machine. Then in that case, the value of the assets needs to be written down. So unless there is a clear

The intention of management to sell the business or discontinue the business. The going concern assumption of principle applies, which means that the carrying value of the assets, which is their original cost less depreciation, is still valid and can be kept in the books. This is an important principle, and you will notice that auditors, external auditors, when they audit the financial statements of a company, they also assess the company's going concern status. They have to, they have to do that, and they have certain criteria or indicators which help them make that decision that the company can present or prepare their financial statements with the going concern assumption.

The next one is the materiality principle, and what it states is that if the amount is not large enough to influence the decision of investors or decision-makers, a misclassification or omission is not material. A, there is an asset with a useful life of 10 years that costs only $25. Right? So, an example would be a calculator. Some of the calculators last many, many years, right? So, in this case, we, if we look at a calculator which cost us only $25, but we know its useful life is 10, maybe even more years, right? But according to the principle of materiality, if we prefer to expense that asset immediately, basically not require it as an asset, instead recorded as an expense in the income statement, we can do that. This is allowed. So, in this case, we don't have to match the useful life of the asset with the allocation of its cost. Okay, so this, this is kind of an exception principle where only if the amounts are small enough, you can choose to ignore some of the other accounting principles, or you can even choose to ignore some of the practices. Materiality varies by size of organization. So, if it's a very, very large organization, of course, its materiality would be larger. Its amounts that are considered small or immaterial would be larger. But if it's a small organization, the amount that is considered immaterial will be smaller. Based on this principle, many organizations have a policy to record as expense assets costing less than a certain amount. So, you will see that very often that many organizations have an amount identified already that any amount that is less than this amount, for example, let's say $5,000. So, a company may have a policy that any amount that is less than $5,000, even though the nature of that item is an asset, it's an asset which has a useful life of more than a year, still for accounting purposes, that amount will be recorded immediately. So, the entire amount will be recorded as an expense in the month of purchase.

Revenue recognition principles. So, the principle states that we have to record revenue as and when goods or services are delivered, regardless of when cash is received. So, it's a combination of accrual and matching, focusing on revenue. An example is when a product is sold for credit, revenue is recorded when the product is delivered, not when cash is received. Okay? Similarly, when revenue is related to a project work, so it's a, it's a long project, it takes some time over which it's completed. Revenue is recorded based on percentage of completion, not when payments are received. So, while the company may receive advanced payments of, let's say, 50% on a project, they will record revenue based on the percentage of completion of that project, and they are, there are very specific guidelines in the standards on how to record the revenue in accordance with the percentage of completion principle.

Consistency principle. But we need to consistently apply accounting principles, policies, and methods unless a better one is available. And this is again to help the users of the financial statements, the decision-makers, understand the performance of the business over multiple periods of time. If the company is changing its accounting policies and principles, which also may change the treatment of accounting entries or assets, liabilities, income, expenses in the financial statements, then it is difficult for the decision-makers to make decisions because they cannot compare the financial results between periods. An example is a straight-line method of depreciation. So, we discussed about an asset with a useful life of 10 years. The company may choose either a straight-line method to record depreciation, which is really total cost of the asset divided by 10, and then that is the amount that is recorded every year, or they could also choose a reducing balance method, which is not an equal allocation of depreciation over the useful life. It's actually dependent on certain other factors which will result in higher depreciation being recorded in the first years or in the earlier years, and then the amount of depreciation reduces every year. Company is allowed to choose any one of those methods, but if they have chosen one, the consistency principle requires that they continue to use that method over a long period of time unless there is a significant reason, a major reason to make the change and it is better for the users of financial statements to have to make that change. Another example is the capitalization policy. We just discussed for example, the amount of materiality, the amount considered as the threshold under which all amounts are recorded as expense instead of assets. The company should not change it every year, right? There should be a consistency in applying that threshold.

