Financial Statements — What Each of the Three Ledgers Is Asking

A Shop's Year

Let us bring back the shop we saw in "What You Actually Own When You Own a Share — And Where You Stand in Line". It is a small company divided into 100 slices. Back then we counted a month, and this time we stretch it to a year. During that year, this shop sold 10,000,000 won worth of goods, and paid 9,000,000 won in material costs, rent, wages, interest on borrowed money, and taxes. What remains for the people who hold the slices is 1,000,000 won.

A person outside the shop knows this year through the financial statements the company puts out to the world.

Among the people who primarily looked at those statements in the early days was a supplier who provided goods on credit. This is a transaction where goods are handed over first, and the payment is received when those goods are sold. That interval was usually 30 to 60 days. What the supplier asked was whether the shop that received the credit could pay it back within that period. In many cases, there was almost no reliable information other than the shop's reputation (DOI: 10.1561/1400000018 · an English-language overview not specific to any country). Assessing the possibility that the other party might not repay its debts through financial statements has continued for over 100 years (DOI: 10.1561/1400000018).

Today, suppliers, banks, investors, management, and credit rating agencies that grade a company's ability to repay its debts all look at these statements (DOI: 10.1561/1400000018). One review organizing accounting literature broadly divides the people who look at the statements into three. Those who buy and sell shares, those who lend money to the company, and those who monitor company management (DOI: 10.1016/j.acclit.2015.02.001 · an English-language review not specific to any country). The person who bought a slice stands on the side of buying and selling shares among them.

Those statements are three sheets, and each of the three sheets asks a different question. What do we hold right now, how much did we earn in a year, and did that money actually come in? This article follows those three questions in turn to see where the shareholder's share appears across the three statements. As seen in the shares primer, the shareholder stands at the very back of the line of people who have claims to receive things from the company. What remains after the people at the front take their set shares in full is the shareholder's share.

This article is written with Korean listed companies and Korea's accounting and disclosure systems in mind. Studies that looked at companies outside Korea or whose abstracts do not specify the country of their sample are noted as such on the spot. The shop's numbers are arithmetic made up for the sake of explanation. This article does not talk about values for any company, nor does it say what number makes a good company.

What You Own Right Now

On the morning of the first day of the new year, a store's bank account holds 5 million won. The warehouse contains 2 million won worth of goods, and the store’s equipment is worth 3 million won. The money borrowed from the bank is 4 million won.

The bundle of financial statements that a company prepares in a standardized format and releases for outside observers is called financial statements. The supplier that provided the goods, the bank that lent the money, and the person who bought a share all look at the same documents. The first page of that bundle contains the numbers we just wrote down.

A statement that lists side by side what a company owns and what it owes at a specific point in time is called a balance sheet. On the side of what is owned, the money in the bank account, the goods in the warehouse, the equipment, and unpaid bills receivable are recorded. On the side of what is owed, the borrowed money and unpaid bills are recorded.

Things that a company owns are called assets. The store's assets are 10 million won, the sum of 5 million won in the bank account, 2 million won in goods, and 3 million won in equipment.

Things that a company owes to others are called liabilities. The store's liability is the bank debt of 4 million won.

The share that remains after subtracting liabilities from assets is called net assets. The store's net assets are 6 million won. On the balance sheets of South Korean companies, this section is recorded under the name "capital."

Net assets are the lines from the shares section transferred onto the ledger. The side that is owed money—in other words, the side whose share is determined by contract—is set up first, and what remains after that is recorded as the shareholders' share. The shares section called the right to this remainder a residual claim. On the ledger, that right sits in the net assets column.

This 6 million won is not necessarily equal to the value of 100 shares. One theoretical model that sets up the relationship between book value and market-assessed value in an equation divides this relationship according to activities. In financial activities where money is borrowed and lent, the two may be equal, but in operating activities where goods are made and sold, the two may differ (DOI: 10.1111/j.1911-3846.1995.tb00462.x · a theoretical model paper not specific to any country). Borrowed money has a fixed repayment amount, so the amount recorded on the ledger is close to the value of that debt. Equipment is recorded at its purchase price, but how much that equipment will earn in the future is not recorded on the ledger.

The same theoretical model sets a company's market value as the sum of all dividends expected to be received in the future, converted into today's value. Converting to today's value means discounting money to be received later so that it can be compared with current money. Money received today can earn interest in the meantime, so the same amount is worth less when received later.

