Linkages among the financial statements arise from the combination of accrual accounting with the underlying economics associated with the firm’s business model.  Understanding these linkages generate predictable patterns across the statements which in turn can provide useful insights into future results.

Accrual accounting rests upon two basic principles:

The revenue recognition principle is that revenues are reported on the accounting income statement in the period they are earned and not the period when the contract is created or the period when cash is collected.  This is an essential part of accrual accounting that immediately can gives rise to both a current and non-current balance sheet item usually referred to as “Unearned Revenues” and an asset referred to as “Accounts Receivable.”  We refer to this as the revenue cycle.

Similarly, the matching principle is that expenses are reported on the accounting income statement in the period they are associated with recognized revenues or the period in which they were incurred if no direct association with revenue can be made such as marketing expenses.  Combined the matching principle results in what we will refer to as the revenue and expense cycle.

Understanding the revenue and expense cycle will generate predictable patterns across the statements and understanding these patterns can be most useful for predicting future income as well as assessing the quality of current earnings. 

In turn, these patterns provide rich insight into how a company applies these two principles.  We will illustrate this for the case of 1-800 Flowers using both Valuation Tutor’s SEC Filings:  A Visual Analysis and Common size Analysis.

The Revenue and Expense Cycle

Consider first the accounting transactions that arise from booking earned and unearned revenues:

Observe cash can be collected even though revenue is not earned in an accrual accounting sense.  When the current unearned revenue is earned or the non-current unearned revenue becomes current then the process continues with:

Under accrual accounting the revenue cycle is completed once unearned revenue has been earned.  Under cash accounting the revenue cycle is completed once the cash is collected.

On the cost side the merchant model of accounting (e.g., selling inventory) books gross revenue and subtracts away Cost of Goods Sold or for a service provider subtracts away cost of sales.  That is, a service related firms report “cost of revenues” separately from “operating costs” when the costs are directly associated with revenue as required by the matching principle.  That is, the cost of revenue side are the costs that directly support completing the revenue cycle. 

Financial analysts look for confirming activity in associated accounts to test credibility of growth.   In the above observe that “pre-payment activity” for a tech stock may serve the same role as inventory for a retailer or manufacturing stock.

If the stock’s business model is an “agent model” (i.e., earning agents or booking fees) then revenue must be reported as net revenue.  That is, gross revenue less the amount rebated to the party the firm is acting on behalf of.   

Example 1:  1-800 Flowers Income Statement

Revenue and Cost Cycle for 1-800 Flowers

This stock does not have any unearned revenues. And increased revenues by 4.8% for the December quarter however much of this was due to growth via new acquisitions as described above.  The increase in web business is likely to explain the reduction in accounts receivable (and thus increase in cash sales) when compared to the same three months a year ago.  However, both inventory and accounts payable have increased significantly more than sales.  These are flags and in future topics you will learn how to analyze this at a deeper level by analyzing the working capital management trends for 1-800 Flowers.

Additional cost behavior analysis related to revenue growth are the operating cost categories:

Observe in the RHS of the graph that Operating income for the latest three months is higher than for the latest six months and similarly for 1-year ago.  Focusing on the LHS of the screen the elements of cost of sales and operating expenses are provided as follows:

First, observe that the 6-months gross profit is larger than the 3-months gross profit for both years but this reverses at the operating profit level for both years.  To explore what is going on we will draw from a higher level of Valuation Tutor which provides common size analysis:

Click on the second button above:

Question:  Why are the 3-month net operating incomes higher for 1-800-Flowers than the 6-month operating incomes and what is driving this?

Answering this question requires a common value analysis.  The following screen looks at these quarterly statements dividing each one by its respective net sales revenue.  A lot is going on in the following screen so we will consider the components sequentially:

The middle part of the screen is the control center.  1-800 Flowers quarterly income statement reports 3-months and 6-months for current and a year ago.  The top middle screen provides the statement dates and so to divide each statement by its respective net sales select the dates for each statement as indicated in yellow (highlighted cells) larger circle above.  The smaller circle indicates what the scaling variable is, which in this case is Net Sales from the Consolidated Statement of Operations.