So, now we will go back to the rules of debit and credit. I think we have developed a very good understanding of assets, liabilities, equity, income, and expenses. We've also learned some of the key accounting principles. We already know the rules of debit and credit. So, I think it's a good time to do some practice on the accounting entries. And after we have done that practice, we'll look at the flow of accounting entries into general ledger, trial balance, and finally financial statements such as balance sheet and income statement. Okay, so are you ready to apply whatever you have learned about the rules of accounting and accounting principles to actual accounting entries? Let's go.

So, the first example that we are going to deal with is a business owner deposits $30,000 in the bank as equity. This is one of the very early entries or very early transactions in a business. When a business owner is setting up the business initially, they allocate some money, they invest some money in the business, and they have deposited $30,000 in the bank as original equity of the business. Okay, if you remember, I mentioned the key in accounting is to understand the dual impact that every transaction has. So, what will be the accounts that will be impacted by this entry? You can clearly see there is an entry in the bank. So, basically, one account is asset, which is cash. And by the way, in accounting, we use the term cash roughly to also refer to about the money in the bank. Okay, so, uh, the first item is cash. What is the other one? Well, actually, you can see that in the example, it's the equity. This initial deposit is made by the owner of the business as equity. So, this is a contribution from the owner, and it will directly impact the equity of the business. Okay, so we have cash on one side, we have owner's equity on on the other side. What is happening to cash in this case? Is it increasing or decreasing? Well, because the amount is being deposited, it is increasing. So, cash is increasing. What is happening to owner's equity? Is it increasing or decreasing? Well, for the business, it is also increasing because the business had no equity or there was no business, and with this deposit, the business now has equity. So, from zero to $30,000, there is an increase in equity. What is the nature of the cash account? Is it an asset, liability, equity, income, and expense? By now, I'm sure you know cash is an asset. And what about equity? Well, the name says it, equity is equity, right? So, we can see that there is an increase in cash, which is an asset, and there is an increase in equity, which is equity. So, what did we learn about the rules of accounting? We know that when asset is increased, there is a debit, and when equity is increased, there is a credit. Remember, assets and expenses debit when increased. Everything else credit when increased. So, the accounting entry would be: Debit Cash $30,000. Credit Owner's Equity $30,000.

Okay, so this was the first entry. Let's go to the next one.

The company buys furniture by paying $10,000 cash. Okay, what are the accounts here? You can see that you can always see that in the, in the example or the statement itself, right? So, cash is one, but what is the other one? Furniture, right? So, we have furniture and cash. What is happening to the furniture? Of course, there is an increase because the company purchased furniture. So, company had has more of furniture by an amount of $10,000. So, there's an increase. What about cash? Well, this, this time the cash is being paid out. Remember in the previous example, the business owner was paying cash into the business bank account, so that's why there was an increase. But in this case, the company is paying cash, so there is a decrease in cash. Okay, what is the nature of furniture? It's an asset. What's the nature of cash? It's an asset. So, we have an increase in asset, but we also have a decrease in asset. What we've learned from the rules of debit and credit? As it increases, debit. As it decreases, asset decrease is credit. So, the accounting entry will be: Debit Furniture $10,000. Credit Cash $10,000. You see how the rules are applying, and there are, there is no exception.

Let's move on to the next one.

The company now buys furniture on credit for $10,000. So, the company buys additional furniture. They already purchased for $10,000 and they purchase additional furniture for $10,000, but this time they did not pay cash. They actually purchased it for credit, which means they have some time before which they need to make the payment, right? So, it's just furniture coming in, but what is going out? Well, at this point, nothing is going out, but there is now a contractual obligation. There's now a liability for the company, and this should maybe jog your memory a little bit about a principle we discussed, which is the accrual principle. So, we are not paying cash right now, but we are purchasing, and this needs to be recorded as a liability. So, the accounts that will be impacted are again furniture, but the other side is accounts payable because whoever we purchased the furniture from is now expecting a payment from us of $10,000. Okay, so the transaction has already happened. The event that led to that $10,000 of amount due has already happened, and what we learned in the definition of liability is a past event resulting in an obligation to pay. So, the event has taken place. We have purchased the furniture. This has also resulted in a liability, which is accounts payable, although we're still not paying cash yet. So, what happens to furniture in this case? Of course, there's an increase. What happens to liability or accounts payable? There is also an increase. And we know when asset increases, there is a debit, but when liability increases, there is a credit. You see how every time there is always a debit and always a credit. So, entry would be: Debit Furniture $10,000. Credit Accounts Payable $10,000.

