{"id":99,"date":"2018-11-14T15:25:33","date_gmt":"2018-11-14T15:25:33","guid":{"rendered":"https:\/\/courses.lumenlearning.com\/suny-personalfinance\/?post_type=chapter&p=99"},"modified":"2018-11-16T18:24:23","modified_gmt":"2018-11-16T18:24:23","slug":"3-1-accounting-and-financial-statements","status":"publish","type":"chapter","link":"https:\/\/courses.lumenlearning.com\/suny-personalfinance\/chapter\/3-1-accounting-and-financial-statements\/","title":{"raw":"3.1 Accounting and Financial Statements","rendered":"3.1 Accounting and Financial Statements"},"content":{"raw":"
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Learning Objectives<\/h3>\r\n
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  1. Distinguish accrual and cash accounting.<\/li>\r\n \t
  2. Compare and contrast the three common financial statements.<\/li>\r\n \t
  3. Identify the results shown on the income statement, balance sheet, and cash flow statement.<\/li>\r\n \t
  4. Explain the calculation and meaning of net worth.<\/li>\r\n \t
  5. Trace how a bankruptcy can occur.<\/li>\r\n<\/ol>\r\n<\/div>\r\n \r\n\r\n<\/div>\r\n

    Clay tablets interested Sumerian traders because the records gave them a way to see their financial situation and to use that insight to measure progress and plan for the future. The method of accounting universally used in business today is known as accrual accounting<\/strong>[footnote]A method of accounting in which economic consequences rather than cash flow consequences define transactions.[\/footnote], in which events are accounted for even if cash does not change hands. That is, transactions are recorded at the time they occur rather than when payment is actually made or received. Anticipated or preceding payments and receipts (cash flows) are recorded as accrued or deferred. Accrual accounting is the opposite of cash accounting<\/strong>[footnote]A method of accounting in which cash flow consequences rather than economic consequences define transactions. Events are defined as cash transactions and recorded only when cash changes hands.[\/footnote], in which transactions are recognized only when cash is exchanged.<\/p>\r\n

    Accrual accounting defines earning as an economic event signified by an exchange of goods rather than by an exchange of cash. In this way, accrual accounting allows for the separation in time of the exchange of goods and the exchange of cash. A transaction can be completed over time and distance, which allows for extended\u2014and extensive\u2014trade. Another advantage of accrual accounting is that it gives a business a more accurate picture of its present situation in reality.<\/p>\r\n

    Modern accounting techniques developed during the European Age of Discovery, which was motivated by ever-expanding trade. Both the principles and the methods of modern accrual accounting were first published in a text by Luca Pacioli in 1494,Luca Pacioli, Summa de arithmetica, geometria, proportioni et proportionalita<\/em> (Venice: Luca Pacioli, 1494). For more information on Pacioli, see http:\/\/en.wikipedia.org\/wiki\/Luca_Pacioli<\/a> (accessed November 23, 2009).<\/span> although they were probably developed even before that. These methods of \u201ckeeping the books\u201d can be applied to personal finance today as they were to trading in the age of long voyages for pepper and cloves, and with equally valuable results.<\/p>\r\n

    Nevertheless, in personal finance it almost always makes more sense to use cash accounting, to define and account for events when the cash changes hands. So in personal finance, incomes and expenses are noted when the cash is received or paid, or when the cash flows.<\/p>\r\n\r\n

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    The Accounting Process<\/h2>\r\n

    Financial decisions result in transactions, actual trades that buy or sell, invest or borrow. In the market economy, something is given up in order to get something, so each trade involves at least one thing given up and one thing gotten\u2014two things flowing in at least two directions. The process of accounting records these transactions and records what has been gotten and what has been given up to get it, what flows in and what flows out.<\/p>\r\n

    In business, accounting journals and ledgers are set up to record transactions as they happen. In personal finance, a checkbook records most transactions, with statements from banks or investment accounts providing records of the rest. Periodically, the transaction information is summarized in financial statements so it can be read most efficiently.<\/p>\r\n