The model imposes one accounting condition. The only ways net assets change are through that year's earnings and transactions of money with shareholders, such as dividends. Under that condition, market value becomes equal to the book net assets plus the future expected excess earnings converted to today's value. Excess earnings are what remains after subtracting the interest on beginning-of-year net assets from that year's earnings. Since shareholders would have earned at least the interest amount if they had entrusted that money elsewhere, excess earnings are the share that exceeds that basic earning. In this model, net assets are one part of the value, and expectations about future earnings fill the rest.

The authors write that the conclusions drawn from this model depend on the tilt of the ledger. This refers to whether the ledger is biased toward recording net assets at low values or recorded without bias. A ledger tilted toward lower recordings hastily writes down drops in value, and does not record increases in value until they actually occur. If the ledger records net assets low, the gap between net assets and value widens by that much.

A single balance sheet also reveals the values used by trade creditors. The value obtained by dividing things that will soon become cash by debts that must be paid within one year is called the current ratio. The goods in the warehouse, unpaid bills receivable, and money in the bank account are placed on the front side, and those debts are placed on the back side. The larger this value, the more the company has coming into its hands soon compared to the debts it must pay soon. This was one of the values used first and most prominently by those extending credit (DOI: 10.1561/1400000018).

The balance sheet answers "What You Own Right Now," and net assets—assets minus liabilities—is the place where the shareholders' share sits on the ledger.

How Much Was Earned in a Year

From January 1st to December 31st, the shop sold 10 million won worth of goods and paid 9 million won.

The ledger that records how much a company earned, how much it spent, and how much was left over the course of a year is called the income statement. If the balance sheet records a single point in time on the night of December 31st, the income statement records what passed back and forth from January 1st to December 31st.

Like the line in the primer on shares, the income statement subtracts everyone whose share is fixed by contract or law, leaving the shareholder's share at the very bottom. Suppliers, landlords, workers, lenders, and the tax authority are those fixed parties.

What is left after subtracting all costs for that year's share—such as material costs, rent, wages, interest on borrowed money, and taxes—from what was sold during the year is called net income. The shop's net income is 1 million won, and this 1 million won is the shareholder's share left at the end of the line for that year.

How much of that 1 million won to hand over to shareholders is decided separately by the company. If the shop decides to pay a dividend of 1,000 won per share, 100,000 won goes out for 100 shares. Because paying a dividend is the act of handing the already remaining shareholder's share over to the shareholders, it moves after all 1 million won of net income has been calculated.

The remaining 900,000 won stays inside the company and is added to the shareholder's share. Therefore, the net assets on the year-end balance sheet become 6.9 million won, which is the 6 million won at the start of the year plus the 1 million won net income minus the 100,000 won dividend.

If what was sold that year was worth 8.5 million won and the costs paid remained 500,000 won, −50,000 won is written at the very bottom of the income statement. If no dividend was paid, net assets decrease from 6 million won to 5.5 million won, and the 4 million won bank debt remains unchanged. This is how the ledger shows the share at the end of the line shrinking first when what is left falls short.

Investors do not always place the same weight on these two figures in the ledger: net income and net assets. In this article, the weight of a figure refers to how closely the stock price moves in sync with that figure. It is a value measured by an equation of the same family as the model in the preceding section. The outside accounting firm that inspects a company's ledger is called the auditor, and there is a Korean study looking at how this weight changes in companies where the auditor has changed. The hypothesis established when starting the study was that changing auditors would have no relation to the weights of the two figures.

The results were different from the hypothesis. In Korean listed companies where the auditor changed, the weight of net income decreased and the weight of net assets increased (DOI: 10.21073/kiar.2023..108.004 · 5,153 firm-years of KOSPI-listed companies from 2011 to 2018). This change appeared when shifting between the four largest accounting firms or between other accounting firms, and when shifting from the four largest to others. When shifting from other accounting firms to the four largest, the weights of the two figures did not change additionally.

The authors explain net income as a figure that "represents potential future performance" and net assets as a figure that "represents liquidation value." Liquidation value is what remains if the shop is wound up right now. The authors interpret the results as follows. Investors perceive that in a company where the auditor has changed, audit quality—in other words, the auditor's power to catch errors in the ledger—has not increased. Rather, they evaluate that the quality of accounting information—meaning the degree to which the ledger figures faithfully show the company's actual state—has decreased. Therefore, they reduced the weight of net income, which speaks of future performance, and increased the weight of net assets, which speaks of what remains upon winding up.

