CFP Lesson 4- Personal Financial Statements Part One

What does a statement of income and expenses represent?

A statement of income and expenses (income statement) represents all income earned or expected to be earned by the client, less all expenses incurred or expected to be incurred during the time period being covered.

What are long term liabilities? What are some examples?

Long-term liabilities are financial obligations owed that are due and expected to be paid beyond the next 12 months. Long-term liabilities are usually the result of major financial purchases and resulting obligations that are amortized over multiple years. Examples of liabilities that are included under long-term liabilities are: • primary residence loans (mortgage) • vacation home loans (mortgage) • automobile loans • student loans • any other type of loan or promissory note

What is an asset?

Assets represent anything of economic value that can ultimately be converted into cash. Depending upon the client's intent regarding disposition of an asset, the asset is further classified into one of the following three categories as reflected on the balance sheet: • Cash and Cash Equivalents (Current Assets) • Investment Assets • Personal Use Assets

What is the formula for net worth?

Assets-Liabilities

What is net discretionary cash flow and what is the formula?

Net discretionary cash flow represents the amount of cash flow available after all savings, expenses, and taxes have been paid. The net discretionary cash flow formula is a result of the statement of income and expenses. Net discretionary cash flow is a critical item when analyzing the statement of income and expenses. Net discretionary cash flow can be positive, negative, or equal to zero. A positive discretionary cash flow indicates that income is greater than savings, taxes, and expenses. This financial situation creates an opportunity for additional savings to accomplish a financial goal, retire debt, or purchase more comprehensive insurance. A negative net discretionary cash flow is one of the most important weaknesses a financial planner must mitigate against. A negative discretionary cash flow indicates that gross income is less than savings, taxes, and expenses. This financial situation requires steps to reduce expenses, taxes, or savings or to increase income. While a client can likely tolerate a negative net discretionary cash flow for a short period of time, ultimately, a negative net discretionary cash flow can lead to financial disaster, including bankruptcy in the most extreme cases.

Where are transactions that are non-cash, non-recurring placed on the balance sheet?

In addition, transactions that are non-cash, non-recurring changes in the balance sheet are not reported on the statement of income expenses. Non-cash, non-recurring changes in the balance sheet include gifting (or receiving) stock and gifting (or receiving) personal use assets, and would only be reported in a statement of changes in net worth.

With respect to budget include includes what?

Income includes all salary, wages, dividends, royalties, interest, and business income.

What are investment assets?

Investment assets include appreciating assets or those assets being held to accomplish one or more financial goals.

What assets are included in cash and cash equivalents?

Typical assets included in cash and cash equivalents are: • cash • checking accounts • money market accounts • savings accounts • certificates of deposit (maturity is less than or equal to 12 months)

What are variable expenses and what are some examples?

Variable expenses are more discretionary than fixed expenses over the short term. A client has more discretion over the amount of variable expenses, which often presents an opportunity for savings if variable expenses are closely monitored and controlled. Examples of variable expense accounts include: • Entertainment Expenses • Vacation Expenses • Travel Expenses • Charitable Contributions (may or may not be considered variable or discretionary)

What are liabilities?

Liabilities represent financial obligations that the client owes to creditors. To satisfy a liability, either a client-owned asset or some other economic benefit must be transferred to the creditor. A liability may be either a legal obligation or moral obligation that resulted from a past transaction. A legal obligation may be a mortgage or a car payment. If a client borrows money from the bank to purchase a house or a car, then there is a legal obligation to repay the loan (a liability). A moral obligation can result from the pledging of a donation to a charity or a not-for-profit entity. A pledge is not necessarily a legal obligation, but if intended to be honored, it does represent a financial liability

What are some debts that are outliers in the short term liability category?

When reporting debts such as a mortgage or a car loan, only the principal portion of the loan that is due in the next 12 months is reported as a short-term or current liability. This treatment is the correct accounting methodology, but is rarely used by individuals in preparation of personal financial statements. Interest expense for the next 12 months is not reported on the balance sheet. If a loan is paid off today, the payoff amount would include the interest expense incurred since the last payment (plus the outstanding principal) because the interest expense is calculated for having a loan outstanding for the previous month. Liabilities only reflect the amount currently owed by the client. Since interest expense for the next 12 months has yet to be incurred, it is not reflected on the balance sheet.

When reporting the outstanding balance of a loan, how should it be reported?

