Learning goals. After completing this chapter, you should be able to (1) construct consistent and accurate coordinated financial statements (CFS) (2) describe the differences and connections among balance sheets, accrual income statements (AIS), and statements of cash flows; and (3) distinguish between endogenous and exogenous variables and how they influence the construction of CFS.

Learning objectives. To achieve your learning goals, you should complete the following objectives:

• Learn how to construct the financial statements included in the CFS.
• Learn how the fundamental accounting equation organizes the firm’s balance sheet entries.
• Learn how to organize a firm’s cash flow data into a Sources and Uses of Funds (SAUF) statement.
• Learn how to distinguish between a firm’s cash income statement and its accrual income statements (AIS).
• Learn how to compute a firm’s cash income statement using cash flow and depreciation data.
• Learn how to distinguish between exogenous and endogenous variables.
• Learn how to compute a firm’s statement of cash flow using data from its checkbook and other cash flow records.
• Learn the consistency requirements that connect data from the firm’s balance sheets, AIS and statement of cash flow.
• Learn the distinction between consistency of financial statements and accuracy of financial statements.
• Learn how to organize firm financial data into a consistent and (as far as possible) accurate set of CFS.

Introduction

Financial statements include balance sheets, the cash income statement, an accrual income statement (AIS), the statement of cash flow (SCF), and the sources and uses of funds (SAUF) statement. Coordinated financial statements (CFS) include beginning and ending period balance sheets, an AIS, and a SCF. We are particularly interested in the financial statements included in CFS because they are interdependent and when constructed consistently can help us identify inaccuracies in our data.

The purpose of financial statements is to provide the firm the information it needs to identify its strengths and weaknesses, to evaluate its performance, to assess its alternative futures, and to guide its choices between alternative futures to the one most consistent with its mission, goals, and objectives.

Financial managers are expected to conduct financial analysis. To be effective in this role, financial managers need to have a basic understanding of financial statements—how to construct them and how to analyze them. The material that follows provides a basic understanding of financial statements and how to construct them. Later chapters will focus on how to analyze them.

There are, of course, other reasons why familiarity with financial statements may be important. We may have an interest in learning about successful firms, and one way to do this is to examine their financial statements. We may be interested in investing in a firm and want to evaluate its financial condition. We may be employed in a job that requires an understanding of financial statements. Or, we may simply want to make informed decisions that influence the financial conditions of firms in which we have an interest.

Ideally, firms maintain properly constructed financial statements which financial managers can use to conduct financial analysis. But the reality is that many firms, especially small firms, do not maintain a properly constructed set of financial statements. Furthermore, many firms do not record all the data necessary to construct an accurate set of financial statements. On the other hand, nearly all firms maintain cash receipts and cash expense records needed to calculate income tax liabilities. And these same tax record lists the book value of long-term assets necessary to construct balance sheets. Fortunately, with balance sheet data and a cash income statement computed from tax records, we can construct a set of financial statements including an AIS.

Financial Statements

Financial statements may vary by type of firm. For example, financial statements prepared for corporations must satisfy generally accepted accounting practices (GAAP) in which ownership claims are represented by shares of stock. Financial statements prepared for sole proprietorships and partnerships are not subjected to GAAP requirements. In addition, some financial statements are based on accrual methods that record transactions when they occur, while others record transactions only when cash is exchanged.

Different financial statements may report the value of assets differently. Some financial statements represent the value of assets at the price at which they could be sold in the current accounting period. These values are referred to as market values. Other financial statements represent the value of assets at the price at which they were purchased less depreciation. In these statements, allowable depreciation is usually described in tax codes. These values are referred to as book values.

The Balance Sheet

The balance sheet describes the firm’s assets—what the firm owns or controls. It also lists the claims on the firm’s assets from outside the firm called liabilities. The difference between assets and liabilities equals net worth and represents the firm’s equity. The balance sheet is constructed at a point in time, e.g. the last day of the year, leading some to describe it as a snapshot of the firm’s financial condition.

In the balance sheets presented in this class, the value of assets and liabilities is a combination of current and book values. Long-term assets are recorded at their book value—their purchase prices less accumulated depreciation determined by tax codes. Most liabilities and current assets are valued at their current values.

The underlying principal for constructing any balance sheet is the fundamental accounting equation: Assets = Liabilities + Equity. The fundamental accounting equation declares that each of the firm’s assets must be financed either by liabilities (funds supplied by those outside the firm) or equity (funds supplied by the firm’s owners). Moreover, the fundamental accounting equation separates the firm’s assets from its liabilities and equity on the balance sheet. We can check the fundamental accounting equation by noting that the total value of assets equals the total value of liabilities and equity for each year the balance sheet is calculated.

Table 5.1 reports 2016, 2017 and 2018 year-end balance sheets for the hypothetical proprietary firm called HiQuality Nursery. Since we will repeatedly use data associated with this hypothetical firm and refer to the firm frequently, we will refer to it in the future using the acronym HQN. When reporting balance sheets for multiple years, the balance sheets in this text will appear in increasing time periods from least current to most current: 2016, 2017, and 2018 in the case of HQN.

Assets

Assets represent everything of value that the firm controls. Assets have value to the firm, mostly because they represent what can be used to generate earnings. The firm’s assets are typically listed in order of liquidity, or nearness to cash. In most cases asset liquidity depends on the ease or cost of converting them to cash.

