If you were a corporation, would you buy your own stock? Do you know enough about your financial performance to answer that question? The best way to analyze your personal financial performance is to view it the same way a business views its financial statements – by creating your own personal financial statement.
In order to treat your personal finances like a business, you need to use the same techniques to account for transactions as a business does.
Why use the same system as a business? The purpose of a business is to generate a profit. Accounting systems have been designed to assist business owners in making decisions to drive profitability. If this is the same goal of your personal finances, why not use the best system that exists to analyze your financial performance?
Understanding accounting and how economic decisions affect the outcome of a business will help individuals understand how those same decisions affect the outcome of a person's financial performance.
What is Accounting?
Accounting is known as “the language of business.” It is a system for recording transactions, in financial terms, to interested parties (you) who use the information to assess performance and make decisions.
The accounting process begins with an economic event, such as signing a lease, buying a house, purchasing groceries, ordering cable TV, or clocking in at work. All of these activities have an economic effect on your personal financial performance.
In the business world, when an economic event occurs within a company, the accountant will enter a transaction into the ledger to record the occurrence.
The ledger is the book or computer file for recording transactions in dollars by account type, with debits and credits in separate columns, and a beginning and ending balance for each account.
Once a month, all of the transactions will be compiled into a trial balance, which is then used to generate an income statement and balance sheet. In the same way, your personal finance transactions can be combined into a personal financial statement, or income statement and balance sheet.
These two statements (as well as some others beyond the scope of this article) are collectively known as “financial statements” or “financials”. Corporations are required to file them quarterly with the SEC.
The income statement shows your monthly or yearly profit or loss, and the balance sheet is a snapshot of your net worth. How does a person have a profit or loss? By spending either more or less than the money they earn.
Double Entry System
Double-entry accounting is a method that tracks where your money comes from and where it’s going. Every transaction gets two entries, a “debit” and a “credit”. For example, when you buy a house with a loan from the bank, you would record an asset, your house, and the loan, a long-term note payable.
If you buy a house for $300,000 and pay $60,000 in cash, you would actually record three lines in your entry, or “journal entry”:
- Debit House $300,000
- Credit Cash $60,000
- Credit Note Payable $240,000
In accounting, debits must always equal credits. An increase to assets is always recorded as a debit, while an increase to liabilities or retained earnings is always recorded as a credit.
An increase to expenses is always a debit, while an increase in revenue is always a credit.
Cash can be confusing because it works exactly opposite of how the bank accounts for cash. At the bank, a credit is an increase in your bank account. In accounting, an increase in cash is a debit to your balance sheet.
Chart of Accounts
Every accounting system has a chart of accounts. This is a list of all the accounts you need to record all the different types of economic events that will occur. Here is a list of typical accounts you would use in your personal life, with their normal debit or credit balance:
BALANCE SHEET ACCOUNTS
Assets – Debit Accounts
Assets are things that you own.
- Checking Account
- Savings Account
- Brokerage Account
- Retirement Account
- Accounts Receivable – money you have earned but haven't received the cash yet
- Fixed Assets – things you own that have a useful life more than a year, cost over $1,000, and a legitimate resale value
- Stamp Collection
- Partnership interest – if you are an owner in a partnership, this represents the value of your partnership interest
Liabilities – Credit Accounts
Liabilities are things that you owe.
- Accounts Payable – money you owe for things you bought, but haven't paid for yet.
- Credit Card Account
- Unpaid rent or lease payments past due
- Notes Payable
Owner's Equity – Credit Accounts
Owners equity is the difference between all of your assets and your liabilities. Owner's equity equals NET WORTH.
Assets – Liabilities = Owner's Equity
Owner's equity has the following accounts:
- Retained Earnings – Earnings from prior years that you didn't spend.
- Net Income – Earnings from the current year that you didn't spend.
INCOME STATEMENT ACCOUNTS
Revenue – Credit Accounts
Revenue is income that you earn from your job, investments, business, etc.
Expenses – Debit Accounts
Expenses are things you pay for like rent, transportation, utilities, groceries, entertainment, etc.
More detail on income statement accounts is covered below under “Income Statement Basics”.
Cash vs Accrual Accounting
Cash basis accounting is based on your cash activity. It tracks when cash comes in and when it goes out. You can think of cash basis accounting similar to your checkbook register – at the end of the month, you balance everything to see how much cash you have in the bank. This is the most simple form of accounting.
For example, if your car breaks down and repairs cost you $750 and you pay with a credit card, you wouldn't recognize the expense until you pay the credit card bill.