Let's go to the next example.

The company now settles the amount payable for furniture. Okay, so naturally, we recorded the liability last time. Now the company has to settle that amount. So, there will be another entry at this point. This is a financial transaction. So, what are the accounts now being impacted? Well, first, there will be the accounts payable that we recorded previously. That $10,000 that was a credit to the accounts payable, now it will be reversed. Okay, so accounts payable and the other side of the entry is of course cash because now we are paying out the money. Okay, so accounts payable is now decreasing because in the last entry it increased. Now we are settling it, so it's going back to zero. So, it's decreasing, and cash is also decreasing because now we are paying the $10,000. So, we know accounts payable is a liability. Cash is an asset. Liability decreasing is a debit, and asset decreasing is a credit. Remember the rules of debit and credit. So, the entry would be: Accounts Payable debit by $10,000 and Cash credit by $10,000.

Let's look at another example.

The company pays $1,200 in rent for the building. Okay, now we know one side because this is again a cash payment. We know one side of the entry is cash. What would be the other side of the entry? It's not accounts payable because the company has already paid. But this time, this is an expense because this is a transaction which is resulting in a decrease in asset, which is cash, and we learn from the definition of expenses. Our expenses are items that decrease an asset and also negatively impact the equity or profits of the company because it's an expense, it's a reduction in the profit. So, one side of the entry is rent expense, and the other side is cash. Is the rent expense increasing or decreasing? Well, in this case, the expense is increasing, right? Because there was again, let's say the company started from scratch. This, there was no rent expense so far, but now in the first month, they have already paid $1,200. So, there's an increase in rent expense, and there is a decrease in cash because cash is paid out. So, this is a good example. We know assets and expenses follow the same debit and credit logic, right? So, if there is an increase in expense, it's a debit, and if there is a decrease in asset, it's a credit, right? So, the accounting entry would be: Rent Expense debit $1,200 and Cash credit $1,200.

Let's take a look at our next example.

So, the company receives $500 in dividend income from an investment. Okay, maybe we, we skipped a transaction where the company would have invested in another company as their investment, but let's say the company had invested in another company and now they have received dividend on that investment. What are the accounts that will be impacted? One, again, we know is cash because the company has received $500. What is the other one? Well, in this case, this is the opposite of the expense because the company has received money, which is actually increasing in asset. So, we know that definition of income is an increase in asset and also an increase in profit because now the company has $500 more for the owners of the company. So, one account is cash, the other one is dividend income. What's happening to cash? Is it increasing or decreasing? Of course, it's increasing. Dividend income is also increasing. So, we know when asset increases, there is a debit, and when income increases, there is a credit. So, the accounting entry would be: Debit Cash $500. Credit Dividend Income $500.

Let's go to the next example.

The company buys 10 bicycles for resale at the cost of $5,000 in cash. So, what are the two accounts that will be impacted? Again, one is easy. If the company has paid cash, and the other one, bicycles. These bicycles will be kept by the company as long as they are sold, right? So, the bicycles are an asset to the company because they are expected to provide economic benefit or money in the future, right? So, one of the account is inventory. Now, any assets that the company buys for resale and as long as they are with the company and not sold yet are considered stock or inventory in accounting language. And the other side of the entry would of course be cash. So, what's happening to inventory? Of course, it's increasing. The company has, let's say, zero inventory of bicycles. Now they have 10 bicycles. So, there is an increase in this asset, and on the other side, there is a decrease in the asset, which is cash. So, increase in asset is debit, decrease in asset is cash. So, accounting entry would be: Debit Inventory $5,000. Credit Cash $5,000. So, note that we discussed this in the accounting principles as well, the matching principle. Although the company has purchased this, these bicycles for sales, but they are not recorded as an expense yet. And the reason is because they have not been sold yet. The amount will be recorded as expense depending on when and how many bicycles are sold. So, we are waiting now. We are keeping the bicycles in the inventory as assets until sale is made, and that is the time when we receive the revenue or income from the bicycles, and according to the matching concept, that is when we will record the cost of sales.