    Bookkeeping\u2014the process of recording what and how and by how much a transaction affects the financial situation\u2014is how events are recorded. Since the advent of accounting software, bookkeeping, like long division and spelling, has become somewhat obsolete, although human judgment is still required. What is more interesting and useful are the summary reports that can be produced once all this information is recorded: the income statement, cash flow statement, and balance sheet.<\/p>\r\n\r\n<\/div>\r\n

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    Income Statement<\/h2>\r\n

    The income statement<\/strong>[footnote]A summary statement of income and expenses for a period; an income statement shows the difference between them or the net profit (net loss) for the period.[\/footnote] summarizes incomes and expenses for a period of time. In business, income is the value of whatever is sold, expenses are the costs of earning that income, and the difference is profit. In personal finance, income is what is earned as wages or salary and as interest or dividends, and expenses are the costs of things consumed in the course of daily living: the costs of sustaining you<\/em> while you earn income. Thus, the income statement is a measure of what you have earned and what your cost of living was while earning it. The difference is personal profit, which, if accumulated as investment, becomes your wealth.<\/p>\r\n

    The income statement clearly shows the relative size of your income and expenses. If income is greater than expenses, there is a surplus, and that surplus can be used to save or to spend more (and create more expenses). If income is less than expenses, then there is a deficit that must be addressed. If the deficit continues, it creates debts\u2014unpaid bills\u2014that must eventually be paid. Over the long term, a deficit is not a viable scenario.<\/p>\r\n

    The income statement can be useful for its level of detail too. You can see which of your expenses consumes the greatest portion of your income or which expense has the greatest or least effect on your bottom line. If you want to reduce expenses, you can see which would have the greatest impact or would free up more income if you reduced it. If you want to increase income, you can see how much more that would buy you in terms of your expenses (Figure 3.3 \"Alice\u2019s Situation (in Dollars)\"<\/a>). For example, consider Alice\u2019s situation per year.<\/p>\r\n\r\n

    \r\n\r\n[caption id=\"\" align=\"aligncenter\" width=\"240\"]\"image\" Figure 3.3 Alice\u2019s Situation (in Dollars)[\/caption]\r\n\r\n<\/div>\r\n

    She also had car payments of $2,400 and student loan payments of $7,720. Each loan payment actually covers the interest expense and partial repayment of the loan. The interest is an expense representing the cost of borrowing, and thus of having, the car and the education. The repayment of the loan is not an expense, however, but is just giving back something that was borrowed. In this case, the loan payments break down as follows (Figure 3.4 \"Alice\u2019s Loan Payments (Annually)\"<\/a>).<\/p>\r\n\r\n

    \r\n\r\n[caption id=\"\" align=\"aligncenter\" width=\"821\"]\"image\" Figure 3.4 Alice\u2019s Loan Payments (Annually)[\/caption]\r\n\r\n<\/div>\r\n

    Breaking down Alice\u2019s living expenses in more detail and adding in her interest expenses, Alice\u2019s income statement would look like this (Figure 3.5 \"Alice\u2019s Income Statement for the Year 2009\"<\/a>).<\/p>\r\n\r\n

    \r\n\r\n[caption id=\"\" align=\"aligncenter\" width=\"969\"]\"image\" Figure 3.5 Alice\u2019s Income Statement for the Year 2009[\/caption]\r\n\r\n<\/div>\r\n

    Alice\u2019s disposable income<\/strong>[footnote]Income available for expenses after tax expense has been deducted; gross income less income tax.[\/footnote], or income to meet expenses after taxes have been accounted for, is $35,720. Alice\u2019s net ncome, or net earnings or personal profit, is the remaining income after all other expenses have been deducted, in this case $6,040.<\/p>\r\n

    Now Alice has a much clearer view of what\u2019s going on in her financial life. She can see, for example, that living expenses take the biggest bite out of her income and that rent is the biggest single expense. If she wanted to decrease expenses, finding a place to live with a cheaper rent will make the most impact on her bottom line. Or perhaps it would make more sense to make many small changes rather than one large change, to cut back on several other expenses. She could begin by cutting back on the expense items that she feels are least necessary or that she could most easily live without. Perhaps she could do with less entertainment or clothing or travel, for example. Whatever choices she subsequently made would be reflected in her income statement. The value of the income statement is in presenting income and expenses in detail for a particular period of time.<\/p>\r\n\r\n<\/div>\r\n