The effect of this is observed in the LHS of the screen such that each statement is now provided in common size form scaled by their respective net revenues.  See the net revenue line is 1.000 for each financial report as circled in the LHS.

The net effect now is to rescale the raw statements provided in the bottom center of the screen to % of Sales provided in the LHS and which can be graphed in the RHS.

This lets us proceed to answer the question.

Question:  Why are the 3-month net operating incomes higher for 1-800-Flowers than the 6-month operating incomes and what is driving this?

First, observe that the % of cost of sales are relatively unchanged and between the years.  As a result, because 6-month sales are greater than 3-month sales then 6-month gross margins are higher in total dollar terms.  This does not carry down to the total operating costs.  The 6-month costs are 36 and 37% respectively for 2011 and 2010 whereas this drops to 32% for the 3-month figures.  Each of the operating cost categories are higher for the 6-month period than they are the for 3-month periods even though the business is highly seasonal (sales are larger at year end). 

The common size chart immediately reveals this:

In the above each group of four has the two 3-month % of sales on the left side and the two 6-month % of sales on the right side of the four vertical bars.  This leads to the cumulative effect in the LHS plot (Total operating expenses).

Under the matching principle these are largely period expenses and thus this reflects that 1-800-flowers allocate significantly more expenses to their final quarter of their financial year (ending July 3, 2011) than they do to their first quarter.

Getting to these timing issues is just one example of the advantage for conducting common size analysis of financial statements.  In Valuation Tutor many other advantages are developed especially when moving into ratio analysis.

Summary: 

Answer to the question is that 1-800 Flowers recognizes more operating expenses in its final quarter (i.e., 10-K report) than it does in earlier quarter (10-Q reports).  This example, provides interesting insight into how the matching principle is applied by at least this company.

The Accounting Equation and Linkages Across the Major Statements

Mathematically the four major financial statements are linked via the beginning and end of period fundamental accounting identity, Assets equal Liabilities and Owner’s Equity.  The income statement and the statement of stockholders’ equity provide the linkage between the two balance sheets.  These reports are based upon two temporary accounts that get closed off to the stockholders’ equity section of the balance sheet every period.  The accounting income summary account is closed off to (accumulated) “Retained Earnings” and the Other comprehensive income account (i.e., Consolidated Statement of Stockholders’ Equity ) is closed off to “Accumulated Other Comprehensive Income.”  Finally, the Consolidated Cash Flow Statement merely provides a reconciliation of the opening and closing balances of Cash and Marketable Securities.  In other words, the underlying driver is the Consolidated Statement of Financial Position which reflects at a point in time the basic accounting equation:

Total Assets = Total Liabilities + Owners’ Equity

Example:  Proctor and Gamble

It is one thing to describe the conceptual framework that underlies modern financial statements.  It is another thing to be able to classify the set of linkages among actual real world financial statements.  In the next section we consider the set of statements filed by Proctor and Gamble (P&G) and their linkages.

For the case of a cash flow statement you will quickly discover that classifications by activity are never completely clean when working with the real world statements.  This is because aggregations within the statement will vary from company to company and cut across category classifications.  P&G has been selected because it provides a nice example of reporting combined with an introduction to real world issues that arise. 

Online by working with the Valuation Tutor software in conjunction with the actual filed statements is that you can quickly compare across a range of companies to see how different companies have dealt with aggregation issues with respect to their external financial statements.  This type of insight can be gained by working with the 10-K Viewer in conjunction with the four Views as depicted below.  For example, View 1 being Consolidated Balance Sheet, View 2 the Consolidated Income Statement and so on.  Furthermore, the plot All 4 Views allows for visual across statement analyses to be performed.

When analyzing the linkages across statements it is useful to further relate these linkages to the nature of activities that directly affect the accounts.  In particular,

Operating Activities

Investing Activities

Financing Activities

Dividend Activities

Linkages Among P&G’s Statements

We can color code the balance sheet items to reveal at a glance whether the major driver of these accounts result from operating activities (lightest green), investing activities (darker green) and financing activities (in-between lighter and darker green).  Classifying these activities in this way is described in the topic titled:  A Quick Tour of the Balance Sheet.