And now we get to that. So, the company now sells five. Remember, they originally purchased 10 bicycles, but they sell five of them for $4,000 in cash. Okay, so there will be two entries at this point. One will be to record the sale, and the other one to record the cost of sale, matching principle. Now, what is the cost per bicycle? We know the company purchased bicycles for $5,000, and there were 10 bicycles. So, that means the cost of each bicycle is $500. And the selling price is $4,000 divided by five because the company sold five bicycles for $4,000. So, the price, selling price is $800. But you can already see on each bicycle they are making a profit of $300, which is $800 minus $500. Okay, so the company sells five bicycles for $4,000. The first entry is this will be the sales side of the entry. So, the accounts that will be impacted are one is cash, of course, because the company has received $4,000. The second will be the sales or income. So, cash is increasing. We're receiving cash, or the company is receiving cash, and sales are also increasing because the company had no sales up until now, but with the sale of these five bicycles, the company now has a sales of $4,000. So, cash is an asset, and sales is income. Accounting entry for this one will be: Debit Cash $4,000. Credit Sales $4,000. Remember again the rules of debit and credit. When liability, liability, equity, and income increase, there is a credit. When liability, equity, and income decrease, there is a debit. On the other hand, when asset and expense increase, there is a debit, and when asset and expense decrease, there is a credit. The rules of debit and credit always apply.

The second entry for the same transaction, the same transaction which is sales of five bicycles. Now we apply the matching principle and and record the cost. So, originally those 10 bicycles were recorded as inventory. Now five of those need to be recorded as cost of sales. So, one of the account that will be impacted is the cost of sales. What is the other account that will be the inventory account? Because the inventory was an asset, and with expected future benefits, now those future benefits are actually being realized. The asset now converts into expense as cost of sale, and we will record cost of sale of five bicycles and a decrease in assets of five bicycles. Okay, so cost of sale, inventory. Cost of sale is an expense, and this is now being increased. So, really, this is because of the matching principle because truly the expense is not happening at the time of sale. We had already purchased it, but because we are matching costs with revenue, the expense is being recorded now. The other impact is inventory will decrease. So, we had inventory of 10 bicycles. Now it has decreased by five. So, there is a decrease in inventory. Cost of sale is an expense, inventory is an asset. So, the accounting entry would be: Debit Cost of Sales $2,500 (5 times $500, we know the cost per single bicycle is $500, so the cost of five bicycles would be $2,500) and Credit the same amount, which is Inventory by $2,500.

Now, what happens to the remaining five bicycles? They are still part of the remaining inventory balance. So, original $5,000 that was the original cost of inventory of 10 bicycles, we sold $2,500. Remaining $2,500 will still be in the inventory account. The books of the company. When the company sells more bicycles, the inventory balance will be reduced further with the cost of sale entry. The entry number two that we just looked at. Note that both sale and cost of sale entries impact the company's profit and ultimately equity. You saw that we noted that the company is making about $300 per bicycle, but the way it's recorded in accounting is through two entries. One is the sale entry where we record the income, and the other entry is the cost of sale entry where we record the expense, and both these entries have an impact on the profits or equity of the company.

Next up, we will learn about the flow of accounting entries. So far, we have practiced 9 accounting entries. So, we have a little bit of practice of double entry. Now it's time to see how these entries flow in the accounting books or accounting records of a company. So, if you look at the flow in these days, modern times where mostly accounting is done through a computer system, the flow would be like this. It starts with the journal entry or the accounting entry itself. This is summarized in a general ledger, which then transfers to the trial balance, and then finally from the trial balance, the financial statements are prepared. So, if you look at each one of them one by one with example, let's start with journal entries.

