Ch. 1 Types of Business and Financial Statements
1.6 Horizontal Model
Learning Objectives
After finishing this section, students will be able to:
- Process transactions in the horizontal model using Excel.
- Create financial statements using the horizontal model.
Accounting is a double-entry system. For every entry into the company accounting records, there has to be an opposite and equal entry. (Financial accounting has quite a bit in common with Newton’s third law of motion — the one about every action having an equal and opposite reaction.)
Now that we have a basic understanding of the financial reports, let’s begin to understand how the numbers are tracked. Accounting systems and accountants use debits, credits, and t-accounts to track accounting transactions. In this textbook, we will use the horizontal model instead of debits and credits. This will allow us to concentrate more on the construction and the understanding of financial statements. The horizontal model also allows you to practice your Excel skills by quickly determining the total of each account.
Accounting Equation
The accounting equation emphasizes a basic idea in business; that is, businesses need assets in order to operate. There are three ways a business can finance the purchase of assets. First, it can sell shares of its stock to the public to raise money to purchase the assets. Second, it can borrow the money from a lender, such as a financial institution. Third, it can use profits earned by the business to finance its activities.
Assets = Liabilities + Equity
Assets
On the left side of the equation are assets. Assets are resources a company owns that have an economic value. Some common examples of assets are cash, accounts receivable, inventory, supplies, prepaid expenses, notes receivable, equipment, buildings, machinery, and land.
Liabilities
On the right side of the equations are liabilities and stockholders’ equity. Liabilities are obligations to pay an amount owed to a lender (creditor) based on a past transaction. It is important to understand that when we talk about liabilities, we are not just talking about loans. Money collected for gift cards, subscriptions, or as advance deposits from customers could also be liabilities. Essentially, anything a company owes and has yet to pay within a period is considered a liability, such as salaries, utilities, and taxes.
Equity
Stockholder’s equity refers to the owner’s (stockholder’s) investments in the business and earnings made. These two components are contributed capital and retained earnings. The owner’s investments in the business typically come in the form of common stock. Another component of stockholder’s equity is company earnings. The retained earnings are what the company keeps at the end of a period to reinvest in the business, after any distributions to ownership occur. Stated more technically, retained earnings are a company’s cumulative earnings since the creation of the company minus any dividends that it has declared or paid since its creation. One tricky point to remember is that retained earnings are not classified as assets. Instead, they are a component of the stockholder’s equity account, placing it on the right side of the accounting equation.
Horizontal Model
The horizontal model allows us to make sure the left side of our equation (assets) is always equal with the right side of the equation (liabilities and stockholders’ equity). For the sake of learning, colors have been added. Accounts in blue appear on the income statement. Accounts in gray appear on the balance sheet. Cash is shown in green and will appear on the Statement of Cash Flow. We will learn about the Statement of Cash Flow in the next section.
| Balance Sheet | Income Statement | Stmt of Cash Flows | |||||||||||||
| Cash | + | Noncash Assets | = | Liability | + | Common Stock | + | Retained Earnings | Revenue | – | Expense | = | Net Income | Cash | OA,IA,FA |
Note: The horizontal model can be downloaded or can be copied from the textbook and placed into Excel. This will save you time.
The following information is provided for the first month of operations for Cheesy Chuck’s Classic Corn.
| Transaction | Description |
|---|---|
| A | The business was started by selling $12,500 worth of common stock. |
| B | Received $85,000 in payment from customers. |
| C | Paid $76,800 for cost of goods used to make popcorn. |
| D | Paid advertising expense of $300. |
| E | $1,200 of wages need to be paid to employees for making the popcorn. The wages will be paid next month (use wages payable and cost of goods sold). |
| F | Paid $12,500 for a piece of popcorn making equipment. |
| G | Miscellaneous expense of $900 occurred. $650 will be paid later (use accounts payable and expense). The other $250 was paid immediately. |
| H | It was determined the company would owe $1,218 in income tax (use income tax payable and expense). |
| I | Dividends in the amount of $1,450 were paid in cash. |
Transaction A
The business was started by selling $12,500 worth of common stock. Cash is the same as a checking account. If you receive money, it will be a positive number in your checking account. If you spend money, it will be a negative number in your checking account. Since we received money, we will increase cash. The money paid by the stockholders is called common stock. Since the stockholders paid money into the company, common stock will increase and
To make sure we did the entry correctly, we use the accounting formula. Think of the accounting formula as a teeter totter. The equal sign of the equation is the fulcrum of the teeter totter. On either side of the teeter totter, a person will get on that weighs exactly the same. This will allow both people to balance and not touch the ground. Hopefully, this analogy brings back a good childhood memory. If we bring the teeter totter back to the accounting formula, both sides of the equation have to be exactly the same.