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    Cash Flow Statement<\/h2>\r\n

    The cash flow statement<\/strong>[footnote]A summary of actual cash flows for a period, detailing the sources and uses of cash and classifying them as from operating, investing, or financing activities.[\/footnote] shows how much cash came in and where it came from, and how much cash went out and where it went over a period of time. This differs from the income statement because it may include cash flows that are not from income and expenses. Examples of such cash flows would be receiving repayment of money that you loaned, repaying money that you borrowed, or using money in exchanges such as buying or selling an asset.<\/p>\r\n

    The cash flow statement is important because it can show how well you do at creating liquidity, as well as your net income. Liquidity is nearness to cash, and liquidity has value. An excess of liquidity can be sold or lent, creating additional income. A lack of liquidity must be addressed by buying it or borrowing, creating additional expense.<\/p>\r\n

    Looking at Alice\u2019s situation, she has two loan repayments that are not expenses and so are not included on her income statement. These payments reduce her liquidity, however, making it harder for her to create excess cash. Her cash flow statement looks like this (Figure 3.6 \"Alice\u2019s Cash Flow Statement for the Year 2009\"<\/a>).<\/p>\r\n\r\n

    \r\n\r\n[caption id=\"\" align=\"aligncenter\" width=\"232\"]\"image\" Figure 3.6 Alice\u2019s Cash Flow Statement for the Year 2009 Note: On a cash flow statement, negative and positive numbers indicate direction of flow. A negative number is cash flowing out, and a positive number is cash flowing in. Conventionally, negative numbers are in parentheses.[\/caption]\r\n

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    As with the income statement, the cash flow statement is more useful if there are subtotals for the different kinds of cash flows, as defined by their sources and uses. The cash flows from income and expenses are operating cash flows<\/strong>[footnote]Recurring cash flows that result from income and expense events.[\/footnote], or cash flows that are a consequence of earning income or paying for the costs of earning income. The loan repayments are cash flows from financing<\/strong>[footnote]Nonrecurring cash flows that result from the borrowing or repayment of debt, or from the issue or repurchase of equity.[\/footnote] assets or investments that will increase income. In this case, cash flows from financing include repayments on the car and the education. Although Alice doesn\u2019t have any in this example, there could also be cash flows from investing<\/strong>[footnote]Nonrecurring cash flows that result from buying or selling assets.[\/footnote], from buying or selling assets. Free cash flow<\/strong>[footnote]Income remaining after the deduction of living expenses and debt obligations that is available for capital expenditures or investment.[\/footnote] is the cash available to make investments or financing decisions after taking care of operations and debt obligations. It is calculated as cash flow from operations less debt repayments.<\/p>\r\n

    The most significant difference between the three categories of cash flows\u2014operating, investing, or financing\u2014is whether or not the cash flows may be expected to recur regularly. Operating cash flows recur regularly; they are the cash flows that result from income and expenses or consumption and therefore can be expected to occur in every year. Operating cash flows may be different amounts in different periods, but they will happen in every period. Investing and financing cash flows, on the other hand, may or may not recur and often are unusual events. Typically, for example, you would not borrow or lend or buy or sell assets in every year. Here is how Alice\u2019s cash flows would be classified (Figure 3.7 \"Alice\u2019s Cash Flow Statement for the Year 2009\"<\/a>).<\/p>\r\n\r\n

    \r\n\r\n[caption id=\"\" align=\"aligncenter\" width=\"231\"]\"image\" Figure 3.7 Alice\u2019s Cash Flow Statement for the Year 2009[\/caption]\r\n\r\n<\/div>\r\n

    This cash flow statement more clearly shows how liquidity is created and where liquidity could be increased. If Alice wanted to create more liquidity, it is obvious that eliminating those loan payments would be a big help: without them, her net cash flow would increase by more than 3,900 percent.<\/p>\r\n\r\n<\/div>\r\n

