Understanding Your Balance Sheet
There are two financial documents that form the basis for tracking an individual's financial health: the balance sheet and the income statement. These two tools work well together because they each have complementary strengths and weaknesses. The balance sheet is an instantaneous snapshot of your financial standing. It describes the culmination of all your past efforts--or more directly--describes the sum of your assets less liabilities. It serves as an excellent indicator of past performance, but says nothing about future potential.
That's where the income statement comes in. Instead of an instantaneous snapshot, the income statement descsribes the inflow and outflow of funds over some specified period of time. This time component allows you to determine which direction your financial health is headed.
To borrow a medical analogy, the balance sheet is an individual's diagnosis; the income statement is the individual's prognosis. Let's focus on the balance sheet, and save the income statement for a later post.
The Balance Sheet contains two parts - Assets and Liabilities. Assets are generally divided into short-term (liquid) assets, and long-term assets. These are often referred to as Current Assets and Fixed Assets. Your checkings and savings accounts belong in the Current Assets category. Your house, cars, jewelry, and retirement accounts belong in the Fixed Assets category. Values for hard assets--such as cars and houses--should appreciate and depreciate with the prevailing market conditions. They should NOT reflect how much you paid for the item. This is especially true for jewelry since the resale market for jewelry is so poor.
Depending on the method of accounting that an individual adopts, a balance sheet can take on varying degrees of complexity. The two fundamental methods of accounting are known as cash basis and accrual basis. For my own purposes, I adopt a hybrid method where I capture all short-term liabilities on an accrual basis, and everything else on a cash basis.
I do this for several reasons. Individual's recurring expenses usually fall into one of three categories: monthly, semi-annual, and annual. If I were to capture all of these expenses on a cash basis, then my December statement would look horrible. That month, my house insurance is due, my property taxes are due, and my car insurance premium is due. Instead of taking a huge hit that month, I choose to accrue an unrealized expense equal to 1/12 of each of these bills each month. In doing so, I can make sure I'm saving enough to cover these expenses and flatten out my monthly expense chart.
At the end of the year, it really doesn't matter which style of accounting I adopt -- my balance sheet will look the same, and my annual expenses will average out the same. But by borrowing this practice from the accrual method of accounting, I can more effectively save for these end-of-the-year expenses. Otherwise, I tend to favor the more conservative cash-basis method of accounting.
However, by adopting a mostly cash-basis method, I omit future assets and liabilities until they become current (within 1 year). For example, I own about $26,000 in stock options that will vest over the next few years. These assets are not visible on my balance sheet because a cash-basis method dictates that these assets aren't realized until fully vested. On the flip side of that coin, I also omit future long-term income tax liability on my tax-deferred retirement accounts.
I tend to favor this mixed approach for the individual because it borrows the most conservative aspects from each accounting method; it forces the individual to save for big end-of-the-year expenses; and it doesn't require any wild guesses about long-term projections (such as stock option prices or income tax rates at retirement).
That's where the income statement comes in. Instead of an instantaneous snapshot, the income statement descsribes the inflow and outflow of funds over some specified period of time. This time component allows you to determine which direction your financial health is headed.
To borrow a medical analogy, the balance sheet is an individual's diagnosis; the income statement is the individual's prognosis. Let's focus on the balance sheet, and save the income statement for a later post.
The Balance Sheet contains two parts - Assets and Liabilities. Assets are generally divided into short-term (liquid) assets, and long-term assets. These are often referred to as Current Assets and Fixed Assets. Your checkings and savings accounts belong in the Current Assets category. Your house, cars, jewelry, and retirement accounts belong in the Fixed Assets category. Values for hard assets--such as cars and houses--should appreciate and depreciate with the prevailing market conditions. They should NOT reflect how much you paid for the item. This is especially true for jewelry since the resale market for jewelry is so poor.
Depending on the method of accounting that an individual adopts, a balance sheet can take on varying degrees of complexity. The two fundamental methods of accounting are known as cash basis and accrual basis. For my own purposes, I adopt a hybrid method where I capture all short-term liabilities on an accrual basis, and everything else on a cash basis.
I do this for several reasons. Individual's recurring expenses usually fall into one of three categories: monthly, semi-annual, and annual. If I were to capture all of these expenses on a cash basis, then my December statement would look horrible. That month, my house insurance is due, my property taxes are due, and my car insurance premium is due. Instead of taking a huge hit that month, I choose to accrue an unrealized expense equal to 1/12 of each of these bills each month. In doing so, I can make sure I'm saving enough to cover these expenses and flatten out my monthly expense chart.
At the end of the year, it really doesn't matter which style of accounting I adopt -- my balance sheet will look the same, and my annual expenses will average out the same. But by borrowing this practice from the accrual method of accounting, I can more effectively save for these end-of-the-year expenses. Otherwise, I tend to favor the more conservative cash-basis method of accounting.
However, by adopting a mostly cash-basis method, I omit future assets and liabilities until they become current (within 1 year). For example, I own about $26,000 in stock options that will vest over the next few years. These assets are not visible on my balance sheet because a cash-basis method dictates that these assets aren't realized until fully vested. On the flip side of that coin, I also omit future long-term income tax liability on my tax-deferred retirement accounts.
I tend to favor this mixed approach for the individual because it borrows the most conservative aspects from each accounting method; it forces the individual to save for big end-of-the-year expenses; and it doesn't require any wild guesses about long-term projections (such as stock option prices or income tax rates at retirement).
posted by Matthew at
5:20 PM
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