A Simple Model. The Accounting Equation

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1 An introduction to the accounting equation in the context of building a financial model. This series introduces the financial statements in the context of a financial model. NOTES TO ACCOMPANY VIDEOS These notes are intended to supplement the videos on ASimpleModel.com. They are not to be used as stand alone study aids, and are not written as comprehensive overviews of the topic detailed. The purpose of these notes is to provide a tangible collection of the visuals used in the videos with comments highlighting the more important aspects covered. 2013, LLC. All rights reserved.

2 This video introduces the accounting equation, which is the most important concept in accounting. This relationship between assets, liabilities and stockholders equity must always hold true. There are no exceptions to this rule. All property owned by the company. All debts the company currently has outstanding. Ownership interests in the company after all debts have The resources a company uses to generate revenue. The means of acquiring assets. After briefly defining the terms and walking through an illustrated example, the equation is expanded upon to introduce double-entry bookkeeping: DOUBLE-ENTRY BOOKKEEPING: the system most commonly employed by businesses to record financial information. Double-entry bookkeeping requires that a change in one account be matched in another account. This is done by recording debits and edits. For every entry the sum of debits must equal the sum of edits. Please see video for an example and greater detail on this topic. Double-entry bookkeeping: most businesses employ a double-entry bookkeeping system to record financial data. Under this system a change in one account must be matched in another account. These changes are made by DEBITS () and CREDITS () to the accounts. For every entry the sum of DEBITS must equal the sum of CREDITS \$ 5,000,000 \$ 5,000,000

3 Debits and edits are difficult to grasp at first. The best way to approach this concept is to revisit the definition as your accounting vocabulary grows. This definition is not included in the video, but can be found under Reference on the website. It can be helpful in better understanding debits and edits because it applies the concept to something everyone understands: cash.

4 The video continues to expand upon the accounting equation to show that Stockholders equity is equal to the sum of contributed capital and retained earnings. Net income is equal to revenues less expenses STOCKHOLDERS' EQUITY = CONTRIBUTED CAPITAL + RETAINED EARNINGS Dividends Net Income NET INCOME = REVENUES - EXPENSES These relationships are important in understanding how financial statements relate to one another and will be elaborated upon in future videos.

5 The video concludes by pointing out that the balance sheet is simply a more formal presentation of the accounting equation. To demonstrate this the video organizes the components of the accounting equation vertically, and then details accounts that fall under assets, liabilities and stockholders equity. Balance Sheet Company Name (000s) ASSETS + - LIABILITIES - + STOCKHOLDERS' EQUITY - + Balance Sheet Company Name (000s) BALANCE SHEET 20X1 ASSETS Current Assets Cash 1,773 Accounts Receivable 7,750 Inventory 4,800 Prepaid Expenses 456 Total Current Assets 14,779 Fixed Assets PP&E, Net of Accum. Depreciation 10,913 TOTAL ASSETS 25,692 LIABILITIES Current Liabilities Accounts Payable 5,665 Line of Credit 792 Current Maturities of Long Term Debt 500 Total Current Liabilities 6,957 Long Term Liabilities Long Term Debt, Net of Current Maturities 5,000 TOTAL LIABILITIES 11,957 EQUITY Common Stock 15 Additional Paid In Capital 5,000 Retained Earnings 8,720 TOTAL EQUITY 13,735 TOTAL LIABILITIES & EQUITY 25,692 Check 0.0 Finally, the video points out that in every thorough financial model, for every accounting period, the balance sheet has a check to make certain that the accounting equation holds true.

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