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    Balance Sheet<\/h2>\r\n

    In business or in personal finance, a critical piece in assessing the current situation is the balance sheet. Often referred to as the \u201cstatement of financial condition,\u201d the balance sheet<\/strong>[footnote]A list of all assets, liabilities, and equity or net worth, at a given point in time, providing a concise picture of financial condition at that time.[\/footnote] is a snapshot of what you have and what you owe at a given point in time. Unlike the income or cash flow statements, it is not a record of performance over a period of time, but simply a statement of where things stand at a certain moment.<\/p>\r\n

    The balance sheet is a list of assets, debts or liabilities, and equity or net worth, with their values. In business, assets are resources that can be used to create income, while debt and equity are the capital that financed those assets. Thus, the value of the assets must equal the value of the debt and the equity. In other words, the value of the business\u2019s resources must equal the value of the capital it borrowed or bought in order to get those resources.<\/p>\r\n

    assets = liabilities + equity<\/span><\/span><\/strong><\/p>\r\n

    In business, the accounting equation<\/strong>[footnote]Assets = liabilities + equity, or the value of assets must be equal to the value of the debt and equity that financed them. In personal finance, assets = debts + net worth, or net worth = assets \u2212 debts.[\/footnote] is as absolute as the law of gravity. It simply must always be true, because if there are assets, they must have been financed somehow\u2014either through debt or equity. The value of that debt and equity financing must equal or balance the value of the assets it bought. Thus, it is called the \u201cbalance\u201d sheet because it always<\/em> balances the debt and equity with the value of the assets.<\/p>\r\n

    In personal finance, assets are also things that can be sold to create liquidity. Liquidity is needed to satisfy or repay debts. Because your assets are what you use to satisfy your debts when they become due, the assets\u2019 value should be greater than the value of your debts. That is, you should have more to work with to meet your obligations than you owe.<\/p>\r\n

    The difference between what you have and what you owe is your net worth<\/strong>[footnote]The value of assets owned after creditors\u2019 claims (debts) are accounted for, or literally, assets \u2212 debts.[\/footnote]. Literally, net worth is the share that you own of everything that you have. It is the value of what you have net of<\/em> (less) what you owe to others. Whatever asset value is left over after you meet your debt obligations is your own worth. It is the value of what you have that you can claim free and clear.<\/p>\r\n

    assets \u2212 debt = net worth<\/span><\/span><\/strong><\/p>\r\n

    Your net worth is really your equity or financial ownership in your own life. Here, too, the personal balance sheet must balance, because if<\/p>\r\n

    assets \u2212 debts = net worth,<\/span><\/span><\/strong><\/p>\r\n

    then it should also be<\/p>\r\n

    assets = debts + net worth.<\/span><\/span><\/strong><\/p>\r\n

    Alice could write a simple balance sheet to see her current financial condition. She has two assets (her car and her savings account), and she has two debts (her car and student loans) (Figure 3.8 \"Alice\u2019s Balance Sheet, December 31, 2009\"<\/a>).<\/p>\r\n\r\n

    \r\n\r\n[caption id=\"\" align=\"aligncenter\" width=\"903\"]\"image\" Figure 3.8 Alice\u2019s Balance Sheet, December 31, 2009[\/caption]\r\n\r\n<\/div>\r\n

    Alice\u2019s balance sheet presents her with a much clearer picture of her financial situation, but also with a dismaying prospect: she seems to have negative net worth. Negative net worth<\/strong>[footnote]The mathematical result of liabilities being greater than the value of assets, or debts being larger than the value that can be used to meet them.[\/footnote] results whenever the value of debts or liabilities is actually greater than the assets\u2019 value. If<\/p>\r\n \r\n

    liabilities<assets\u00a0<\/strong>then\u00a0assets\u00a0\u2212\u00a0liabilities>0;\u00a0<\/strong>net\u00a0worth>0\u00a0<\/strong>(net\u00a0worth\u00a0is\u00a0positive)<\/p>\r\n

    If<\/p>\r\n

    liabilities>assets\u00a0<\/strong>then\u00a0assets\u00a0\u2212\u00a0liabilities<0;\u00a0<\/strong>net\u00a0worth<0\u00a0<\/strong>(net\u00a0worth\u00a0is\u00a0negative)<\/p>\r\n \r\n