The above color coded statement the basic set of categories are described in the topic  “A Quick Tour of the Balance Sheet.”  In later chapters you will learn how to extract even finer information from these linkages using business ratio analysis and activity analysis.

Working line by line we have the following items:

Current Assets

Cash and Marketable Securities (Category:  Operating)

Accounts Receivable (Category:  Operating)

Inventory (Category:  Operating)

Prepaid Expenses (Category:  Operating)

Deferred Taxes (Category:  Operating)

Non-Current Assets

Property, Plant and Equipment (Category:  Investing)

Leases (Category:  Investing)

Deferred Taxes (Category:  Operating)

Pension Fund (Category:  Investing)

Long-Term Investments  (Category:  Investing)

Intangible Assets (Category:  Investing)

Liabilities

Current Liabilities

Accounts Payable (Category:  Operating)

Notes Payable (Category:  Operating and Financing)

Current Maturities of Long-Term Debt (Category:  Financing)

Accrued Liabilities (Category:  Operating)

Unearned Revenue or Deferred Credits (Category:  Operating)

Deferred Income Taxes (Category:  Operating)

Non-Current Liabilities

Long Term Debt (Category:  Financing)

Capital Lease Obligations (Category:  Financing)

Postretirement Benefits Other Than Pensions (PRB) (Category:  Investing)

Commitments and Contingencies (Category:  Operating)

Non Controlling Interests (Category:  Financing)

Stockholders’ Equity

Common Stock (Category:  Financing)

Additional Paid-In Capital (Category:  Financing)

Retained Earnings  (Category:  Operating)

Accumulated Other Comprehensive Income (Category:  Operating)

Other Equity Accounts  (Category:  Financing)

Linkages Among the Financial Statements:  The Consolidated Income Statement

The Income Statement largely reflects the result of a firm’s operating activities.  In addition, part of the financing decision, interest on debt financing, is also reflected in the income statement.  Investing activities also affect the income statement via depreciation and amortizations but often this is aggregated with other line items as is the case for Proctor and Gamble below.  However, these items are itemized in the Statement of Consolidated Cash Flows considered in the next topic.

Linkages Among the Financial Statements:  The Consolidated Statement of Stockholder’s Equity

There are four major categories highlighted in the Statement of shareholders’ Equity which can be classified in terms of their usual major drivers are as indicated:

Foreign Currency Translations (Operating activities)

Unrealized Gains and Losses (Operating, Investing and Financing Activities)

Retirement Related Benefit Plans (Investing activities)

Hedge Accounting Adjustments (Operating and Financing Activities)

The hedge accounting adjustments can arise from hedging both operating risks (e.g., commodity price increases) as well as financing risks (e.g., creating synthetic fixed rate loans using interest rate swaps).  Similarly, unrealized gains and losses can arise from operating activities (lower of cost or market), investing activities (gains and losses arising from fair value accounting for investments), and similarly for financing activities.

The retirement related benefit plans can be interpreted as related to human capital, an important component of a firm’s capacity to produce products and services.

Linkages Among the Financial Statements:  The Consolidated Cash Flow Statement

This is the Statement that draws together the other statements. It is organized around the business activities of a firm so the color highlighting below is fairly transparent.  There is one note to point out.  US GAAP mixes some financing activities into the operating activities section.  This is due to how US GAAP treats interest expense.

In the P&G example below, observe that the Cash Flow Statement in the indirect form starts with Net Income after tax and adds back Depreciation and amortization, the non-cash expenses.  It then adjusts for changes in working capital and so on.  However, there is no adjustment for interest expense in the cash flow from operations and so implicitly this ends up in the operating activity section of the Cash Flow Statement.  This is not the case for dividends of course.

By the end of this topic you should have a reasonable working knowledge of the inter-relationships across the different financial statements.  You are encouraged to repeat this same exercise for a small sample of firms.  This will let you compare notes to see how different firm’s treat accounting aggregation differently.