Current Assets. Current assets are cash and near-cash assets that are expected to be liquidated or converted to cash during the next year. Current assets are typically assets whose liquidation will not significantly disrupt the operation of the firm. We describe current assets next in their order of liquidity, or their nearness to cash.

• Cash balances are the firm’s most liquid assets.
• Marketable securities are interest-bearing deposits with low risk of losing principal and can easily be converted to cash if needed.
• Accounts receivable include completed sales, for which payment has not been received.
• Notes receivable represent short-term loans the firm has made to others that are expected to be repaid during the coming year. Notes receivables are important for firms for whom lending money and earning interest on their loans is a significant source of income.
• Finally, inventories may be of two kinds. One kind of inventory represents the value of inputs on hand that can be used in future production or manufacturing of goods. A second kind of inventory are products available for sale. Inventories are often the least liquid of the firm’s current assets, and their value is often not known until they are sold.

Long-term assets. Long-term assets yield services over several time periods. Liquidation of long-term assets would typically disrupt the operations of the firm and would occur only if the firm were facing a solvency crisis or replacing long-term assets with more productive ones.

Some balance sheets distinguish long-term assets by the length of time they will be held by the firm before being liquidated, referring to them as intermediate versus long-term assets. We prefer to distinguish between long-term assets by whether or not they depreciate. Depreciable long-term assets include machinery, equipment, breeding stock, contracts, long-term notes receivable, building and improvements. Non depreciable long-term assets are mostly land.

Book value versus market value of long-term assets. The book value of long-term assets is equal to their purchase price less accumulated depreciation: book value = acquisition cost – accumulated depreciation.

Accumulated depreciation is intended to reflect the loss in value of long-term assets due to use or the passage of time. As a practical matter, the depreciation rate is usually determined by tax codes.

While long-term assets are valued at their book value in the balance sheet, firms are also interested in the market value of their long-term assets. An asset’s market value is the price at which it could be sold in the current market. An asset’s book value is almost always different than its market value, the price at which the asset could be sold in the current period. Two reasons why an asset’s book value and market value differ are because an asset’s book value ignores appreciation and its depreciation is set by predetermined rates (rather than market forces), most often reflected in tax codes.

Tax consequences created by depreciable assets are complicated. Consider an example. Suppose a firm purchased a depreciable asset for $1,000 and then depreciated its value by $100 for four years and then sells the asset for $1,300. The difference between the realized market value of $1,300 and its book value of $600 consists of recaptured depreciation of $400 and capital gains of $300. The $300 of capital gains are taxed at the capital gains tax rate. Because the depreciation shielded the firm’s income from income tax, the tax savings from $400 of depreciation is recaptured at the firm’s income tax rate.

To better understand why book value is not equal to market value, think about what determines market value. As will be demonstrated later, the market value of an asset generally depends on the discounted value of future cash flow the asset is expected to generate. The cash flow characteristics that are important in establishing the market value of an asset include:

• the size and/or number of expected future cash flow;
• the timing of expected future cash flow; and
• the risk and variability of future cash flow.

In general, the larger the size and/or number of expected future cash flow, the larger will be the market value of the asset. Likewise, the sooner the asset is expected to generate cash flow, the higher will be the asset’s market value, because a dollar today is generally preferred to a dollar later. Finally, as the risk or variability of an asset’s future cash flow increase, the lower will be the asset’s market value. To account for the influence of the size, timing, and risk of an asset’s cash flow on an asset’s value, later chapters will introduce the concepts of the time value of money. The concept of certainty equivalent measures was introduced in the chapter Managing Risk.

Liabilities

Liabilities are obligations to repay debt and accrued interest charges. They are listed according to the date they become due. Current liabilities are debt and interest payments due during the current period and pose the greatest liquidity demands on the firm’s resources. Long-term liabilities are debts that will come due after the current year. Equity, which represents residual ownership of the firm’s assets, has no fixed due date and is consequently listed after current and fixed liabilities.

Current liabilities. Current liabilities include the following:

• Notes payable are short-term debt (written promises) the firm is obligated to pay during the current year.
• The current portion of long-term debt (LTD) is the portion of LTD that is due during the upcoming year.
• Accounts payable equal the value of purchases made for inputs but not paid.
• Accrued liabilities are expenses that have been incurred through the operation of the firm and the passage of time, but have not been paid. Examples of accrued expenses include taxes payable, interest payable, and salary and wages payable.

Non-current long-term debt is the final category of liabilities, a long-term liability. Non-current long-term debt is that portion of the firm’s debt due after the current period. These are usually long-term notes payable, mortgages, or bond obligations.

Equity

Equity, or net worth, is the difference between assets and liabilities, the difference between what one owns and what one owes. The firm’s equity is an estimate of what owners of the firm would have left if they sold all their assets at their book value and paid all their liabilities valued at their market value. Therefore, equity is an important indicator of a firm’s financial health.

The actual difference between what one owns and what one owes, if required to sell all of one’s assets and repay one’s liabilities, depends not only on the difference between the market value and book value of assets but also on the liquidity of the firm. Therefore, some caution is called for when interpreting the equity appearing on the firm’s balance sheet as an indicator of its financial well-being.

Equity consists of accumulated retained earnings reported in the AIS and contributed capital by the firm’s owners. One practical note is that when reconciling assets and liabilities, contributed capital is sometimes treated as a residual variable.