The accounting formula is in the horizontal model in gray. Looking at the balance sheet portion of the horizontal model as a teeter totter, you can see that the left side of the equation (cash of $12,500) is equal to the right side of the equation (common stock of $12,500). Our accounting equation, or teeter totter, is perfectly balanced.
| Balance Sheet | Income Statement | Stmt of Cash Flows | |||||||||||||
| Cash | + | Noncash Assets | = | Liability | + | Common Stock | + | Retained Earnings | Revenue | – | Expense | = | Net Income | Cash | OA,IA,FA |
| 12,500 | = | 12,500 | |||||||||||||
Transaction B
Received $85,000 in payment from customers. Cash was received from customers. Payments from customers are considered revenue for our business. Revenue goes on the income statement. Solving Revenue ($85,000) – Expenses ($0) = Net Income ($85,000) gives us the amount that will close down to Retained Earnings (R/E). Remember the Retained Earnings formula is Beg R/E ($0) + Net Income ($85,000) – Dividends ($0) = End R/E ($85,000).
Cash and Revenue are in bold as the main entry. The Net Income and Retained Earnings cells are not in bold. These cells should be automatically populated with an Excel formula. Demonstration of the Excel formula can be found in the 1.6a Example.
Looking at the balance sheet portion of the horizontal model, you can see that Cash and Retained Earnings are both $12,500. Our accounting equation is perfectly balanced.
| Balance Sheet | Income Statement | Stmt of Cash Flows | |||||||||||||
| Cash | + | Noncash Assets | = | Liability | + | Common Stock | + | Retained Earnings | Revenue | – | Expense | = | Net Income | Cash | OA,IA,FA |
| 85,000 | = | 85,000 | 85,000 | – | = | 85,000 | |||||||||
Transaction C
Paid $76,800 for cost of goods used to make popcorn. Cash was paid to vendors. Payments to vendors are considered expenses for our business. Expenses goes on the income statement. Solving Revenue ($0) – Expenses ($76,800) = Net Income (-$76,800) gives us the amount that will close down to Retained Earnings (R/E). Remember the Retained Earnings formula is Beg R/E ($0) + Net Income (-$76,800) – Dividends ($0) = End R/E (-$76,800). Cash is decreasing and the expense (Cost of Goods Sold) is increasing.
Looking at the balance sheet portion of the horizontal model, you can see that Cash and Retained Earnings are both -$76,800. Our accounting equation is perfectly balanced.
| Balance Sheet | Income Statement | Stmt of Cash Flows | |||||||||||||
| Cash | + | Noncash Assets | = | Liability | + | Common Stock | + | Retained Earnings | Revenue | – | Cost of Goods Sold | = | Net Income | Cash | OA,IA,FA |
| -76,800 | = | -76,800 | – | 76,800 | = | -76,800 | |||||||||
Transaction D
Paid advertising expense of $300. Cash was paid to a vendor for advertising expense. Cash is decreasing and the expense (advertising) is increasing
Looking at the balance sheet portion of the horizontal model, you can see that Cash and Retained Earnings are both -$300.
| Balance Sheet | Income Statement | Stmt of Cash Flows | |||||||||||||
| Cash | + | Noncash Assets | = | Liability | + | Common Stock | + | Retained Earnings | Revenue | – | Advertising Expense | = | Net Income | Cash | OA,IA,FA |
| -300 | = | -300 | – | 300 | = | -300 | |||||||||
Transaction E
$1,200 of wages need to be paid to employees for making the popcorn. The wages will be paid next month (use wages payable and cost of goods sold). Employees are often owed money at the end of the month but will not be paid until the next month. Since we need to record the expense now, we will make an entry to an expense (cost of goods sold). We will learn more about adjusting entries in Chapter 2 and cost of goods sold in Chapter 3. Until we pay the wages to the employees, we will keep track of the expense in Wages Payable. Payable means we are liable to pay later. Both wages payable and cost of goods sold will increase.
Looking at the balance sheet portion of the horizontal model, you can see that Wages Payable ($1,200) and Retained Earnings (-$1,200) make the right side of the equation equal zero. With zero on the left side and zero on the right side, our accounting equation is perfectly balanced.
| Balance Sheet | Income Statement | Stmt of Cash Flows | |||||||||||||
| Cash | + | Noncash Assets | = | Wages Payable | + | Common Stock | + | Retained Earnings | Revenue | – | Cost of Goods Sold | = | Net Income | Cash | OA,IA,FA |
| = | 1,200 | -1,200 | – | 1,200 | = | -1,200 | |||||||||
Transaction F
Paid $12,500 for a piece of popcorn making equipment. Paying cash to invest in better equipment is a normal business activity. Cash will decrease and equipment will increase.