So, general entries record all business transactions or double entries in chronological order. So, in old times when there were no computer systems, imagine you are the accountant and you have a journal in which you are making sure that all of the accounting entries are being recorded. So, the best approach would be that you record each accounting entry or business transaction based on when they take place. So, that's why the general entries were recorded in a chronological order, that is, based on the date and time. Let's take a look at the example of our accounting entries that we just practiced. So, here I have summarized all of the entries we have done in Excel in a general journal format. So, in our case, let's say the name of the company was Bold Bikes Company. So, in the books of Bold Bikes Company for the month of January, you can see all of the entries are entered based on the date. So, it starts with 1st of January when the owner of the business invested $30,000. So, the entry was Cash debit, Owner's Equity credit, and there is usually some description as well, such as in this case, to record initial contribution to equity. And then all the other transactions that we just practiced are also entered. So, you can see on the same day, he purchased furniture for cash. Then on 5th of January, he purchased, he made another purchase of furniture, but this time on credit, right? Then on the 10th of January, he paid out payable for the furniture purchased. On 15th of January, he paid rent. On 16th, he received dividend income. On the 20th of January, there was a purchase of 10 bicycles, so it was regarded as inventory. On the 23rd January, there was a sale of five bicycles, so the accountant recorded sales, and on the same day, 23rd January, he also recorded cost of sales. So, these are about nine entries which are shown or which are entered in the general journal, or this is the first step where the accounting entries are recorded in a sequence based on the date and time.

Okay, so the next step is the general ledger. Now, general ledger is where all of these accounting transactions are summarized, but this time they are based on the account number or general account type. Let's take a look at that. So, the general ledger will look something like this. So, as you can see, each account will have an account numbers. In the case of cash, for example, we have account number 1100. It may be different for each company, each organization. There's usually some logic applied when assigning account numbers if they are usually in a sequence. So, for example, it may start with the current assets, so account numbers for current assets first, then non-current assets, then liabilities and equity. So, in this case, you can see that for cash, the account number is 1100. Double one double zero. And you can see all of the entries are summarized here. So, general ledger is a very good summary if you want to see what happened in the cash account, right? And this will give you a summary of all the transactions that took place. So, on the 1st of January, cash was deposited, and then there were these purchase of furnitures, payment of rent, receiving of dividend on investment, and then purchase of bicycles, and finally sales of bicycles, right? The same way, all the other accounts are also summarized. There's usually a date, period, description, debit, and credit, and final balance as well, which is important. So, how is the final balance calculated? As we are looking at an example of a company that just started brand new, so the start of the month on the 1st of January, before any transaction took place, the balance in the cash account was zero. The first entry increased the balance to $30,000. The second entry, which was a payment, reduced the balance by $10,000 to $20,000, and similarly all the way down to at the end of the month, the balance is $8,300. The same for inventory. It started with nothing, but then $5,000 worth of inventory was added. Half of that was sold, so you have now the balance of $2,500 at the end of the month. Furniture was purchased twice, $10,000. We have $20,000 balance. You can always see in a general ledger what amounts were debited and what amounts were credited. The same for accounts payable. We started, there was a balance, but it was already paid off during the month, so the closing balance is zero. Owner's equity at the start of the business, $30,000 were deposited. No change in there. The owner's equity usually remains the same unless any changes are done by the owners of the business. And then, of course, we have the sales. We recorded the sales of $4,000. Note that this is showing a negative balance. Usually, negative balance denotes a credit balance, and positive balance denotes a debit balance. Similarly, dividend income of $500, cost of sales of $2,500, and see it's a positive balance because it's a debit balance, and then rent of $1,200. If you look at total debits and credits, this is the sum of all of the entries that are done so far. You will see that they're always equal.