Checkbooks and Sources and Uses of Funds (SAUF) Statement

Most small firms record cash flow data in checkbooks, credit card statements, or other financial worksheets. These data are important for the construction of financial statements. They also supply the information needed to construct the firm’s income tax returns. Consider HQN’s cash flow data recorded in its checkbook reported in Table 5.2. To simplify the reporting of cash flow data, individual entries of the same kind have been combined into general categories.

Checkbooks

Beginning cash balance. Beginning cash balance is the cash the firm had on hand at the end of the previous period. It also appears on the first line of the firm’s checkbook.

Cash receipts. Cash receipts may include cash received from the sale of tangible products like grain and livestock. Cash receipts may also include cash received from services the firm sells to other firms such as tiling, harvesting, and veterinary services. Cash receipts may include government payments from  sponsored activities and insurance payments. Finally, cash receipts include reductions in accounts receivables and inventories that represent previous sales and production converted to cash in the present period.

Cash cost of goods sold (COGS). Cash COGS reflect the direct cost of materials and labor used to produce the goods that were sold to generate the firm’s revenue. Cash COGS vary with the production levels and are usually the largest expense in most businesses. Finally, cash COGS include reductions in accounts payable that represent expenses incurred in the previous periods paid for in the present period.

Cash overhead expenses (OE). Cash OE represent the cost of operating and administrating the business beyond those included in COGS. These expenses typically include such things as administrative expenses, general office expenses, rents, salaries, and utilities. OE are difficult to assign to a particular production activity because they contribute to more than one project. Moreover, they tend not to vary with changes in production levels although they may vary over time. Cash OE may also include payments on accrued liabilities. Finally, cash OE include reductions in accrued liabilities incurred in previous periods paid for in the present period.

Taxes. Taxes include all compulsory contributions to and determined by governmental units. Taxes may be imposed on property, profits, and some goods used in production and sales.

Interest. Interest is the cost paid to use money provided by others during the current period. We sometimes distinguish between interest paid on long-term and short-term debt obligations.

Cash purchases or sales of long-term assets. Depreciable and non-depreciable long-term assets provide services for more than one period providing the firm a measure of control over its capital service flow not afforded by rental agreements.

Loan payments and account and note payments. Loan payments and account and note payments reflect payments on the amount of financial resources owed others. Sometimes referred to as principal payments, in the case of loans, note payment reflect reductions in the financial obligations of the firm as opposed to interest payments charged for the use of the financial resources of others.

Owner draw. Owner draw represents funds withdrawn from proprietary firms by its owners. These payments may be in exchange for services rendered by the firm’s owner. In other cases, owner draws are funds withdrawn from the firm to meet financial needs of the firm’s owner.

The Sources and Uses of Funds (SAUF) statement.

The data recorded in the firm’s checkbook and other cash flow records can be organized as an SAUF statement that identifies sources of cash for the firm (cash inflows) and uses of funds (cash outflows). The SAUF statement is consistent with the cash flow data reported in HQN’s checkbook in Table 5.2. HQN’s SAUF statement is reported in Table 5.3.

At the beginning of the period, firm managers make cash flow projections recorded in the SAUF statement. These projections allow the firm to plan in advance for cash flow shortages or for investment and savings opportunities. Obviously, a negative ending cash balance is not possible; therefore, the firm adjusts its cash expenses or cash receipts so that the firm remains solvent. In the last column of HQN’s SAUF, ending period cash balances were projected to equal $51.

Notice that the entries in the Checkbook reported in Table 5.2 match those in the SAUF statement reported in Table 5.3, except that they are organized as sources of funds coming into the firm and uses of funds representing funds flowing out of the firm. Consistency between the firm’s SAUF statement and its checkbook requires cash at the ending periods in the balance sheet and the SAUF are equal.

Statement of Cash Flow (SCF)

The firm’s balance sheet describes its financial position at a point in time while the firm’s statement of cash flow (SCF) describes the firm’s cash flow over a period of time between the firm’s beginning and ending balance sheets. The main purpose of the SCF is to find the change in the firm’s cash position during the accounting year.

Three major cash flow activities. The firm’s SCF is similar to its SAUF statement except that it separates cash flow into the three categories: (1) cash flow from operations, (2) cash flow from investments, and (3) and cash flow from its financing activities.

The cash flow from operations reflect the cash flow generated by the firm in producing and delivering its goods and services. Cash flow from operations reflect the firm’s management of its production and marketing activities.

The cash flow from investment activities result from the firm’s sale and purchase of long-term assets. Sales of long-term assets whose market value exceeds its book value create realized capital gains and depreciation recapture. Cash flow from investment activities reflect the firm’s investment management strategies.

The cash flow from financing activities result from borrowing new debt, repaying old debt, raising new equity capital, and returning capital to owners. Cash flow from financing reflect the firm’s management of its debt and equity.

Cash flow for the firm during the accounting period are summarized by its change in cash position. By adding cash on hand at the end of the previous period to the change in cash position reported in the statement of cash flow, we obtain cash on hand at the end of the period. As a result, the change in cash position links the beginning and ending cash on hand reported in the balance sheet.

The SAUF statement derived from the checkbook contains all the data required to construct a statement of cash flow (SCF) for the firm. While cash flow can occur in any order in real life, we have arranged them in the SAUF statement by categories: cash flow associated with operations, cash flow associated with investment, and cash flow associated with financing.