Looking at the balance sheet portion of the horizontal model, you can see that Cash (-$12,500) and Equipment ($12,500) make the left side of the equation equal zero. With zero on the left side and zero on the right side, our accounting equation is perfectly balanced.
| Balance Sheet | Income Statement | Stmt of Cash Flows | |||||||||||||
| Cash | + | Equipment | = | Liability | + | Common Stock | + | Retained Earnings | Revenue | – | Expense | = | Net Income | Cash | OA,IA,FA |
| -12,500 | 12,500 | = | |||||||||||||
Transaction G
Miscellaneous expense of $900 occurred. $650 will be paid later (use accounts payable and expense). The other $250 was paid immediately. In this transaction, we need three entries. Cash will decrease, Accounts Payable will increase, and Miscellaneous Expense will increase
Looking at the balance sheet portion of the horizontal model, you can see that Cash (-$250) is the left side of the equation and Accounts Payable ($650) and Retained Earnings (-$900) added together makes the right side of the equation (-$250). Our accounting equation is perfectly balanced.
| Balance Sheet | Income Statement | Stmt of Cash Flows | |||||||||||||
| Cash | + | Noncash Assets | = | Accounts Payable | + | Common Stock | + | Retained Earnings | Revenue | – | Misc. Exp | = | Net Income | Cash | OA,IA,FA |
| -250 | = | 650 | -900 | -900 | |||||||||||
Transaction H
It was determined the company would owe $1,218 in income tax (use income tax payable and expense). Both income tax payable and income tax expense will increase.
Looking at the balance sheet portion of the horizontal model, you can see that Income Tax Payable ($1,218) and Retained Earnings (-$1,218) make the left side of the equation equal zero. With zero on the left side and zero on the right side, our accounting equation is perfectly balanced.
| Balance Sheet | Income Statement | Stmt of Cash Flows | |||||||||||||
| Cash | + | Noncash Assets | = | Income Tax Payable | + | Common Stock | + | Retained Earnings | Revenue | – | Income Tax Expense | = | Net Income | Cash | OA,IA,FA |
| = | 1,218 | -1,218 | – | 1,218 | = | -1,218 | |||||||||
Transaction I
Dividends in the amount of $1,450 were paid in cash. Dividends are paid to stockholders. In an accounting system when this transaction occurs, dividends will “hide” in retained earnings. For this reason, a dividend account is not created on the horizontal model as an expense. Remember the Retained Earnings formula is Beg R/E ($0) + Net Income ($0) – Dividends ($1,450) = End R/E (-$1,450). Cash and Retained Earnings are decreasing. The stockholders now have less money to keep inside of the company. Remember Retained Earnings means revenue to keep.
Looking at the balance sheet portion of the horizontal model, you can see that Cash and Retained Earnings are both -$1,450. Our accounting equation is perfectly balanced.
| Balance Sheet | Income Statement | Stmt of Cash Flows | |||||||||||||
| Cash | + | Noncash Assets | = | Liability | + | Common Stock | + | Retained Earnings | Revenue | – | Expense | = | Net Income | Cash | OA,IA,FA |
| -1,450 | = | -1,450 | |||||||||||||
Summary
When transactions A through H are put into the same horizontal model, the last row can be summed to find the account balances (in bold) that will appear on the financial statements. In reviewing these numbers, you can see that the transactions create the financials statements from previous sections:
The Statement of Cash Flow will be discussed in the next section. To save time and frustration, I suggest adding a description for each transaction as seen in the far right column of the horizontal model below.
| Balance Sheet | Income Statement | Stmt of Cash Flows | |||||||||||||||||||
| Cash | + | Equipment | = | Accounts Payable | + | Wages Payable | + | Income Tax Payable | + | Common Stock | + | Retained Earnings | Revenue | – | Expense | = | Net Income | Cash | OA,IA,FA | Description | |
| A | 12,500 | + | = | + | + | + | 12,500 | + | – | = | Stock | ||||||||||
| B | 85,000 | + | = | + | + | + | + | 85,000 | 85,000 | – | = | 85,000 | Revenue | ||||||||
| C | -76,800 | + | = | + | + | + | + | -76,800 | – | 76,800 | = | -76,800 | COGS | ||||||||
| D | -300 | + | = | + | + | + | + | -300 | – | 300 | = | -300 | Advertising | ||||||||
| E | + | = | + | 1,200 | + | + | + | -1,200 | – | 1,200 | = | -1,200 | Wages | ||||||||
| F | -12,500 | + | 12,500 | = | + | + | + | + | – | = | Equipment | ||||||||||
| G | -250 | + | = | 650 | + | + | + | + | -900 | – | 900 | = | -900 | Misc. | |||||||
| H | + | = | + | + | 1,218 | + | + | -1,218 | – | 1,218 | = | -1,218 | Income Tax | ||||||||
| I | -1,450 | + | = | + | + | + | + | -1,450 | – | = | Dividends | ||||||||||
| 6,200 | + | 12,500 | = | 650 | + | 1,200 | + | 1,218 | + | 12,500 | + | 3,132 | 85,000 | – | 80,418 | = | 4,582 | Totals | |||
Watch video from 1:14 to 25:50
The following transactions for Video Services Company (VSC) occurred.
