The Basics of the Accounting Model
As a subset of the Investment-Vehicle Model, the Accounting Model revolves around the balance sheet of a corporation and identifies decisions not based on entities but on functions. The balance sheet is a snapshot of corporate health identifying where some decisions have paid off and where some have put the corporation at risk.
As a paradigm for defining the corporation, the Accounting Model is accurate but can sometimes be misleading. Advantages of defining a corporation with the Accounting Model include categorizing a company by functions rather than entities. A disadvantage includes the fact that the definition is always historic.
Balance Sheets in the Accounting Model
The balance sheet is a formal financial statement that shows a firm’s position at one point in time. On the left-hand side, assets are listed including cash, securities, accounts receivable, inventory, and both tangible and fixed assets. The left-hand side of the balance sheet represents investment decisions made by managers of a firm within the principle-agent relationship.
The right-hand side of the balance sheet is made up of two categories: The first category, debts, includes such items as accounts payable, current debt, current liabilities, long-term debt, and bonds. The second category, owner’s equity, includes all that is left over when liabilities are subtracted from debt and represents what the investors are “worth” were the firm sold for face value at the time the balance sheet was tabulated. The right-hand side of the balance sheet represents the financing decisions made by the managers of the firm.
The Accounting Model has several advantages. First, it is highly integrated. Unlike the Investment-Vehicle Model, the firm is categorized into functions rather than entities. Consequently, it provides a view of how the firm fits together. The model is also universally familiar to anyone with even basic finance and accounting knowledge. Comparisons of different time periods in a firm’s life are made easy by The Accounting Model as are comparisons with other firms. It is possible to think of this model as a reorganization of the Investment-Vehicle model into a more internally-focused view of the corporation.
The Accounting Model has one major disadvantage when defining a corporation; it is largely historic. It shows what the corporation looked like at one point in time in the past. Evaluations of expected future conditions and events are ignored by the Accounting Model and, consequently, important decisions can not be made with this model alone. Investigation into future decisions requires information from other sources to create a complete picture of the firm.
Regardless of its limitations, the Accounting Model as a definition of the firm has endured for about as long as corporations have existed. Decisions made with this model are assumed to benefit from the functional rather than entity components contained in the Investment-Vehicle Model. However, a few caveats are well taken when dealing with an historical document.
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This post is part of the series: Financial Models: Three Ways to View a Corporation
- How Financial Market Investors Use the Investment Vehicle Model
- The Accounting Model for Defining Corporations
- Understanding Corporations: The Contracts Model as a Definition