Under the accrual method, revenue (income) is recorded in the month that it is earned, and expenses are recorded in the month they are incurred.
In our previous example using the accrual method, you would record the $750 expense when you incurred it. You would debit the expense, and credit a liability account to show that you owe it to your credit card company.
The accrual basis gives a more realistic idea of income and expenses during a period of time, providing a long-term picture of the business or personal performance that cash accounting can’t provide. It allows you to run KPIs (Key Performance Indicators) and trends on where your financial performance is heading.
All personal finance accounting guidance on Beyond Pennies follows the accrual method of accounting. If you truly want to take the next step in understanding how to increase your net worth, the accrual accounting basis is an advanced method you can use to make this happen.
This becomes especially important as you begin to grow new revenue streams, and understand how your business income streams are performing.
Income Statement Basics
The purpose of the income statement is to report a summary of revenues, expenses, gains, losses, and the resulting net income that occurred during a year, quarter, or month. The formula for the income statement is Revenue (or Gain) – Expense (or Loss) = Net Income.
Net income flows over to the balance sheet as a credit, or increase to Owner's Equity. At the end of the year, net income is closed out to retained earnings, and the income statement starts over with the new year.
Negative net income is a loss, and it also flows over to Owner's Equity, as a debit balance or decrease.
The obvious goal here is to maximize revenues and minimize expenses, thus achieving the maximum net income possible.
There are two levers on the income statement that affect your financial position: revenue and expense. Learning how to recognize them under the accrual accounting method is the first step to using your personal finance income statement to analyze your financial performance.
Revenue is the money that flows into your coffers. Possible sources of revenue include:
- Your day job
- Regular Pay
- Investment Income & Interest
- Stock Market
- Peer-to-Peer Lending
- Real Estate Rents
- Savings Account
- Business Income
- Product or Service Sales
- Affiliate sales
- Ad revenue
- Other revenue
- Other Income
- Child Support
- Stimulus Checks
- Tax Refund
Expenses are the what you pay for living expenses and other things you choose to spend your money on. Typical expenses include:
- Repairs & Maintenance
- Property Tax & Insurance
- Car Payment
- Repairs & Maintenance
- Car Insurance
- General Household Expenses
- Home Decor
- Travel & Entertainment (T&E)
- Travel (airfare, hotel, rental car, etc.)
- Cable TV & Streaming Subscriptions
- Restaurant Meals
- Movie Tickets
- Medical & Dental
- Benefits expenses (paycheck deduction)
- Prescriptions & Medication
- Medical (out of pocket)
- Dental (out of pocket)
- Child Support
- Income Tax expense
- Interest expense
- Depreciation expense
- Other Stuff You Spend Your Money On
Here's a list of items that are commonly considered expenses, but are actually accounted for on the balance sheet under the accrual accounting method:
- Home Purchases(expensed out over the life of the asset as depreciation expense – typically use 30 years; mortgage is a note payable that is entered as a liability on the balance sheet)
- Credit Card Payments (expenses recognized when purchases are made, not when payments are made)
- Student Loan Payments (expenses recognized when debt is incurred, not when payments are made)
Accrual Accounting Example Using Personal Finances
For example, let's say you were paid $3,000 in gross wages. Gross wages are the amount you are paid by your employer before any taxes or other deductions occur. Let's say you also accrued 3 hours of PTO (paid time off) that you can either use or have paid out to you. In this scenario, you plan to pay 50% of your PTO out to yourself instead of using it.
Some companies allow PTO pay outs, and others will pay your balance to you when you leave the company. If your company offers this benefit, PTO is a future cash flow that you've already earned. You earn some every month.
Under the accrual method of accounting, you will recognize the PTO as revenue in the month you earn it, not the month you cash it out. It becomes a “receivable” on the balance sheet, which we will cover in the next article.
In this example, you are paid gross wages of $3,000 twice in the month of May for a total of $6,000, plus you earned 6 hours of PTO for the month.
In order to accrue your PTO revenue in May, you need to know your hourly rate. If you are paid hourly, you already know your rate. If you are paid a salary, you can calculate your pay rate using the following formula:
Annual Salary / 2,080 hours = Hourly Rate
In our example, assuming a semi-monthly pay cycle, your annual salary is $3,000 x 24 pay periods = $72,000 annual salary. Using our formula above, we will calculate the hourly rate as follows:
$72,000 / 2,080 hours = $34.62 per hour
If you accrued 6 hours of PTO in May, and plan to pay out 50% of it (you will use the rest on vacation), you will take your hourly rate of $34.62 and multiply it times 3 hours, for a total $103.86 of PTO revenue (assuming you don't use it to take time off).