Okay, now in this flow, the third item would be the trial balance. So, what is a trial balance? A trial balance is a list of all accounts with balances. Let's take a look at example of the trial balance as well. So, from this general ledger, we can see a summary of all of these individual account balances in a trial balance. So, here you have the trial balance. You can see now we don't have that much detail. We just have the account, account number, and name, and then the whether the balance is debit or credit, and what is the amount of the balance. So, remember, cash at the end of the month was $8,300. Inventory at the end of the month was $2,500, and so on. So, this is a summary of all of the balances. You may recall I mentioned that assets usually have a debit balance, and which is exactly the case in this case. Accounts payable, if there was a balance, would probably be a credit balance, but in our case, in this example, we have already paid them up for accounts payable, so there's no balance there. Similarly, owner's equity, we have a credit balance by default. And then we discussed also that all income accounts usually have a credit balance, and all expense accounts usually have a debit balance. So, again, you can see all the debit and credit balances are equal, and this is a very good summary of all of the accounts in the books and what are their balances at any given point in time. And when I say any given point in time, as you can see, it says trial balance, January 31st. So, this is information as of January 31st. However, if you wanted to see all the transactions that took place, you could actually go back to any single general ledger. So, again, for example, for cash, you can see all the transactions that took place in the month, and here you have the final balance of January 31st.

Now, this trial balance is a very important report. From this report, we prepare financial statements. The financial statements include the balance sheet, income statement, also known as profit and loss statement, cash flow statement, changes in equity, and comprehensive income. We will take a look at balance sheet, income statement, and cash flow from the entries that we have learned so far, and changes in equity and comprehensive income are two other statements which we will look at a little later. So, going back to our example, as you can recall, assets, liabilities, and equity are reflected in the balance sheet, while income and expenses, or sales and expenses, are reflected in the income statement. So, first, we are creating the balance sheet. So, we focus on the asset, liability, and equity accounts. So, this is a very, very small balance sheet based on the entries that we have done so far. These balances, you can probably remember now. We have a cash balance of $8,300. Again, it's coming directly from the trial balance. Inventory $2,500, that's the sum of current assets. Furniture, we know is a non-current asset, and the balance at the end of the month is $20,000. So, we have total assets of $30,800. On the other hand, we have no accounts payable at this point, zero. Our current liabilities are zero. However, we have owner's equity of $30,000, which is this. And then you see retained earnings, which is really the accumulated profits at any given point. So, for the month of January, with the sales and dividend income and the cost of sales and rent paid, we know that our profit was $800. So, that is reflected here in the equity section because again, this profit belongs to the owners, belongs to the equity, so it is shown in the equity section. And you can see that the total of assets and liabilities and equity is equal. This is our balance sheet equation, or the accounting equation that we discussed earlier.

Now, let's look at the income statement. So, now we will focus on the income and expense accounts in the trial balance, and those are reflected in the income statement as follows. Again, a very, very simple, basic income statement. One important distinction between a balance sheet and income statement that we need to understand is, as you can see, income statement is for a period. So, it is a summary of the transactions for a given period, and in this case, we are looking at the full month of January. So, all the transactions that impact income and expenses for the month of January, we see the net result here. However, balance sheet is at a given point. So, this balance sheet shows the balances, shows the assets, liabilities, and equity as at January 31st. Right? So, it's a snapshot. It's as if somebody took a picture of the situation at the end of the month, and that situation shows that the company has balance in the bank or in hand of $8,300. The company on 31st January has inventory of $2,500, and the same for furniture, equity, and retained earnings. However, income statement shows the impact for the period. So, in our example, we only had one transaction on the 23rd of January, which is resulting in sales of $4,000. But if there were other transactions for the month of January, they would all be summed up together and shown here. And the same applies for cost of sales, other operating expenses, and other income. Okay, remember the distinction. Income statement, the report for a period, and balance sheet is a report for a given point in time. And an example that you could think of is that if I ask you, what is the bank balance that you have in your bank right now? And if you check your bank account or tell me the balance, that is the balance sheet. But if I ask you, how much money have you earned during this year in the last 12 months? So, that total money in that 12-month period, that would be something that would reflect in an income statement. So, that's the difference between a period report and a point-in-time report, right? So, income statement is a period report, balance sheet is a point-in-time report.

So, we can see in this example, we had sales of $4,000. We also recorded cost of sales of $2,500. That makes our gross profit of $1,500. So, gross profit is really the, the amount of money that we earned on a net basis after deducting the cost of selling a product. So, gross profit is strictly related with the product itself. And then if you add other expenses, operating expenses, and other income, then you get to net income, right? In our case, the operating expenses were $1,200, which is really only rent in this case. And then other income reflects the dividend income that the company received of $500. So, in total, the company made $1,500 in gross profit, but then after deducting operating expenses and adding other income, we have net income of $800. And this $800 of net income will be reflected in the balance sheet as retained earnings at the end of the year. All the income statement accounts are settled and turned to zero, and that balance is transferred to the balance sheet in the retained earnings account.

