Forecasting Financial Statements with No Plugs and No Circularity

Abstract

Typical textbooks on corporate finance and forecasting and budgeting recommend "closing" and matching the financial statements using what is known as a plug. A plug is a formula to match the Balance Sheet using differences in some items listed in it in such a way that the accounting equation holds. This is a very easy way to do it but it encompasses some risks. The risks are that certain numbers in the financial statements could be in error and still the plug would indicate that everything is correct because the Balance Sheet matches.

In this work we show how to construct financial statement without plugs and circularity.

The basic learning objective of this work is to develop the students' and practitioners' abilities for constructing a proper financial model to forecast financial statements without plugs and without circularity.

We explain how the plug works and which its drawbacks are. We present a detailed example that can be used by any student, teacher or practitioner to properly construct consistent financial statements. The example shows how to relate different cells in the spreadsheet and the reader is encouraged to develop the example by herself.

We present some criticisms received against the no plug, no circularity approach and we discuss them. Finally, as a conclusion we suggest that the use of plugs should be discontinued when teaching forecasting financial statements and budgeting.

Keywords: Accounting, Forecasting Financial Statements, Decision Making, plugs, Planning and control, double entry principle, unbalancing problem

JEL Classification: E47, G31