The income statement answers "How much was earned in a year," and its net income at the very bottom is the shareholder's share left at the end of the line for that year.

Did That Money Actually Come In

Out of the 10 million won worth of goods the shop sold, 2 million won was sold on credit in December, so the payment had not arrived by December 31. The store sold 10 million won worth of goods, but the payment that actually entered the bank account is 8 million won, while the money paid out remains 9 million won.

The net profit on the income statement is still 1 million won. This is because the sale is recorded in the year the goods were handed over. However, if you count the money that came into and went out of the bank account from that year's business, 8 million won came in and 9 million won went out, meaning the bank account decreased by 1 million won.

The difference left when you subtract the cash actually moved through that year's operations from the profit recorded in that year's books is called the accrual. For the shop, the net profit is 1 million won, but the cash moved through business operations resulted in a net outflow of −1 million won because more went out than came in. Subtracting this cash from the profit reveals the distance between the two. That magnitude of 2 million won is the shop's accruals, which equals the 2 million won in unpaid credit sales.

When that credit payment arrives in March of the following year, the direction flips. 2 million won enters the bank account, but because that revenue was already recorded in this year's profit, it is not recorded again on the following year's income statement. Profit and cash record the same transaction in different years, and accruals are where that time lag piles up.

A separate ledger that records how much cash actually flowed in and out of the company's hands over the course of a year is called the statement of cash flows. This ledger is divided into three sections: operating activities, which sell goods and buy materials; investing activities, which buy and sell facilities; and financing activities, which borrow and repay money. In South Korea, corporate accounting standards have made the disclosure of this ledger mandatory since 1994 (KCI ART001150943).

A company falling into distress refers to a state where it cannot repay debts as they come due (DOI: 10.1561/1400000018). This definition does not contain profit. Viewed through this definition, the question becomes what is in hand on the due date, and that was also what the supplier, who provided goods on credit, was asking.

That third ledger contained information absent from profit. Information on operating and financing cash flows carried additional information that accounting profit information did not possess, and these two categories also possessed information that the other lacked (KCI ART001150943 · data under South Korean corporate accounting standards from 1994 to 2000). This means the cash figures from operations and financing revealed things you could not know by looking at the profit numbers alone, and each of the two categories further revealed things the other could not provide. The authors present this as empirical evidence that the statement of cash flows, mandatory to disclose since 1994, is useful.

Making a profit and having money arrive in the bank account diverge even within the same year, and the statement of cash flows answers "Did That Money Actually Come In".

One Company Year, Three Ledgers

On the night of December 31, the shop's year is recorded across three ledgers.

• Income statement: Sold 10,000,000 won worth of goods, paid 9,000,000 won, and made a net profit of 1,000,000 won.
• Statement of cash flows: Business activities reduced the bank account by 1,000,000 won, and a separate dividend of 100,000 won went out, reducing the account by a total of 1,100,000 won over the year.
• Statement of financial position: Combining 3,900,000 won in the bank, 2,000,000 won in accounts receivable, 2,000,000 won in inventory, and 3,000,000 won in equipment equals 10,900,000 won in assets. Liabilities are 4,000,000 won. Net assets are 6,900,000 won.

The three ledgers interlock. Subtracting the 1,100,000 won from the statement of cash flows from the opening bank balance of 5,000,000 won leaves the 3,900,000 won on the statement of financial position. Adding the 1,000,000 won net profit from the income statement to the opening net assets of 6,000,000 won and subtracting the 100,000 won dividend yields 6,900,000 won. The 2,000,000 won not yet collected opens up a gap between the income statement and the statement of cash flows, and sits on the statement of financial position as accounts receivable.

The shareholder's share appears three times in this year. The 1,000,000 won on the income statement is the share left at the end of the line for that year. The 6,900,000 won on the statement of financial position is the opening shareholder's share plus the share left over that year. The 100,000 won on the statement of cash flows is the cash that actually passed into the shareholders' hands, of which 1,000 won went to a person holding 1 share.

Where the bank looks first is different. Viewed through the definition of distress, what the bank asks is what will be in the bank account on the day the 4,000,000 won debt comes due. Viewed through the current ratio, the side that will soon become cash places 3,900,000 won in the bank, 2,000,000 won in accounts receivable, and 2,000,000 won in inventory, while the side that must be paid soon places the portion of that debt coming due within one year. Exactly how much that portion is was not specified in this shop's example.