Now, let's look at the cash flow statement. So, again, we are only using the nine accounting entries that we practiced together or we learned together. So, these are again very simple financial statements. In reality, the financial statements are a little more complex with a lot more number of transactions. First point, statement of cash flow is similar to the income statement. It is for a period and not a given point in time like the balance sheet. Okay, so the cash flow statement is divided into three sections. The first section is cash provided by operations or operating activity. Second section is cash provided by investments or investment activities. And then finally, the third section is cash provided by financing activities. Okay, so what are operations or operating activity? It is the regular business that the company performs. So, for example, in this case, Bold Bikes Company is in the business of buying and selling bikes. So, it is really related to the operations of buying and selling bikes. Investing activities, when the company invests in other assets. So, for example, purchasing of assets, property, plant, and equipment, or any income received on investments would be classified as investing activities. Financing activities reflect how the company's sources funds, sources money. So, of course, in our example, the only source so far is the issue of shares, the initial equity investment that the owner has done. So, any financing activities are reflected here. And again, we will look at each of these financial statements, balance sheet, income statement, cash flow, in detail. This example is just to show you the flow of the entries that we just learned. Okay, so we are looking at cash flow from direct method. There are two methods to prepare cash flow. One is the direct method, the other one is the indirect method. So, the direct method is where we actually look at all individual transactions or we summarize them to understand what was the cash flow, what was the cash inflow or cash outflow from each activity. This is actually the method that is recommended by standards, but it's not an easy method. It's not easy to have all the information readily available. So, most organizations prefer the indirect method. And the difference between direct and indirect method is that in the indirect method, we start with net income from the income statement and adjust any non-cash items that we are aware of out of that net income to arrive at the cash provided by operations. Okay, so it's more like an indirect method of arriving at the cash flow from operations compared to the direct method where actual direct cash flows are reflected in the cash flow statement. Okay, so if you look at cash used by operations. So, we know customers, cash collected from customers is an operating activity. It's the normal business operations. So, we know that we had sales of $4,000, and all of that money was received in cash. So, we have cash collected $4,000. Cash paid to suppliers, we know that when the company purchased 10 bicycles, it ultimately paid them $5,000 in the month of January. So, that's a negative amount or a cash outflow. Similarly, the company also paid rent of $1,200. And that's pretty much it for the cash flow from operations. These are the three operating activities which impacted cash flow, and there's the net total of negative $2,200.

Now, if you look at the investing activities, the company purchased furniture costing $20,000. That's negative cash flow. However, the company also received dividend income of $500 in the investing activities. So, the net cash flow from investing activities is $19,500. Now, we look at financing activities, and that's only the issue of shares, or really, it's only the investment of the owner, deposit cash for equity, and that's $30,000 positive. Now, this gives us the total from financing activities, and if we add all of these activities up, which is cash flow from operations, cash flow from investing activities, and cash from financing activities, we arrive at a net balance of $8,300. So, in the cash flow, we also reconcile the total movement, which was $8,300 for the period, to the final closing balance. Now, in this case, we are really looking at the start of a business where initially there was nothing. So, cash and cash equivalents at the beginning of the period was zero, and the movement during the period of January in cash is $8,300 positive net positive movement. At the end of the month, the cash balance is $8,300. So, these three cash flow activities shown in the three sections show the period activity. Okay, and that's the sum of the total period. However, we add the opening balance at the start of the period to give us the final closing balance, and this amount, cash and cash equivalents at the end of the period, would match your cash balance, cash and cash equivalents in the balance sheet at the end of that period. So, in this case, you can see it matches. It nets. Let's say in the month of January, the company had further cash flows. So, then all of those further cash flows will also be added, and then your total cash and cash equivalents balance at the end of the period will always match what you see in the balance sheet.

