[MUSIC] Last week, we recorded economic events that took place in the campus bookstore in the second year of operations. Some of the transactions we cover we had already seen them in the first week, such as the sale of books, the cost of books sold, the purchase of different kind of assets. While other transactions were introduced for the first time such as the payment of dividends or the sale of the asset. We accounted for all these transactions using T-accounts. Remember that in a T-account, the left hand side is called the debit and the right hand side is called the credit. No matter whether it's an asset or a liability or owner's equity. In the case of assets such as cash, we record the increases on the debit side and we'll record the decreases on the credit side. In the case of liabilities and owner's equity accounts, the convention is reversed. So for increases, we credit the account, and for decreases, we debit the account. For example, when the campus bookstore received a bank loan of 30,000 Euros, what we did is debit the cash accounts because there is an increase in cash. We have received the cash from the bank, and credit the bank loan, because now we have a new obligation, to return this money to the bank in the future. We also saw that accountants, actually use journal entries to record transactions, so in the example that we have here, the journal entry would be debit cash, 30,000, credit bank loan 30,000 as well. So a journal entry just indicates which account is changing and whether we are debiting or crediting it. Note that the basic accounting equality, assets equal owners equity plus liabilities always has to hold after each transaction. So you can have different combinations of accounts changes but always respecting these basic equality. For example, when we purchase software we credit cash, because we are paying cash, so cash goes down and we debit the software account, indicating that another asset is going up. So the equality holds, we have an increase in one asset and a decrease in another asset by the same amount. Another combination that you can find, So the journal entry would be debit software 3,000 and credit cash 3,000. Another combination you may find is the payment of Selling General and Administrative expenses. So on the one side we credit cash because we are paying so cash goes down 37,000 Euros and on the other side you have owner's equity going down through the profit and loss account because we recognized an expense so we debit the profit and loss account for 30,000 Euros as well. What is clear is that for each transaction the basic accounting equality has to halt, and for this to happen every time you make a journal entry, an entry in the accounting. The total amount of debits, the total sum of debits has to be equal to the total sum of credits. If that is the case, then the accounting equality will always hold. After accounting for all the transactions in period two using T-Accounts, remember that we prepare the financial statements. First of all, to prepare the balance sheet what we need is, calculate the ending balance of each one of the T-accounts. This ending balance is the balance that shows on the balance sheet for each one of the accounts. After preparing the balance sheet we prepare two additional financial statements. One of them explains the change in the profit and loss account. Remember that the profit and loss account is contained here, and the retained profits. So we want to know what happened during the year with the generation of net worth for the shareholders through the operations. How good was the performance of the company? How efficient were the operations of the company? We do that with the income statement. Next, we wanted to explain what happen with the cash accounts. So we want to explain the change in cash and for that, we use the cash flow statement. The cash flow statement explains how cash has been generated and consumed by the company during the year. So as you see, the balance sheet is the picture at the bonding kind of the company with all the sources of capital and uses of capital. Whereas the income statement and the cash flow statement are a sort of a movie of what happened during the year with the PNL account and the cash account. In the preparation of the cash flow statement using the direct method, we take the cash T-account, and we classify all the cash payments and receipts under three different groups. The cash flow from operations, the cash flow from investing activities, and the cash flow from financing activities. Division of all these cash flows explains the change between the ending balance and the beginning balance of the cash account. We also mentioned that there is another method to prepare the cash flow statement, which is called the indirect method. In the indirect method, we start with the net income, and we make a bunch of adjustments to get the cash flow from operations. However, we said that this method goes beyond the scope of this course, it's a more advanced topic. I now refer you to a technical note that you can read to go deeper into this topic. In the next few videos we're going to explore a basic idea that by now you should have very clear in mind. Profitability is not the same as liquidity, although they are related. Later, we will review the performance of the campus bookstore in the last two years, based on the analysis of the financial statements. Finally, we're going to read and interpret the financial statements of a real company, so that we can accomplish the goal of this course, to be able to read and interpret financial statements for decision-making. Let us start by explaining the difference between accrual accounting and cash accounting. [MUSIC]