Net cash flow from operations. The first entry in HQN’s checkbook is cash receipts of $38,990. This represents a source of cash, and is therefore entered in the “credit” or “deposit” column of the checkbook. The next items that appear in the checkbook are cash COGS of $27,000, cash OE of $11,078, interest paid of $480, and taxes paid equal to $68. We find net operating cash flow by subtracting from cash receipts, cash expenditures or COGS, cash OE, interest and taxes.

Net cash flow from investments. Net cash flow from investment activity is calculated from checkbook entries equal to $70 which corresponds to net cash flow from investment. It is calculated as the difference between purchases of long-term assets ($100) less sales of long investments assets equal to $30. These calculations for HQN in 2018 are recorded below.

It is important to recognize that some purchases may be paid for with borrowed funds. In this case the borrowed funds would be entered in the SAUF as a source of funds while the purchase reflects own plus borrowed funds expended to acquire the long-term asset.

Net cash flow from financing. Cash flow from financing activities recorded in the checkbook reflect the difference between borrowing and repayment of long-term debt and payments of notes payable. Interest paid on long-term debt and notes payable is included in net cash flow from operations. Finally, dividends paid and owner draw are subtracted and the difference between new equity contributed and purchased is reflected in the net cash flow from financing. HQN’s 2018 net cash flow from financing are recorded below.

An alternative to calculating net cash flow from financing is to use the difference between the ending and beginning balance sheet to the find the change in long-term debt and current long-term debt plus the change in notes payable. Finally, we subtract payment of dividends and owner draw. Net cash flow calculated using the balance sheet rather than the checkbook is reported next.

We demonstrate that cash flow associated with borrowing LTD, repaying current and noncurrent portions of LTD, and converting noncurrent LTD to current LTD are properly accounted for by adding changes in current and noncurrent LTD. To this end, consider the following. We assume transactions occur at the end of each period. Current and noncurrent LTD at the end of the previous period are designated and respectively. Current and noncurrent LTD at the end of the current period are designated and respectively. Assume that at the end of the current period: (1) the firm reduces its outstanding LTD by paying amounts and on noncurrent and current LTD balances respectively ; (2) it increases its LTD by borrowing amount ; and (3) some noncurrent LTD^N becomes current LTD^C—an amount equal to . We can now write the identity:

(5.1)  

In words, current LTD at the end of the period equals current LTD at the beginning of the period plus noncurrent LTD converted to current LTD less current LTD payments made at the end of the period. Then we find the difference between current LTD at the end of the previous and current periods as:

(5.2)  

Similarly, we write the identity

(5.3)  

In words, noncurrent LTD at the end of period one is equal to noncurrent LTD at the beginning of the period plus additional LTD borrowings, less noncurrent LTD converted to current LTD minus noncurrent LTD payments. Then we find the difference between noncurrent LTD at the end of the previous and current periods as:

(5.4)  

Finally we add to find:

(5.5)  

Since cancels when the two equation are added together, we prove that including the difference in current and noncurrent LTD in the financing cash flow section of the statement of cash flow properly accounts for borrowing and payment of LTD and transferring funds from noncurrent to current LTD.

We are now prepared to calculate the change in the net cash position of the firm by combining HQN’s cash flow from operations, investing, and financing.

An alternative statement of cash flow calculates Net Cash Flows from financing, logically equivalent to Table 5.4a, using changes in Current and Non-current LTD and Changes in notes payable, including as before dividends and owner’s draw. The alternative to Table 5.4a, especially useful when data on borrowings and payment data is not available, is reported below:

Since the ending cash position of the firm in the previous period was $930, a change in the cash position associated with the firm’s cash flow implies that the ending cash position of the firm is: $930 – $330 = $600. This amount, $600, corresponds to the cash balance appearing at the end of the current period’s balance sheet. Indeed, a check on the consistency of the calculation that uses a checkbook to construct a statement of cash flow is that the change in cash position reconciles the cash balances appearing in the end of period balance sheets. Furthermore, the beginning and ending cash balances in the checkbook must equal the ending cash balances in the end of period balance sheets. In this case, the beginning and ending cash balances in the checkbook are $930 and $600, respectively, which matches the ending cash balances in the previous and current end of period balance sheets.

Cash Income Statements

Unlike the balance sheet—which is a picture of the firm’s assets, liabilities, and net worth at a point in time—the firm’s income statement is a record of the firm’s income and expenses incurred between two points in time. Profits (losses) reported in the firm’s income statement are reflected in the firm’s balance sheet as an increase (decrease) in the firm’s equity. Therefore, the firm’s income statement provides the details that explain changes in the firm’s equity. To complicate matters, there are two distinct income statements, cash and accrual. We first discuss the firm’s cash income statement.

Cash income statements record the firm’s income and expenses when they generate a cash flow. One of the most important uses of a cash income statement is to determine the firm’s tax obligations. The cash income statement is also an important tool for determining the liquidity of the firm—to determine if its cash receipts are sufficient to meet its cash expenses.

