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first year use the average calculationâ€”they wonâ€™t be used
anyway, and this makes the formulas more consistent
across the periods.
The Retained earnings account on the balance sheet for
u

the second year (and for other subsequent years) is a
formula that looks at the prior periodâ€™s retained
earnings and adds the net income to that. This is because
retained earnings is the cumulative total of a firmâ€™s
earnings.

EFFECTS OF THE PLUGS ON THE
INCOME STATEMENT
Because the Surplus funds and the Necessary to finance are cash
and debt, respectively, we can assume that they will produce
income interest and income expense. What this means is that
the very act of calculating such a plug number will create a
change in the income statement, which will cause the retained
earnings to vary and the balance sheet to become unbalanced
again.

Effect of Interest Income from
Surplus Funds
Here is an illustration of the effects of the interest income from

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Balancing the Balance Sheet 141

that the accounts on the balance sheet on their own have created
a Surplus funds (shown as SF) amount:
3. Interest income adds to net income

2. Which creates interest income

4. Net income adds to retained earnings

1. SF plug appears

6. Which makes SF increase even more

5. Which adds to right side of B/S

As you can see, there is a circular reference in the model.
Step 1, for example, is affected by step 6, which is the result of
calculations based on step 1 itself! Not to worry, we still have
Excelâ€™s iteration setting on (Tools > Options > Calculation, check
the Iteration box).
Note also that it is not likely that the numbers will â€˜â€˜blow
upâ€™â€™â€”get ever larger with each iteration by diverging from each
other. In this system, there is an increase in the numbers with
each iteration, but each increment is only a small portion of the
previous increase, so the numbers can be said to converge. Each
increase is progressively smaller than the previous increase, until
we arrive at a final iteration with such a small increase that
Excel stops the calculations. The convergence happens because
each increase in the Surplus funds causes a corollary increase

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Chapter 7
142

equivalent to the (Surplus funds Ã‚ Interest income rate). If there
is an Income tax rate in the income statement calculations, the
increase is further reduced and becomes (Surplus funds Ã‚ Interest
income rate) * (1 Ã€ Income tax rate). Of course, the numbers can
still not converge if we put in an Interest income rate that, on an
after-tax basis, would create an interest income number greater
than the starting amount (e.g., a starting Surplus funds number
of \$100 creates an after-tax interest income of \$101, but this
is clearly not a situation that we can expect to find in normal
economic environments).

Effect of Interest Expense from
Necessary to Finance
The same kind of calculation circularity is seen when the plug is
on the liabilities side as the Necessary to finance plug. The steps
are seen below:
3. Interest expense reduces net income

2. Which creates interest expense

4. A smaller net income flows to
retained earnings

1. NTF plug appears

6. Which makes NTF increase even more

5. Which reduces the right side of BS

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Balancing the Balance Sheet 143

In both illustrations, the same thing is happening: the
appearance of a plug sets in motion a chain of calculations that
results in the plug converging to a slightly higher ending
number. One might say that is due to the phenomenon of the
modelâ€™s calculating â€˜â€˜interest on interest.â€™â€™

Reality Check
How does this fit into the real world? Actually, quite well. For
our projected numbers, we can imagine a company having to
borrow \$100 million at the beginning of the year to meet its
working capital needs. Over the year, with a 10 percent interest
rate, it will have to pay \$10 million in interest expense, money it
does not have (thatâ€™s why it has to borrow, after all), so it really
should borrow \$110 million. But borrowing the additional \$10
million means that it will have \$1 million interest on that bor-
rowing (this is the â€˜â€˜interest on interestâ€™â€™ idea), so it really should
borrow another \$1 million. And that is going to create another
\$0.1 million in interest, so we should borrow that much more,
but then, there will be interest on that borrowing and so on . . . .

DEVELOPING THE MODEL FURTHER
Now that we have an understanding of how to create a working
and balancing model, the next steps are to develop it so that it
fits real world conditions. We have been using just a limited set
of unspecific accounts, after all. Furthermore, the cash flow state-
ment is not developed yet. That is best done when we have a
more complete set of accounts, the better to illustrate the compo-
nents of that statement. Chapter 8 is a return to some accounting
points that cover just the types of accounts that you will come
cash flow statement.

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CHAPTER 8

Income Statement and
Balance Sheet Accounts

In Chapter 7, we used a very simple and simplistic income state-
ment and balance sheet to demonstrate the balancing mechanism.
In this chapter, we address what the â€˜â€˜real lifeâ€™â€™ counterparts of
these financial statements should have.

THE INCOME STATEMENT
The income statement is a listing of revenues and expenses and
shows the flows of the company over the reporting period. The
typical reporting period is annual. The fiscal year of a company
is the span of the year over which it chooses to report its earn-
ings. Although most companiesâ€™ fiscal year is the same as the
calendar year, ending on December 31, a company can choose
any date in the calendar year as its fiscal year-end in order to
show the best possible seasonal condition. Many department
stores, for example, use January 31 as their fiscal year end. This
is a point in the year after the year-end holiday sales when their
inventories are low and their cash holdings are high.
145

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Chapter 8
146

The basic form of the income statement is this:
Sales
Ã€ Cost of goods sold
Â¼ Gross profit
Ã€ Selling, general, and administration (SGA) expenses
Ã€ Depreciation
Ã€ Amortization of intangibles
Ã€ Operating expenses
Â¼ Earnings before interest and taxes (EBIT)
Ã€ Other non-operating expense
Ã¾ Interest income
Ã€ Interest expense
Â¼ Earnings before taxes (EBT)
Ã€ Taxes
Â¼ Net income
Ã€ Dividends
Â¼ Net to retained earnings

Compare this layout with the simplified layout we used in
the previous chapter. The essential lines in that layout are the inclu-
sion of the interest income and interest expense lines, which allow
any interest produced by the balance sheet plugs to be included in
the modeling flows; these lines are also seen in the layout here.
The moral of the story is that the basic structure that we created in
the last chapter can be used as the basis for a â€˜â€˜realâ€™â€™ model. It is
a matter of adding more lines to capture the various accounting
items. These additional lines are static as we defined the term in
the last chapter: they do not change with each iteration of the
model during the balancing convergence. What this means is
that, if you wish, you can expand the number of rows for, say,
operating expense from one row to any number of rows, and the
model will still work. And the same applies for the balance sheet.
EBIT stands for Earnings before interest and taxes, and
one would think that below this line there will only be interest
and taxes. But EBIT is a very specific accounting term that
defines the earnings that are related to a companyâ€™s main
avenue of business, or what are called the operating earnings
or operating profit. So below EBIT, you will often see other
expenses that are not directly related to the main avenue of
business (that is, other than interest or taxes). This is why you

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Income Statement and Balance Sheet Accounts 147

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