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Note: Bold face type indicates the changes in the balance sheet caused by the transaction.


The two steps that we have just taken to add the cash
amount on the left- and right-hand sides of this simple balance
sheet demonstrate double-entry bookkeeping. Note that the totals
have also increased.
Let™s continue. Now that we are flush with cash, we can
splurge on some furniture. Let™s say we spend $5000 of our
cash. Cash decreases by this amount (step one of double-entry
bookkeeping) and a new item called ˜˜Furniture™™ worth $5000
appears (step two). In effect, the $10,000 in starting Cash has
been redistributed, so that half remains as Cash and the other
half is now classified under Furniture. There is no change in the
totals for either side of the balance sheet.
BALANCE SHEET NO. 3

Cash: $5,000 Mortgage: $80,000
House: $100,000 Equity: $30,000
Furniture: $5,000
TOTAL: $110,000 TOTAL: $110,000


We still have extra cash and decide to use that to reduce the
mortgage. The cash amount goes down by $5000 to $0 and, to
complete the double entry, the mortgage amount also goes down
by $5000. The totals also change.
BALANCE SHEET NO. 4

Cash: $0 Mortgage: $75,000
House: $100,000 Equity: $30,000
Furniture: $5,000
TOTAL: $105,000 TOTAL: $105,000


Even in this simple balance sheet, you can see how the
double-entry steps have helped us keep track of the transactions.




TLFeBOOK
Guerilla Accounting for Modeling 115




The final balance sheet is quite different from the first one. We
own more than before”our equity is up by $10,000. This increase
is fully accounted for by having $5000 more in total assets and
owing $5000 less on the mortgage.
So, we can derive the following rules of thumb from this.
If the change is on both sides of the balance sheet
u

(balance sheets 2 and 4), the change is in the same
direction: if the left side goes up, the right side goes up
too, and vice versa. Consequently, the totals also change
accordingly.
If the change is on one side only (balance sheet 3), then
u

the change is in the opposite direction: if one account goes
up, the corresponding double-entry account must go
down, and vice versa. The totals do not change in this
case.
In either case, the lesson to remember is this: the two sides
of the balance sheet must always balance. This is the beauty of
double-entry bookkeeping: you cannot get lost in the balance
sheet. Keep in your head the image of two blocks on the balance
sheet and their having to be the same height as we go deeper
into modeling. This mental concept will carry you quite far in
helping you to figure out accounting flows.


DEBITS AND CREDITS
The material in this section is not really needed to create a finan-
cial model, but later on as you grapple with new accounts and
need to understand what the flows look like, understanding
these concepts will be very helpful.
We have been talking about accounts going ˜˜up™™ and
˜˜down,™™ and that is a serviceable way of describing the changes
in the balance sheet. However, for your background knowledge,
let™s go over the more precise terms used in accounting to
describe the two entries of double-entry bookkeeping:
Debit, sometimes written as Dr
u

Credit, sometimes written as Cr
u




TLFeBOOK
Chapter 6
116




T-Accounts
A debit must always have a credit (and vice versa, of course).
Debits and credits are the entries for something called a
T-account. This is just a little diagram to show the two sides
of a bookkeeping entry. The left side is called ˜˜debit™™ and the
right side is called ˜˜credit,™™ and you must always use this order.
The diagram itself looks like the letter ˜˜T,™™ hence the name:

Debit Credit




Despite how we use the word in everyday language, a debit
does not always mean a decrease. Likewise, a credit does not
always mean an increase! Confused? Here is the real deal:
debit describes an increase of an asset, but a decrease
A
u

of a liability or equity account.
credit describes a decrease of an asset, but an increase
A
u

of a liability or equity account.
Let™s use the steps in the previous balance sheet illustrations
and show them as T-accounts:

BALANCE SHEET NO. 2: WINNING THE $10,000 LOTTERY

Debit Credit

Cash: $10,000
(Asset increases)

Equity: $10,000
(Equity account increases)

BALANCE SHEET NO. 3: BUYING $5000 WORTH OF FURNITURE WITH CASH


Debit Credit

Furniture: $5000
(Asset increases)

Cash: $5000
(Asset decreases)




TLFeBOOK
Guerilla Accounting for Modeling 117




BALANCE SHEET NO. 4: PREPAYING $5000 OF MORTGAGE WITH CASH


Debit Credit

Mortgage: $5000
(Liability decreases)

Cash: $5000
(Asset decreases)



We have established the facts that a debit must go hand-in-
hand with a credit and that changes ˜˜across™™ the balance sheet
move in the same direction, whereas changes in the same side go
in opposite directions. The T-account works beautifully to show
the one-two sequence of double-entry bookkeeping, but if you
are like me when I first learned this, the direction of changes is
still hard to remember. What goes up and down with a credit?
What goes up and down with a debit?



How to Remember Debits and Credits
Here is one way of remembering what debits and credits do that
I have found works for me. Perhaps it will work for you, too.
Think of the schematic cross-section of a river, split into two
halves. Like a balance sheet, the left half is assets, the right
half is liabilities and equity.
On the left half, the left bank is the debit and because it is
high, this represents an increase; the river bottom is the credit
and because it is low, this represents a decrease.
On the right half, the low river bottom is the debit, and this
represents a decrease. The high right bank is the credit, and this
represents an increase.

Assets Liabilities and Equity
Debit (increase) Credit (increase)

Credit (decrease) Debit (decrease)




TLFeBOOK
Chapter 6
118




HOW THE INCOME STATEMENT CONNECTS
WITH THE BALANCE SHEET
We have been discussing how the balance sheet changes as
various accounts change. One way that a balance sheet changes
is through the infusion of earnings from the income statement,
which comes in as additions to the retained earnings. (Pop quiz:
is that a debit or credit to retained earnings?) This is the connec-
tion between the income statement and the balance sheet. The
balance sheet ˜˜collects™™ the flow that comes from the incoming
statement it is in, whether it is positive (a profit) or negative
(a loss). Either way the flow is a credit to retained earnings.
The following is the continuation from the last balance
sheet. Now, let™s assume that in the next year, we receive a pay-
check of $5000. There™s income tax of 30 percent, so our take-
home net income is $5000 ‚ (1 À 0.30) ¼ $3500. In terms of a
T-account, it would look like this: The retained earnings account
increases and, on the other side, the corresponding entry to the
credit is a debit to cash:

Debit Credit

Cash: $3500
(Asset increases)

Retained earning: $3500
(Equity increases)

Here™s what the balance sheet changes would look like:
INCOME STATEMENT
Revenues $5000
Tax (at 30%) $1500
Net income $3500


BALANCE SHEET NO. 5
Cash: $3,500 Mortgage: $75,000
House: $100,000 Equity: $30,000
m




Furniture: $5,000 New equity: $3,500
TOTAL: $108,500 TOTAL: $108,500

These are the basic flows that we will work with as we
continue with our modeling.




TLFeBOOK
CHAPTER 7


Balancing the
Balance Sheet

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