HQN’s 2018 Cash income statement. Using data from the firm’s checkbook or its SAUF statement plus the ending balance sheets, we are prepared to complete a cash income statement. Sometimes the cash income statement is referred to as a modified cash income statement because it includes depreciation which is not a cash flow event but which is an expense allowed when computing taxable income. The 2018 HQN cash income statement constructed using data from HQN’s checkbook plus book value asset data from ending balance sheets used to calculate depreciation is reported below:

Notice that all of the entries in the cash income statement are entries in the firm’s checkbook and SAUF statement except for realized capital gains and depreciation recapture and depreciation. Depreciation is listed as an expense even though it may not reflect a cash flow event because it represents a loss in value to the firm of assets previously purchased. To find the depreciation for HQN we begin with a fundamental relationship that applies to all depreciable long-term assets (DLTA):

Beginning DLTA + purchases of DLTA – sales of DLTA (book value) – depreciation = Ending (book value) DLTA

Notice that the sale of DLTA is listed at their book value. This is necessary to maintain the value of DLTA at their book value in the balance sheets. Solving for depreciation in the identity above and substituting data from the checkbook and balance sheets we find:

Depreciation = Beginning DLTA + purchases of DLTA – sales of DLTA (book value) – Ending DLTA

Depreciation = $2990 + $100 – $30 – $2710 = $350.

Finally, depreciation recapture is treated a separate category of cash receipts to the firm because it represents a value that was previously deducted as an expense included in depreciation and is now received as an unexpected income (or loss). Depreciation recapture plus capital gains is equal to the market value of DLTA sold less the book value of DLTA sold provided the sale price is not greater than the original purchase price.

Realized capital gains (losses) + depreciation recapture = Sale of DLTA (market value) – sale of DLTA (book value)

= $30 – $0 = $30.

In this example, we assume that DLTA were sold at their book value so realized capital gains plus depreciation recapture are zero.

Accrual Income Statement (AIS)

HQN’s 2018 accrual income statement (AIS) is reported in Table 5.6. Because the accrued income statement is the more common of the two income statements, we sometimes drop the word accrual and refer to it as the firm’s income statement. We create HQN’s income statement by adding to cash transactions non cash exchanges affecting the financial condition of the firm.

An important check on the consistency of HQN’s balance sheets and its AIS is that additions to retained earning of ($185) should equal the difference between beginning and ending retained earning in the balance sheet.

We now explain in more detail the calculation of the individual entries in the AIS. In addition, by rearranging the numbers used to find AIS entries, we can find cash income statement entries.

Finding accrued income. Our first checkbook entry records cash receipts of $38,990. So, what is the difference between cash receipts and accrued income? Accrued income includes cash receipts from the sale of products, insurance, and government payments plus credit sales—creating accounts receivable. In addition, accrued income includes inventory increases—production essentially sold into inventory. Both increases in accounts receivable and inventory increase accrued income. While cash receipts are recorded in the checkbook, changes in accounts receivable (Δ Accounts Receivable) and changes in inventories (Δ Inventories) are found as the differences between accounts receivable and inventory entries in the two ending period balance sheets. Since we can find changes in accounts receivable and changes in inventories, we can now calculate accrued income equals the following:

Accrued Income = Cash Receipts + Δ Accounts Receivables + Δ Inventories

$40,000 = $38990 + ($440) + $1450

Notice that cash receipts understate actual income in this example.

Total revenue. Adding cash receipts, realized capital gains / depreciation recapture, changes in inventory, and changes in accounts receivable provides a measure of the firm’s total accrued income.

Finding accrued COGS. The checkbook records cash COGS of $27,000. But accrued COGS must add to cash COGS the COGS that the firm purchased on credit which increased the firm’s accounts payable. The amount of goods the firm purchased on credit can be calculated as the difference between accounts payable at the beginning and at the end of the year recorded in the firm’s balance sheets. For HQN, changes in accounts payable (Δ Accounts Payable) equal $1,000, allowing us to find accrued COGS as:

Accrued COGS = Cash COGS + Δ Accounts Payable

$28,000 = $27,000 + $1000

Note that cash COGS understate actual COGS.

Finding accrued OE. The checkbook records cash OE of $11,078. But accrued OE must add to cash OE the overhead expenses that were purchased on credit increasing the firm’s accrued liabilities. In general, changes in accrued liabilities (Δ Accrued Liabilities) equal the difference between accrued and cash overhead expenses, and can be found as the difference between accrued liabilities recorded in the ending period balance sheets. The difference between ending period accrued liabilities equals ($78), meaning that the firm actually paid off some accrued liabilities incurred in earlier periods in addition to paying for overhead expenses incurred during the current period. We express accrued overhead expenses as:

Accrued OE = Cash OE + Δ Accrued Liabilities

$11,000 = $11,078 + ($78)

Note that cash OE overstate actual overhead expenses.

Calculating depreciation in the accrual income statement. We previously calculated depreciation in the cash income statement and found it to equal to $350. The calculation of depreciation is the same in both the accrual and cash income statement.

Earnings Before Interest and Taxes (EBIT). After subtracting from the firm’s total revenue, its cash COGS, change in accounts payable, cash OE, changes in accrued liabilities and depreciation, we obtain a measure of the firm’s profits (total revenue minus total expenses). But the profit measure obtained is before subtracting interest costs and taxes. Therefore, we call this profit measure Earnings Before Interest and Taxes are paid (EBIT).

Earnings Before Taxes (EBT). Subtracting interest expenses from EBIT gives the firm’s earnings before taxes (EBT), which are the firm’s profits after paying all expenses except taxes.

Net Income After Taxes (NIAT). Subtracting the firm’s tax liabilities from EBT gives the firm’s net income after taxes (NIAT), generally referred to as the firm’s profits. NIAT is also what is available to be reinvested in the firm or withdrawn by the owners.

Interest costs, taxes, and withdrawals. The checkbook records interest costs of $480, taxes equal to $68, and withdrawals of $287. These are paid in cash and can be entered directly in the AIS.

