## 10. Financial statements model

To better understand the effects of transactions on financial statements and see the relationships between a financial statement's elements, a statements model can be created. There are two forms of a statements model: vertical and horizontal. As its name implies, the vertical model arranges financial statement elements from top to bottom on a page.

The horizontal model arranges financial statement elements horizontally across a page. In the horizontal model, the balance sheet is presented to the left, followed by the income statement, and the statement of cash flows.

Let us demonstrate the usefulness of the horizontal model and apply it to the five transactions we covered earlier. Note that if a transaction does not affect the model, a related cell in the table below shows "n/a". In the statement of cash flows, FA means cash flows from financing, IA means cash flows from investing, and OA means cash flows from operating activities.

1. Obtained capital acquisition: \$5,000
2. Borrowed cash: \$2,000
4. Paid expenses with cash: \$1,000
5. Distributed cash to owners: \$500

Illustration 14: Horizontal statements model for Friends Company

 Event No Balance Sheet Income Statement Cash Flow Cash = Liabilities + Equity Rev. - Exp. = Net Income 1 5,000 = n/a + 5,000 n/a - n/a = n/a 5,000 FA 2 2,000 = 2,000 + n/a n/a - n/a = n/a 2,000 FA 3 3,000 = n/a + 3,000 3,000 - n/a = 3,000 3,000 OA 4 (1,000) = n/a + (1,000) n/a - (1,000) = (1,000) (1,000) OA 5 (500) = n/a + (500) n/a - n/a = n/a (500) FA Totals 8,500 = 2,000 + 6,500 3,000 - (1,000) = 2,000 8,500

With respect to Events 1 and 2, it is clear that only the balance sheet and the statement of cash flows are affected. There is no effect on the income statement. Furthermore, you can see that Event 1 increases assets and equity and that the cash inflow is defined as a financing activity. Event 2 has a similar effect, except that liabilities increase instead of equity.

Event 3 affects three financial statements. Assets and equity increase on the balance sheet. The revenue recognition causes net income to increase, and the cash inflow is shown as an operating activity on the statement of cash flows.

Event 4 is the opposite of Event 3. Assets, equity and net income decrease. Cash flow statement shows this decrease as an operating activity.

Finally, Event 5 shows a decrease in cash and equity. The cash distribution is not shown anywhere in the income statement. That's because distribution is not an expense and thus, it is not included in the determination of net earnings. The cash distribution is categorized as a financing activity in the cash flow statement.

Using the horizontal model helps in understanding the effects produced by each event, so it is advisable to use it as often as possible while learning the principles of financial accounting.

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