In our example, you recognize a total $6,103.86 of revenue for the month of May.
In accrual accounting, you recognize the expenses as they are incurred, not when they are paid.
For example, let's say you have a 12-month lease for the condominium that you live in. Per the terms of the lease, you owe $1,800 per month in rent. For some reason, you are unable to pay your rent on time. Its due on the 1st of the month. You talk to your landlord and he agrees to let you pay it with next month's rent.
Even though you aren't paying it until next month, you incurred the expense in the current month. Under the accrual accounting, you would recognize the expense in the month you owed it, not the month you paid it. As a journal entry, you would debit expense and credit accounts payable, a liability account.
Going back to your paycheck from the revenue example, you need to record some expenses to bring your gross wages down to net. Let's say that although your gross wages were $6,000, you only received $4,500 in your bank account. You will need to account for the other $1,500. Let's say there was a $900 deduction for taxes, a $420 deduction for medical and dental benefits, and you contributed $180 to your 401k (3% of your gross wages).
$900 is booked to tax expense
$420 is booked to benefits expense
$180 for 401k is not an expense – its an asset, and will hit the balance sheet, not the income statement, as an increase to your retirement account. (we will cover this in the article on creating a balance sheet)
The journal entry looks like this:
- Bank Account $4,500 (balance sheet)
- Retirement Account $180 (balance sheet)
- Benefits Expense $420 (income statement)
- Tax Expense $900 (income statement)
- Revenue $6,000 (income statement)
Let's not forget to recognize the PTO we expect to cash out later in the year. The journal entry looks like this:
- Accounts Receivable- PTO $103.86 (balance sheet)
- Revenue $103.86 (income statement)
When you cash the PTO out, you will make a journal entry that looks like this:
- Bank Account $103.86 (balance sheet)
- Tax Expense $15.58 (income statement)
- Revenue $103.86 (income statement)
An advanced topic would be discussing the idea of recognizing the PTO accrual at the Net Realizable Value (NRV) of the receivable, or deducting out the tax prior to the accrual. I don't its necessary to get that picky with your personal finance financials, but for those super nerds out there, go for it.
Credit Card Expenses
Let's say you used a credit card offering 0% interest (if you pay in the next 12 months) to pay for a purchase of $750 in car repairs on May 12th. You won't make your first payment on the credit card until next month. Under the accrual method of accounting, you recognize the car repair expense in the month its incurred. In our example, in May.
Our journal entry in May looks like this:
- Repairs and Maintenance $750.00 (income statement)
- Credit Card Liability $750.00 (balance sheet)
Our journal entry in June when we make a $50 payment looks like this:
- Credit Card Liability $50.00 (balance sheet)
- Bank Account $50.00 (balance sheet)
Other Expenses Incurred
In our example, here are the remaining expenses you incurred in the month of May and already paid for:
- Utilities – $500
- Transportation – $525
- General Household – $700
- Travel & Entertainment – $100
- Medical & Dental – $500
Now let's put it all together. The image below shows a snapshot of our accrual-based income statement resulting from the transactions we discussed.
As you can see in the image, after recognizing all expenses for the month, there's net income of $329. Net income is an increase to your net worth.
Using a purely cash-based method of accounting, your net income would be $975 instead of $329. Why? You didn't expense your car repairs because you haven't paid for them yet.
If you remember from our example, you used a credit card with a 0% 12 month special promotion. You'll probably spend the rest of the year paying for it; however, you incurred the expense in May, so you should reflect that on your income statement. Otherwise you are understating your true cost of living (operations).
Also, you didn't accrue your PTO payout because you haven't taken it yet.
That's why a cash-based method can falsely inflate or deflate your net income, and product a inaccurate picture of your financial performance.
Below is the income statement revised based on the cash method of accounting.
Using the same accounting methods that businesses use to report their financial performance can give you insight into your personal financial performance and net worth.
When the accrual accounting method is used to create a personal financial statement, the statement produces a more accurate picture personal financial performance. When the cash based method is used, net income is misleading, and can give an inflated view of financial results.
The next step is understanding how the income statement works in conjunction with the balance sheet to demonstrate the full financial picture of the company or person. The cash flow statement reconciles the accrual basis to the cash basis, and helps the owner understand how cash increased and decreased from operations, investments, and financing activities.
These three statements work in tandem to demonstrate the full picture of a business or person's financial performance.