Dividends and owner draw. Dividends and owner draw represent payments make to owners of the firms from the firm’s profits. In the case of dividends, these reflect payments made to compensate owners of the firm for their investments in the firm. In the case of owner draw, these may include payments to owners for services rendered or to meet the financial needs of the firm’s owners.

Finding Cash Receipts, Cash COGS, and Cash OE from the accrual statement. Usually, firms have access to cash receipts, cash COGS, and cash OE from which it can find accrued income, accrued COGS, and accrued OE. This was our approach in the previous section. However, we could reverse the calculations beginning with accrued income, accrued COGS, and accrued OE and then solve for cash receipts, cash COGS, and cash OE. These calculations are described next and are essential in order to complete the firm’s statement of Cash Flow when we begin with accrual data rather than cash flow data.

Suppose that we knew that accrued income were equal to $40,000. We could find cash receipts by subtracting from accrued income, change in accounts receivable and change in inventory:

$38,990 = $40,000 – ($440) – $1450

Finding cash COGS. Suppose that we knew that accrued COGS were equal to $28,000. We could find cash COGS by subtracting accrued COGS change in Accounts Payable:

$27,000 = $28,000 – $1,000

Finding accrued OE. Suppose that we knew that accrued OE were equal to $11,078. We could find cash OE by subtracting from accrued OE, change in accrued liabilities.

$11,078 = $11,000 – ($78)

More Complicated Financial Statements

Compared to HQN’s balance sheets, income statements, and SCF described in this chapter, balance sheets, income statements, and SCF for an actual firm are often much more complicated. In what follows, we highlight the main differences between HQN’s financial statements and financial statements of actual firms.

Level of detail. One of the main differences between HQN’s financial statements and financial statements of actual firms is the level of detail. For example, the income statement may separate total sales into sales of livestock and livestock products, crops sales, and sales of services. Expenses may be separated into seed, fertilizer, other crop supplies, machinery hire, feed purchased, feeder livestock purchased, veterinary services, livestock supplies, fuel and oil, utilities, machinery repairs, insurance, rents, hired labor to name a few. Additional inventory details may include livestock and crops held for sale and feed, value of growing crops, farm supplies, and prepaid expenses.

Data deficiencies. Another difference between HQN’s financial statements and financial statements of actual firms is the quality of the data. HQN’s data are assumed to be accurate and consistent. Data supplied by actual firms is sometimes neither accurate nor consistent. Other data deficiencies of actual firms may include the following. 1) The data are rarely complete, especially for large complex firms with several activities. 2) Data from the firm’s activities may be reported by different persons using different metrics. 3) Some of the same data are provided from different sources and are not equal. 4) Personal data may be confounded with firm data.

Exogenous and endogenous variables. There are two types of variables in CFS: exogenous versus endogenous. The value of exogenous variables are determined outside of the CFS . It can be observed and supplied by sources other than the firm. Endogenous variables are calculated using exogenous variables so that any change in exogenous variables produces changes in endogenous variables. For example, the cash flow variable is an exogenous variable because it can be observed and recorded. Other data, such as firm’s equity or additions to retained earnings are computed using exogenous and sometimes other endogenous variables. The problem occurs where the value in the CFS can be observed and calculated. For example, end of period cash is calculated from beginning period cash plus change in cash position. But end of period cash may be observed by referring to the firm’s checkbook. If the exogenous variable is accurate, then the observed and calculated numbers will be equal and consistent. But in some cases they are not equal and the firm will be required to take steps designed to reconcile the differences.

Consistency versus accuracy. Two words describe financial statements: “consistency” and “accuracy”. Consistency means that we compute values for variables in the CFS in the same way every time so that changes in primary data produce predictable changes in calculated data. Accuracy means that our measurement conforms to the correct value of what is being measured. The financial statements are consistent if the following are true: “additions to retained earnings” reported in the accrued income statement reconciles retained earnings in the ending period balance sheets. The reconciling equation is: beginning retained earnings plus additions to retained earnings equals retained earnings in the ending period balance sheet. A second consistency requirement is that the change in cash position reported in the statement of cash flow reconciles cash balances in the ending period balance sheets. The reconciling equation is: beginning cash plus change in cash position equal ending cash. Finally, the third consistency condition is that the fundamental accounting identity is true; namely, that assets equal liabilities plus equity.

The financial statements may be consistent, but not all the data may be accurately recorded. On the other hand, if the financial statements are not consistent, we can be sure they are not accurate. We summarize our description of financial statements by declaring that consistency is a necessary condition for an accurate set of financial statements but consistency is not sufficient for an accurate set of financial statements.

Hard and soft data. Faced with the data challenges described above, financial managers are charged with the task of preparing the most accurate and consistent set of CFS possible. Guidelines for this task include determining which data is “soft” and which data is “hard.” Soft data is estimated or may lack a supporting data trail. Still, it represents the best guesstimates available. Hard data has a reference or an anchor. For example, the sale of a product is usually recorded although there may be some benefits or costs associated with the sale that are not recorded. Interest costs and taxes are recorded and can be considered hard data. Inventories are more difficult to determine if they are hard or soft because they change over a reporting cycle and their estimated value at the beginning and ending balance sheets may not be available. So, an important task of the financial manager is to assess the reliability of the different data.

