So remember our game plan for all of these is decide which asset, liability, or owner's equity accounts go up or down and make sure that the balance sheet equation stays in balance. So, our first one that we need to take care of is the fact that while we recorded revenues and cost of goods sold, we didn't record anything for the fact that we had workers that worked during that period. Okay. So we have some employees that we had hired who worked during the period and they earned wages of $4,000. But we haven't paid that yet. It's actually not due until next month. In addition, because the workers have worked pretty well, we've decided to give them a raise that's going to be effective next month. So do we need to record anything? Okay. And the answer is yes. Even though we haven't paid them, they have done the work and we have to associate the cost of that work with the revenues that they helped to generate. So even though no cash is going out, we do owe them for the work. So an account payable is going to go up. We'll actually call this wages payable account, to distinguish it from the account payable that goes to the supplier. And then the corresponding entry to balance this out is going to go to retained earnings. This is lowering our income as part of the wage expense for the period. So even though we didn't pay any money, we owe the money, and so we record the income. Now what if we actually pay the $4,000 in cash? What would we have done differently? We wouldn't have recorded a payable, instead the asset cash would have gone down. Note that either way income goes down. We recognize the income, whether you pay it in cash or not. The cash flow statement cares about, did you pay it in cash? The income statement cares about, did you actually use the workers and do you owe them for the work? In general, with labor expenses, you're going to have a combination of an amount that you paid this period and an amount that you will pay in the future period, vacation, sick leave, pensions, etc, would be all examples of a wages payable type account that you would record for amounts that you're actually recording in the income statement today. Our next one that we're going to look at is depreciation. Remember we bought a building and we paid $36,000 for it. We used that building for a month. Now we need to associate some but not all of the $36,000 with this month's use. How much? It depends on how long we expect this building to last and what we think it's going to be worth at the end of the useful life. So, suppose we think we're going to use it for 10 years in total, then straight line depreciation might say take the $36,000 and divide it by 10, that's $3,600 a year. Divide that by 12 and that's $300 per month. So that would be straight line depreciation that we would then charge off. The asset comes down, and income goes down, retained earnings goes down through this depreciation expense. Implicit in this though is the assumption that the building would eventually go all the way down to zero by the end of its useful life. Now another fact in the case here is that in fact the market price of real estate has gone up by two percent in the area during the period. Do we reflect that in the financial statements? Okay. And in the U.S, the answer is no. Okay. We ignore that. We don't let you write up assets, while you continue to hold them. Under IFRS accounting though, firms do have the option to actually write things up. If we don't do that, back in the U.S. situation, note that we've actually written the asset down when we think it's gone up in value. So we have a mismatch between the book value of the asset and the market value of the asset. And this is a common thing. Does anything ever happen to that difference? It turns out that that eventually is taken care of. And this is an important feature of accounting that its errors correct over time. Suppose we kept continuing to depreciate assets by $300 per month, and kept doing that for 10 years, at the end of 10 years the asset would now be on the books at zero. Yet it might actually be worth a lot. Suppose it's worth $100,000 at the end of 10 years, so it's gone up in value. What if we sold it at that point? What would we record? We would record again on that sale and it would go through that period's income statement. The gain on sale would be $100,000 and we sold it for $100, and it's on our books at zero. In some sense that high gain on sale reflects the fact that we've been depreciating too much over the prior 10 years. And if you look at the income statements as a whole, you would see depreciation that accumulated of 36 and again on sale of 100 for overall cumulative income of 64. That's exactly the difference between what we bought the building for and what we sold it for. So accounting is always going to trew up to the difference in the cash flows. If we had done the accounting differently, and only depreciated it down to 10, and then sold it for 100, all the numbers would be different individually but they'll again add up to the same thing. If it's on the books for 10 and we sell it for 100, the gain is now 90, but the depreciation from 36 down to 10 is only 26. The overall impact is again 64. So accounting always trews up to the real cash flows, it's just that sometimes it can take a long time before that happens. In this case in 10 years. We could talk about other kinds of adjusting entries but this is good enough for our purposes to illustrate the concept. If we look at all of the entries now, okay, this gives us our final balances. This is all we need to put together a balance sheet. We just need to format it appropriately. So, a U.S. company would put it together like this, with the current assets first and then the long term assets. Note that in the property plan equipment, I've shown separately the original book value of the asset minus the accumulated depreciation, the net is what actually shows up on the balance sheet. On the liability side, we don't have any long term assets in or long term liabilities in this case, but we do have some current ones. And then we've got some stockholders' equity accounts as well. Remember that an IFRS account would flip the current and the long term assets and maybe flip the liabilities and the stockholders' equity account. We also have enough information to put together our income statement. Okay. Looking back at the revenue transactions and the expense transactions, we've got revenues of 33, cost of goods sold of 20, which gives us a gross margin of 13. Wage expense and depreciation expense or further subtractions and that brings income to $8,700. Note that retained earnings though started at zero and it's only at $5,700, but income was $8,700. What's the difference? Well, that was that dividend that we had paid out. Okay. And the statement of stockholders' equity actually helps us see that. It gives the beginning balance for every stockholders' equity account, which started it zero in this case because we're a startup, and the ending balance and shows how we got there. Retained earnings is going up because of the income, and then down because not all of it retained because some of it is paid out as a dividend. Okay, so these are our financial statements for our case firm. The only thing that we still need to do for this is construct the cash flow statement and we'll do that in a future video.
