11.2 Auditing and Balancing a 3-Statement Model

Audit is a sequence, not a glance

Quick Answer: CFI's core course Auditing and Balancing a 3-Statement Model is a sequence, not a stare-at-the-BS moment. Work in this order: (1) Assets − Liabilities − Equity = 0; (2) cash on the BS equals CFS ending cash; (3) retained earnings (RE) rollforward (beginning RE + NI − dividends = ending RE); (4) PP&E rollforward; (5) debt rollforward; (6) signs and units; (7) hardcoded numbers inside forecast formulas (blue inputs vs black formulas); (8) error flags. A BS that balances is necessary but not sufficient — omitting the same item on both the CFS and RE (classic: dividends) keeps Assets = L+E while cash and equity are both wrong. Hunt a residual by changing one driver and watching which check does not move. A forgotten D&A add-back of $1,000, with BS cash linked to the CFS, produces a $1,000 hole, not a mystery.

After the 27 February 2026 program refresh this course is required core (course 5 of 15), sitting immediately after 3-Statement Modeling. The FMVA final's Excel case studies are scored on whether the three statements still articulate when you toggle a driver — the same skill as this audit list. Circularity (Section 11.1) can create a residual of cents if Maximum Change is loose; a $1,000 residual is almost never iteration. It is a missed flow.

The eight-step order

Do not start at step 7. Color is how you prevent the next error; it does not tell you why this year is off by $1,000. Always get the identity and the cash tie first. A Circ Switch of 0 will make interest wrong on purpose; the identity should still be $0. If turning the switch on creates the imbalance, the audit target is the interest/revolver block from 11.1, not the RE rollforward.

Worked balanced year (the control)

Use this as the live control so the two breaks below have a denominator. Opening BS: cash $5,000, AR $2,000, inventory $3,000, net PP&E $10,000 (assets $20,000). AP $2,000, debt $5,000, common stock $8,000, RE $5,000.

Year-1 operations: revenue $20,000, COGS $12,000, cash SG&A $3,000, D&A $1,000 → EBIT $4,000. Interest $400 (8% on beginning debt — beginning-balance interest, so this control is not circular). EBT $3,600, tax 25% = $900, NI = $2,700. AR +$500, inventory +$200, AP +$300, so ΔNWC = $400. Capex $2,000. Dividends $500. No debt draws or paydowns.

Ending BS: cash $5,800, AR $2,500, inventory $3,200, net PP&E $10,000 + $2,000 − $1,000 = $11,000. Assets = $22,500. AP $2,300, debt $5,000, common $8,000, RE $5,000 + $2,700 − $500 = $7,200. L+E = $22,500. Steps 1–5 all pass: identity $0, cash tie $5,800 = $5,800, RE/PP&E/debt rollforwards hold.

Keep this $22,500 total in view. Every broken-model example below is this same year with one formula ripped out. If your case file has several errors, still hunt them one driver at a time; stacking three fixes at once is how you create a fourth.

Worked break: forgotten $1,000 D&A add-back

Leave the IS, PP&E rollforward, RE, and every other CFS line alone. Drop only the +$1,000 D&A add-back on the CFS. New CFO = $2,700 − $400 = $2,300. Net change in cash = $2,300 − $2,000 − $500 = −$200. CFS ending cash = $4,800.

If BS cash is linked to CFS ending cash (the CFI-standard construction), the BS becomes:

• Assets = $4,800 + $2,500 + $3,200 + $11,000 = $21,500
• L+E still $22,500 (RE still includes NI after D&A; PP&E is still net of D&A)
• Assets − L − E = −$1,000

The hole equals D&A. Depreciation already reduced NI (and therefore RE) and already reduced net PP&E; those two hits net to zero inside the BS. The CFS must add D&A back so cash does not take the same hit a third time. Miss the add-back, and cash (an asset) is $1,000 too low — the textbook imbalance.

Diagnostic shock. Increase D&A from $1,000 to $2,000. A correct model still balances: NI and RE fall by $750 after tax; cash rises by the $250 tax shield; PP&E falls by another $1,000. With the add-back still missing, the imbalance moves from $1,000 to $2,000. The check that moves one-for-one with D&A is the CFS add-back, not tax and not capex.