Over-identified Variables

An over-identified variable is one whose endogenously calculated value can be observed and recorded as an exogenous variable. For example, consider ending cash balances recorded in the ending period balance sheet. Calculated as an endogenous variable, ending cash balances equal beginning cash balances recorded in the beginning period balance sheet plus changes in cash position calculated in the statement of cash flow. In addition, the financial manager may observe the ending cash balance recorded in the firm’s checkbook. In some cases, however, the financial managers can observe data reflecting the value of endogenous variables. For example, financial managers may observe ending cash balances and have calculated them as an endogenous value using consistency conditions of coordinated financial statements. In this case, values for the variable ending cash balances are over identified. When entries in the CFS can be both observed as an exogenous variable and calculated as an endogenous variable, the CFS variables are over identified.

Ideally, the observed exogenous variable value equals the endogenous variable value. In such fortunate cases, the datum is most likely accurate and consistent with other variable values. When the values for the over-identified variables are not equal, the financial manager can be assured that either the endogenous or the exogenous variable values or both are inaccurate. If the observed value is from hard data, then the financial manager must revisit the values of other exogenous data that were used to calculate the endogenous variable value. Therefore, over-identified variables provide a useful means for evaluating the accuracy of one’s financial statements and exogenous data values used to find the values of endogenous variables.

Constructing Consistent Coordinated Financial Statements (CFS): A Case Study

We now construct a consistent set of financial statements for an actual firm using the data they supplied. In the process, we will experience some of the data deficiencies described earlier and the challenge of having our CFS be both accurate and consistent. We will call our case study firm, Friendly Fruit Farm (FFF) because producing and selling fruit is the firm’s main commercial activity.

To assure that our financial statements are consistent, we will use the template prepared for analyzing HQN and described in more detail in the appendix to the chapter System Analysis. The categories in the HQN template are aggregated compared to actual firms. To fit the data supplied by FFF to the HQN template will require side-bar calculations that organize the data to correspond with the general categories described in Tables 5.1, 5.4, 5.5, and 5.6. The general rule for deciding when side-bar calculations are required is the following: if for any given entry of the CFS there are two or more instances of that item supplied by FFF, a side bar calculation is required. Therefore, the number of side-bar calculations will depend on the firm being examined and the data which the firm supplies.

FFF balance sheets. FFF supplied the following balance sheet data.

Having collected financial data for FFF’s balance sheets we proceed to organize it into categories described by the balance sheets prepared for HQN. The main reason for doing so is to insure consistency. The second reason for doing so is to organize it into categories amenable to ratio analysis important for financial analysis and management. The balance sheet categories used by HQN which we want to duplicate for FFF are described in Table 5.1 .

Cash and marketable securities. We begin by noting that ending period cash balances cannot be negative. Otherwise they are liabilities. But in the balance sheets provided by FFF, they report negative cash balances in both end of period balance sheets. We set them to zero and include them as liabilities included in accounts payable. Our first line in FFF’s ending period balance sheets is:

Accounts receivable. FFF lists accounts receivables. They also lists prepaid expenses and hedging accounts that have properties similar to accounts receivable. All three measures represent short-term sacrifices by the firm for benefits they have not yet received. Usually, accounts receivables reflect firm sales for which it has not yet been compensated in cash. In the case of prepaid expenses, it represents payments for goods they have not yet received. In the case of a hedging account, they represent funds paid for options not yet exercised. Adding to accounts receivable, prepaid expenses and hedging funds produces a more inclusive measure of accounts receivable equal to:

Inventories. FFF lists several inventories in its ending period balance sheets. We list and sum these below.

We now find the sum of FFF’s current assets by adding cash and marketable securities, accounts receivable, and inventories and report the results below.

We now find FFF’s depreciable long-term assets. Note that FFF listed intermediate and long-term assets. In the HQN template, we distinguish long-term as either depreciable or non-depreciable. We consider property, plant, and equipment as depreciable long-term assets and land and buildings as non-depreciable long-term assets. Note that in the FFF supplied balance sheets, they list non-farm assets, which we ignore since our analysis is focused on the farm firm. We now list FFF’s depreciable and non-depreciable long-term assets and find their sum.

We find FFF’s total assets as the sum of current and long-term assets and report the result below.

Notice that the total firm assets calculated above do not match the total firm assets calculated by FFF. This is because the negative cash balances have been shifted to the liabilities section of the balance sheet.

Next we prepare FFF’s liabilities data to match HQN’s reduced categories template. We begin by listing notes payable. We include in this category current notes payable and government loans.

Next we include accrued interest and current portion of the long-term debt and current payments on loans in the category current portion of long-term debt.

Next we list FFF’s accounts payable including negative balances in cash reported in the asset portion of the balance sheet.

Combining our current liabilities entries and summing we find the sum of FFF’s current liabilities:

Now we consider our long-term liabilities described as long-term debt. The first long-term liabilities is noncurrent long-term debt which is listed below.

We add current liabilities to noncurrent long-term debt to find FFF’s total liabilities.

Finally, we compute FFF’s equity as the difference between its total assets and it total liabilities and find it equal to:

Populating FFF’s Cash Income Statements to Conform to HQN’s Income Templates

To enable FFF to populate its income statements, it supplied the following data.

Finally we sum the cash receipts categories:

FFF also reported that in 2018 it paid $12,712 in interest charges, $4,628 in taxes, and that the owners withdrew $44,402. FFF also reported the purchase and sale of assets as $57,048 and $1,185 respectively. We assume that the sale of assets was at their book value.