| Date | Transaction Detail |
|---|---|
| Year 1 #1 | Issues $20,000 shares of common stock for cash. |
| Year 1 #2 | The company borrowed $5,000 from creditors. |
| Year 1 #3 | The company provided services to customers and received $4,000. |
| Year 1 #4 | The company paid expenses of $2,900. |
| Year 1 #5 | The company paid $500 in dividends to its stockholders. |
| Year 2 #1 | The company issued additional common stock for $4,500. |
| Year 2 #2 | The company paid $2,000 to reduce its liabilities. |
| Year 2 #3 | The company provided services to customers and received $6,700. |
| Year 2 #4 | The company paid expenses of $4,300. |
| Year 2 #5 | The company paid $700 in dividends to its stockholders. |
| Year 3 #1 | The company issued additional common stock for $2,500. |
| Year 3 #2 | The company borrowed $1,000 from creditors. |
| Year 3 #3 | The company provided services to customers and received $7,400. |
| Year 3 #4 | The company paid expenses of $7,900. |
| Year 3 #5 | The company paid $300 in dividends to its stockholders. |
| Year 3 #6 | The company paid $9,000 to purchase land. |
Instructions:
- Using the Horizontal Model (remember you can copy this from the textbook), prepare entries for the above transactions.
- Prepare an Income Statement for Year 1. (Note: I did a simple income statement without income tax expense so you can easily see how the numbers come from the horizontal model.)
- Prepare a Statement of Stockholders’ Equity for Year 1.
- Prepare a Balance Sheet as of Year 1.
- Repeat #1 through #4 for Year 2 and 3.
1.6a Practice
The following transactions for Monica’s Candy occurred in December 20X4.
| Date | Transaction Detail |
|---|---|
| Dec. 1 | Issued $10,000 shares of common stock to friends for cash. |
| Dec. 5 | Purchased equipment by paying cash for $2,000. |
| Dec. 10 | Paid December rent of $2,400 for an industrial kitchen. |
| Dec. 15 | Purchased $3,500 worth of groceries (candy making ingredients) to prepare candy for wedding on December 18. Since these ingredients will be used immediately, decrease cash and cost of goods sold. |
| Dec. 18 | Sold $8,000 of candy to customers for a wedding and received cash immediately. |
| Dec. 20 | Monica is the only employee. She paid herself a monthly salary of $1,500. |
| Dec. 22 | Advertising expense of $500 was paid to a local wedding influencer. |
| Dec. 27 | Dividends were paid of $550. |
| Dec. 30 | Kitchen equipment broke and a repair man charge for $100 to fix it. A bill was received but not paid. |
- Using the Horizontal Model, prepare entries for the above transactions.
Check Figures:
- Cash, $7,550
- Total Assets, $9,550
- Net Income, $0
- Solution (Excel file will download)
1.6a Homework
The following transactions for Avalee’s Marketing Agency occurred.
| Date | Transaction Detail |
|---|---|
| Jan. 3 | Issues $20,000 shares of common stock for cash. |
| Jan. 5 | Purchases equipment for $3,500. |
| Jan. 9 | Provides and receives cash for $5,500 in services to a customer. |
| Jan. 12 | Paid $300 utility bill with cash. |
| Jan. 14 | Paid $100 cash in dividends to stockholders. |
| Jan. 20 | Paid $3,600 cash in salaries expense to employees. |
| Jan. 27 | Provides and receives cash for $1,200 in services to a customer. |
| Jan. 30 | Paid general expenses of $1,400. |
Instructions:
- Using the Horizontal Model, prepare entries for the above transactions.
- Prepare a multi-step Income Statement for January 20X8. Income Tax Expense is calculated at 21%. You do not need to include income tax expense in the Horizontal Model only the reports. Going forward as directed, we will put income tax expense in the Horizontal Model.
- Prepare a Statement of Stockholders’ Equity as of January 31, 20X8.
- Prepare a Balance Sheet as of January 31, 20X8.
Licensing and Attribution:
Content on this page is adapted from the following openly licensed resource(s):
Principles of Accounting, Volume 1: Financial Accounting by Mitchell Franklin, Patty Graybeal, and Dixon Cooper licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License