The same $1,000 hole appears if you forget dividends on only one statement, but the dollar amount then equals the dividend, not D&A. Do not memorize $1,000 as a magic constant. Memorize: the imbalance equals the flow that hit one side of the BS and not the other.

Worked break: dividends, including the false balance

Miss dividends only on the CFS (RE correctly subtracts $500): CFS ending cash = $6,300; assets $23,000; L+E $22,500; imbalance +$500. Cash is too high by the unpaid dividend.

Miss dividends only on RE (CFS correctly pays $500): ending cash $5,800; RE $7,700 instead of $7,200; assets $22,500; L+E $23,000; imbalance −$500.

Miss dividends on both CFS and RE: cash too high $500 and RE too high $500. Assets still equal L+E. Step 1 passes. Step 2 may also pass, because BS cash is tied to a CFS that is internally consistent with itself. Step 3 — the RE rollforward against NI and the dividend driver — is the check that catches it. This is why CFI's order puts the identity first and the RE rollforward third, and why it balances is not the end of the audit.

The same canceling-error pattern exists for other paired flows. Forget capex on the CFS while still adding it to PP&E and you break the identity by capex (cash too high). Forget a revolver draw on the CFS while still showing the debt on the BS and you break the identity the other way (cash too low). Forget the draw on both the CFS and the debt rollforward and the BS can balance with a silent understatement of leverage — another reason step 5 exists.

Hunting: change one driver

When the identity is a stubborn $1,000 (or $37.12), do not audit 400 formulas in random order. Shock one driver and watch the dashboard:

Units and signs (step 6) are the cheap remaining traps: a model in $ thousands with capex typed as 2000000 instead of 2000 blows PP&E and cash by three orders of magnitude; a CFS that adds capex instead of subtracting it creates a hole equal to 2 × capex relative to a correctly reduced PP&E (cash too high by capex, PP&E down by capex).

Blue vs black and the flag dashboard

CFI / FMVA color convention: blue font = inputs (hardcodes, the Circ Switch, rates, minimum cash); black font = formulas. A forecast-year cell that shows 1000 with no formula, in blue or in black, is a hardcoded number in a forecast formula — step 7. It will not move when you shock D&A, which is exactly how the hunting table exposes it. Finding a blue 1000 inside a D&A line that is supposed to come from a depreciation schedule is an audit fail even if today's identity is $0, because next year's capex shock will not flow.

Put the checks where a reviewer (or you, 40 minutes into a case) can see them:

Balance check:  =Assets - Liabilities - Equity
Cash tie:       =BS_Cash - CFS_Ending_Cash
RE check:       =EndRE - (BegRE + NI - Dividends)
PPE check:      =EndPPE - (BegPPE + Capex - DA)
Debt check:     =EndDebt - (BegDebt + Draws - Paydowns)
Flag:           =IF(OR(ABS(Balance)>0.01,ABS(CashTie)>0.01,ABS(RECheck)>0.01),"ERROR","OK")

Wire the flag to a cell with conditional formatting so ERROR is visible without scrolling to row 200. Cents of residual after a circular interest loop are usually Maximum Change, not a missing $1,000 add-back: tighten max change, or round the check to the nearest dollar if the case is in whole dollars, but do not hide a $1,000 hole inside a $1,000 tolerance.

On the timed Excel case, budget the first minutes after a driver change to this dashboard, not to formatting. If the flag is OK with Circ Switch = 0 and ERROR with Circ Switch = 1, go back to Section 11.1 and inspect average-balance interest and the revolver plug — the statements are articulated until the circle is turned on, which means the circle is feeding a signed-wrong or #REF!-adjacent cell.

Exam close for 11.2

• Order: identity, cash tie, RE, PP&E, debt, signs/units, blue vs black, flags.
• Forgotten D&A add-back → cash $1,000 too low → Assets − L − E = −$1,000 when PP&E and RE already reflect D&A.
• Dividends missed on both CFS and RE can still balance — the RE rollforward is not optional.
• Shock one driver; the check that will not move is the broken link.
• Blue = input, black = formula; hardcoded forecast D&A is a defect even if today's identity is $0.