A quick look at the indirect method of cash flow. So, in the indirect method, instead of directly going to the cash collected from customers or cash paid to vendors or suppliers, we start with the net income, which was $800. If you recall from our income statement, this is the $800. Then we will adjust for any non-cash items or any items that should actually be reflected in the investing activities or financing activities. Okay, so we don't have any non-cash items, but a good example of a non-non-cash item is depreciation expense. In our example, we did not have that entry so far, so we are not excluding any depreciation expense here. But we do have dividend income, and dividend income should really be reflected in the investing activities. So, we exclude it from here. So, you see a negative $500 here, but you see positive $500 here because we are actually showing the cash flow from dividend out of operations, but in the investing activities. Then we have indirect method of calculating the cash flow from accounts receivable, inventory, and accounts payable. We call it the changes in working capital. So, you really need the balance sheet to calculate these, and you can see in case of accounts receivable, it is no change, right? There's no accounts receivable so far in this balance sheet. And you see I have created a comparative balance sheet of the previous this period that should actually be December 22. Yeah, so end of December 2022, there was nothing. So, in accounts receivable, there is no change. There's no activity, so we leave it as zero. Inventory, we had zero inventory at the end of December, but during the month, or say at the end of January, we have now inventory of $2,500. So, when we do indirect cash flow, any increase in inventory and account receivable is a negative cash flow, as you can see with the brackets here. And any increase in accounts payable is a positive cash flow. So, in this case, inventory has increased. You can see from 0 to $2,500. We see a negative cash flow of $2,500. And we don't have, although we did have accounts payable during the month, but by the end of the month, there is no accounts payable. You can see it's still zero. So, for cash flow perspective, it's, it's neutral. There's no change in accounts payable. Again, this is indirect. It's a little complicated to understand, but the impact is exactly the same. So, if you see cash provided or used by operations is showing $2,200 negative, which is exactly the same as what we calculated for cash provided from operations. So, as I mentioned, we will discuss the cash flow and other financial statements in more detail later, but for now, it's important to note that the cash from operations in total is the same whether you use the direct or indirect method. Okay, cash from investing activities and financing activity is usually very similar or the same as what you see in the direct method. There's no real change there. So, again, at the end, you have the same balance. Cash flow for the full period is $8,300 positive, mainly driven by the owner's investment. All the other activities, such as investing activities, had a negative outflow, and also operations had a negative outflow. That is also why it's important to look at cash flow because if you just look at the income statement and you see the company has made a profit of $800 in the month of January, but if you look at the cash flow, you see the company actually has a negative cash flow of $2,200 from operations. Right? So, the operating activities actually resulted in an outflow of cash. Similarly, investing activities resulted in an outflow of cash. The only reason why you're seeing positive cash flow is the owner invested the money. There was a deposit of $30,000 at the start of the year. So, if you look at it from the owner's perspective, he invested $30,000, and at the end of the month, he is actually looking at $8,300. So, there appears to be a loss of $21,700. But it's not a loss, it's an investment in business, and now he has a few assets in the balance sheet, right? He has furniture of $20,000. Okay, he also have inventory of $2,500 that he can sell, and he's of course still has $8,300 in cash.

Hope this clarifies the flow of accounting entries. So, again, these are the four major activities. These days, with computerized systems, of course, there are more steps involved. There has to be accounting reviews of all the entries. Sometimes you have to adjust the trial balance. Sometimes you have missing entries. But if you are using a computerized accounting system, a lot of those issues are already taken care of. All you need to do is start entering the entries in the system. In the accounting system, it will automatically be summarized into general ledger and trial balance. Some systems will also provide you the financial statements depending on the setup of the system. And even if the financial statements are not provided by the system, you know how to prepare the financial statements utilizing the trial balance. Wow, you have come a long way. You have learned a lot in this video. Do you have any questions? You like more clarity on? Do you have any comments? Did you find this information helpful? Every comment matters. Let me know and do not forget to subscribe to my channel for more accounting and finance related tutorials and videos. So, till the next time, my friend, wish you all the best. Take care and bye for now.

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