The current ratio comes from a single statement of financial position, but when the 2,000,000 won in accounts receivable actually comes in is recorded on the following year's statement of cash flows. This shop made a profit of 1,000,000 won that year, but its bank account decreased by 1,000,000 won through business operations, and with the 100,000 won dividend also going out, the bank account became 3,900,000 won.

The same year remains as three numbers across three ledgers. How much was earned that year is a net profit of 1,000,000 won, whether that money came in is a bank account decrease of 1,000,000 won from business operations, and what is owned right now is net assets of 6,900,000 won.

The value of 100 shares is not written as a number anywhere in the three ledgers. In the theoretical model seen earlier, that value was the net assets plus the excess profits expected in the future, converted into today's value and added. Net assets are in the ledgers, but those expectations are not written as numbers in the ledgers. This model builds those expectations using ledger numbers like this year's net assets and profit, along with other information.

Where to Look Next

The books are only one of several sources of information about a company (DOI: 10.1561/1400000018). This article read the numbers in the three books exactly as written.

How much human discretion goes into writing those numbers, whether the books are tilted toward writing down bad news first, how tightly auditors hold that leash, and whether reading the books can put you ahead of others are covered by "How Far Can the Books Be Trusted — Where Discretion Ends, and Whether Reading Them Puts You Ahead".

What a shareholder's stake is a right to is covered by "What You Actually Own When You Own a Share — And Where You Stand in Line", and what happens to your slice when the company prints more slices to raise money is covered by "Issuing New Shares — What Happens to the Slice You Already Own". Where money like the 4 million won a bank lends comes from in the first place is examined by "Where Money Comes From".

Source Papers

• "Financial Statement Analysis and the Prediction of Financial Distress" (2011) — DOI: 10.1561/1400000018 — For over 100 years, financial statement analysis has been used to gauge the likelihood that a borrower will fail to repay its debts, with early primary users like trade creditors focusing on short-term repayment capacity such as inventory turnover periods (typically 30 to 60 days) because they had little reliable information other than the borrower's reputation. Financial distress is a state of failing to fulfill maturing debt obligations, today's users have expanded to trade partners, banks, credit rating agencies, investors, and management, and financial statements are merely one of several information sources about a company (English overview · the second half of the abstract is a section-by-section table of contents).
• "Accounting conservatism: A review of the literature" (2015) — DOI: 10.1016/j.acclit.2015.02.001 — A review paper summarizing the impact of conservatism on financial statement numbers and users. It identifies three main user groups of financial statements: (1) stock market users, (2) bond market users, and (3) corporate governance users.
• "Valuation and Clean Surplus Accounting for Operating and Financial Activities" (Feltham·Ohlson, 1995) — DOI: 10.1111/j.1911-3846.1995.tb00462.x — Book value equals market value in financial activities, but they can differ in operating activities. Setting market value as the present value of expected dividends, under clean surplus accounting it equals book value plus the present value of expected abnormal earnings (earnings minus interest on beginning book value). The conclusion of the analysis depends on whether accounting is conservative or unbiased (theoretical modeling paper).
• "감사인 교체와 회계정보의 가치관련성" (2023) — DOI: 10.21073/kiar.2023..108.004 — 5,153 firm-years of KOSPI-listed companies from 2011 to 2018, using the Ohlson (1995) model (a separate paper in the same lineage as the Feltham·Ohlson paper above). Contrary to the hypothesis that there would be "no relevance", auditor changes lowered the value relevance of net income and raised the value relevance of net assets (observed in horizontal and downward changes, with upward changes showing no additional effect). The authors judge that investors assessed that audit quality did not rise and accounting information quality fell, thereby reducing the weight on net income—which points to future potential performance—and increasing the weight on net assets—which represents liquidation value.
• "현금흐름표의 유용성" (2005) — KCI ART001150943 — Cash flow statement data from 1994 to 2000. Information on operating and financing cash flows provides additional information that accounting earnings information does not possess, and cash flows across these functional areas each possess additional information that the others lack. Presented as empirical evidence of the usefulness of the cash flow statement, whose disclosure was made mandatory by corporate accounting standards starting in 1994. ⚠️The abstract's "first" sentence contradicts itself by stating that investing cash flow has informational effects and then stating it found none — the main text does not report the results for investing activities.