    Negative net worth implies that the assets don\u2019t have enough value to satisfy the debts. Since debts are obligations, this would cause some concern.<\/p>\r\n\r\n<\/div>\r\n

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    Net Worth and Bankruptcy<\/h2>\r\n

    In business, when liabilities are greater than the assets to meet them, the business has negative equity and is literally bankrupt. In that case, it may go out of business, selling all its assets and giving whatever it can to its creditors<\/strong>[footnote]Lenders; anyone to whom debt is owed.[\/footnote] or lenders, who will have to settle for less than what they are owed. More usually, the business continues to operate in bankruptcy, if possible, and must still repay its creditors, although perhaps under somewhat easier terms. Creditors (and the laws) allow these terms because creditors would rather get paid in full later than get paid less now or not at all.<\/p>\r\n

    In personal finance, personal bankruptcy<\/strong>[footnote]An economic situation when the value of debts is greater than the value of the assets that can be used to satisfy them. Formal bankruptcy is also a legal process aiming to compensate creditors, governed by the laws of the nation or state in which it occurs.[\/footnote] may occur when debts are greater than the value of assets. But because creditors would rather be paid eventually than never, the bankrupt is usually allowed to continue to earn income in the hopes of repaying the debt later or with easier terms. Often, the bankrupt is forced to liquidate (sell) some or all of its assets.<\/p>\r\n

    Because debt is a legal as well as an economic obligation, there are laws governing bankruptcies that differ from state to state in the United States and from country to country. Although debt forgiveness was discussed in the Old Testament, throughout history it was not uncommon for bankrupts in many cultures to be put to death, maimed, enslaved, or imprisoned.BankruptcyData.com, http:\/\/www.bankruptcydata.com\/Ch11History.htm<\/a> (accessed January 19, 2009).<\/span> The use of another\u2019s property or wealth is a serious responsibility, so debt is a serious obligation.<\/p>\r\n

    However, Alice\u2019s case is actually not as dismal as it looks, because Alice has an \u201casset\u201d that is not listed on her balance sheet, that is, her education. It is not listed on her balance sheet because the value of her education, like the value of any asset, comes from how useful it is, and its usefulness has not happened yet, but will happen over her lifetime. It will happen in her future, based on how she chooses to use her education to increase her income and wealth. It is difficult to assign a monetary value to her education now. Alice knows what she paid for her education, but, sensibly, its real value is not its cost but its potential return, or what it can earn for her as she puts it to use in the future.<\/p>\r\n

    Current studies show that a college education has economic value, because a college graduate earns more over a lifetime than a high school graduate. Recent estimates put that difference at about $1,000,000.Sandy Baum and Jennifer Ma, \u201cEducation Pays: The Benefits of Higher Education for Individuals and Society\u201d (Princeton, NJ: The College Board, 2007).<\/span> So, if Alice assumes that her education will be worth $1,000,000 in extra income over her lifetime, and she includes that asset value on her balance sheet, then it would look more like this (Figure 3.10 \"Alice\u2019s Balance Sheet (revised), December 31, 2009\"<\/a>):<\/p>\r\n\r\n

    \r\n\r\n[caption id=\"\" align=\"aligncenter\" width=\"903\"]\"image\" Figure 3.10 Alice\u2019s Balance Sheet (revised), December 31, 2009[\/caption]\r\n\r\n<\/div>\r\n

    This looks much better, but it\u2019s not sound accounting practice to include an asset\u2014and its value\u2014on the balance sheet before it really exists. After all, education generally pays off, but until it does, it hasn\u2019t yet and there is a chance, however slim, that it won\u2019t for Alice. A balance sheet is a snapshot of one\u2019s financial situation at one particular time. At this particular time, Alice\u2019s education has value, but its amount is unknown.<\/p>\r\n

    It is easy to see, however, that the only thing that creates negative net worth for Alice is her student loan. The student loan causes her liabilities to be greater than her assets\u2014and if that were paid off, her net worth would be positive. Given that Alice is just starting her adult earning years, her situation seems quite reasonable.<\/p>\r\n\r\n

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    Key Takeaways<\/h3>\r\n