We now populate FFF’s AIS, using cash receipts and expense data supplied by FFF and changes in FFF’s completed balance sheet entries.

Detailed explanations of the AIS entries follow.

• FFF reported total cash receipts equal to $389,743.
• Change in accounts receivables was calculated by finding the difference between accounts receivable in FFF’s ending period balance sheets equal to ($61,037 – $40,867) = $ 20,170.
• Change in inventory was calculated by finding the difference between inventories in FFF’s ending period balance sheets equal to ($211,308 – $186,298) = $25,010.
• FFF reported Cash COGS equal to $107,119.
• Change in Accounts Payable was calculated by finding the difference between accounts payable reported in FFF’s ending period balance sheets equal to $25,970 – $9,676 = $16,294.
• FFF reported Cash OE equal $196,806.
• Change in accrued liabilities was calculated by finding the difference between accrued liabilities in FFF’s ending period balance sheets equal to ($31,782 – $43,793) = ($12,011).

The next expense category required by FFF’s AIS is depreciation. The data for calculating the change in long-term assets was available in FFF’s balance sheets. FFF also reported its sale and purchases of long-term assets as $57,048 and $1,185 respectively. The formula for depreciation is:

Purchases of depreciable LTAs – sales of depreciable LTAs (book value) – ∆ depreciable LTAs (book) = depreciation.

Making the necessary substitutions, we find FFF’s 2018 depreciation:

$57,048 – $1,185 – ($116,966 – $108,162) = $47,059.

• Summing cash and noncash receipts we find total revenue.
• Summing cash and noncash expenses we find total expenses.
• Subtracting total expenses from total revenue, we find earnings before interest and taxes (EBIT) equal to $79,656.
• FFF reported interest costs equal to $12,712 which were subtracted from EBIT to obtain Earning Before Taxes (EBT) equal to $66,944.
• FFF reported taxes equal to $4,628 which were subtracted from EBT to obtain Net Income after paying interest and taxes (NIAT) of $62,316.
• FFF reported paying dividends and owner withdrawals of $44,402 which were subtracted from NIAT to find changes in retained earnings of $17,914.

Cash income statement. Using the cash receipts and expense data supplied by FFF, we can easily find its cash income statement

Statement of Cash Flow. We now have all of the data required to find FFF’s statement of cash flow. We begin by finding FFF’s net cash flow from operations.

Net cash flow from investment activity is calculated from data used to find depreciation and equals

Net cash flow from financing activities reflects the difference between borrowing of long-term debt and notes payable and principal and interest payments on long-term debt and notes payable. Finally, dividends paid are subtracted and the difference between new equity contributed and purchased is computed.

What to do? Consider the following example. You are visiting in a new town and are trying to find your way to an important site. Suppose that you stop a person you assume is familiar with the location and ask for directions which the person provides. You thank the person for directions and begin your journey to your destination. But just to make sure you are on the right path, you consult your map and find that the directions you just received are in conflict with your map. You are faced with a choice. Which set of directions do you choose? They both can’t be correct.

We face a similar problem when our completed financial statements aren’t consistent. Somewhere in our entries there is an error(s). Therefore to populate our template we have to decide what numbers to believe.

In our case the conflict arises when reported primary data and calculated data required to reconcile the various financial statements are inconsistent. The first requirement is to establish consistency beginning with the calculated entries. Consistency is a necessary condition for accuracy and makes it a logical place to begin. Then we determine if the primary data that conflicts with the calculated number is hard or soft. If it is reasonably hard data, and is higher that the calculated data we explore the data for under estimates of cash inflows and over estimates of cash outflows. We follow the reverse process if the primary data is less than the calculated data. If we can find soft data that can be changed to make the calculated data consistent with the primary data—we make the changes.

Summary and Conclusions

In this chapter we have learned how to construct CFS. Coordinated financial statements are tools that we will use in the next chapter to analyze the firm’s strengths and weaknesses. Constructing financial statements for actual firms with less than perfect and complete data is somewhat of an art.

Questions

1. Define the differences between consistent financial statements and accurate financial statements.
2. Discuss the statement: “consistent financial statements are necessary but not sufficient for accurate financial statements.”
3. What are some conditions required for financial statements to be consistent?
4. In a typical data set provided by a farm firm, what data is most reliable (hard) and which data is least likely to reliable (soft)?
5. Below is a completed 2018 checkbook and 2017 and 2018 ending period balance sheets for the “Grow Green” vegetable farm. Use the numbers in their checkbook and their two balance sheets to create a 2018 cash and AIS and statement of cash flow.

6. Compare the differences and the advantages and disadvantages of cash and AIS.
7. In problem 5, you should have found ending cash to equal $630 which is the same as the observed ending cash. Instead assume that the ending cash balance recorded in the balance sheets provided was equal to $650. Describe the possible adjustments you might make to observed variables to make consistent observed ending cash and the calculated ending cash. Provide a revised set of CFS that are consistent with ending cash calculated and observed.
8. Most firm managers who are also the firm’s financial manager keep less than the complete data set required to construct a complete set of financial statements. And even the data they collect are not in the format we expect, requiring us to reformat the data we do have. With less than complete data sets, we are forced to do the best we can with what we have. What follows is a typical data set which ABM 435 teams have used in the past to construct a set of consistent and accurate set of financial statements. Using the data provided, construct a consistent and, to the extent possible, accurate set of financial statements.

Other balance sheet related data include the following: