Financial Modelling fundamental accounting principal

In financial modelling and in accounting there is a fundamental rule that must be satisfied in order for financial statements to balance and make sense, which is Double Entry. This means that any financial event that occurs for a company must impact two of the financial statements in order for them to make sense, and also that if something happens on the asset side of the balance sheet that there must be a corresponding effect on the liabilities and equity side of the balance sheet. Sometimes a financial event can impact all three financial statements simultaneously, however these events can be analysed as two seperate events (or more) impacting two financial statements each. A summary of some different types of financial events and the financial statements they must impact in order for a financial model to balance are listed below:

  • Income received: This will always impact the Income Statement (P&L) and will always impact the balance sheet as well. It can impact the balance sheet by increasing an asset or decreasing a liability, and also by increasing equity. It may or may not affect the cash flow statement as income can be recognised prior to cash being received;
  • Expense incurred: This will always impact the Income statement, and will always impact the balance sheet, but in the opposite manner to income. It can impact the balance sheet by decreasing an asset or increasing a liability, and will also reduce equity. As with income, expenses may or may not affect the cash flow statement as expenses can be recognised prior to cash being paid;
  • Capital raised: This will impact the cash flow statement by increasing cash flows from financing activities, and will affect the balance sheet by increasing the relevant balance sheet item (either debt or equity), as well as increasing the cash balance;
  • Capital expenditure: This will reduce cash flow on the cash flow statement in the cash flow from investing activities section, and will reduce cash on the balance sheet and correspondingly increase a fixed asset balance.