When reporting the outstanding balance of a loan, the current portion of the liability should be reported separately from the long-term portion of the liability. This allows the financial planner to make a comparison between current assets and current liabilities and to evaluate the client's liquidity status and ability to meet short-term financial obligations.

Is the fair market value of the personal use assets more important than the investment assets?

the exact economic or fair market value of personal use assets is less important than the exact fair market value of investment assets. Reasonable and conservative estimates are usually adequate when valuing personal use assets, because the client will likely continue to use their personal use assets to maintain their lifestyle through the retirement years.

Along with expenses, recurring savings contributions must be reported on the statement of income and expenses. Examples include savings contributions to the following types of accounts:

• 401(k) plan • 403(b) plan • 457(b) plan • IRA (Traditional or Roth) • Education Savings • Any other type of savings account contributions • Reinvested dividends, interest, or capital gains

What are fixed expenses? What are some examples?

Fixed expenses remain static for a specific period of time, regardless of changes in spending or income. For example, a homeowner cannot generally change the amount of property taxes. They remain relatively fixed. There is less discretion over fixed expenses in the short term. Examples of fixed expense accounts include: • Mortgage Payment • Car Payment • Boat Payment • Student Loan Payment • Property Taxes • Insurance Premiums • Federal and State Income Taxes Withheld • Social Security Payments Withheld It is important to understand that fixed expenses can change with more extreme changes, such as selling a home or car. Actions, such as these, are sometimes required under extreme circumstances (for example, losing a job without an adequate emergency fund)

How are liabilities laid out on the balance sheet?

. Liabilities are valued at their current outstanding balance as of the date of the balance sheet. The current outstanding balance represents the amount owed to the creditor, including amounts for any bills that have been received but not yet paid. Liabilities are categorized according to the timing of when the liability is due or expected to be paid. The categories of liabilities are: • short-term or current liabilities (expected to be paid within one year) • long-term liabilities (expected to be paid beyond one year)

What is a balance sheet?

A balance sheet, or as commonly referred to, a statement of financial position, represents the accounting for items the client "owns" (assets) and items that are "owed" (liabilities). The difference between assets and liabilities is the owner's equity (net worth). The balance sheet provides a snapshot of the client's assets, liabilities, and net worth as of a stated date such as at the end of a calendar quarter or at the end of the calendar year

What does community property mean?

Community property is a civil law statutory regime under which married individuals own an equal undivided interest in all property accumulated during their marriage. During marriage, the income of each spouse is considered community property. Property acquired before the marriage and property received by gift or inheritance during the marriage retains its status as separate property. However, if any separate property is commingled with community property, it is often assumed to be community property. The states following the community property regime are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. Community property does not usually have an automatic right of survivorship feature although some states, including Texas and California, have a survivorship option.

What are cash equivalents?

Cash and cash equivalents (current assets) represent assets that are highly liquid, which means they are either cash or can be converted to cash (within the next 12 months) with little to no price concession from their current value

With respect to budgeting, taxes include:

Clients should budget 20-25 percent of their gross pay for federal, state, and local income taxes, and Social Security. Presenting the percentage of income being allocated to each line item expense allows the planner and client to evaluate expense trends over time. Over time, with income increasing and controlled spending, expenses as a percentage of income should decrease. Other alternatives to decrease spending include: • Focus on 2-3 expenses and reduce them in the short term. Possibly remove a phone land line and just use a cell phone. • Install a "smart" thermostat to better manage utility expenses. • Make sure any auto loan is repaid before purchasing a new car. • Avoid making emotional purchases, instead focus on long term goals.

With respect to budgeting, living expenses include?

Clients should budget 50 percent or less of their gross pay for living expenses. Living expenses include all discretionary expenses, plus non-discretionary expenses, and housing costs. Discretionary expenses include entertainment, vacations, clothing, cable television, etc. Non-discretionary expenses are food, utilities, phone, etc.

With respect to budget, debt payments include?

Debt payments include a mortgage payment, car payments, student loans, boat loans, etc. Total debt payments should be less than or equal to 36 percent of gross pay. Housing costs, which is simply a client's mortgage payment, should be less than or equal to 28 percent of gross pay.

What are personal use assets? What do they include?

Personal use assets are those assets that maintain the client's lifestyle. Examples of assets included in personal use assets are: • personal residences • automobiles • furniture • clothing • boats • jet skis • vacation homes • electronics (television, stereo, iPad, etc.) • collectibles (art, antiques, coins)1 The value of personal use assets is usually determined by client estimation as opposed to appraisal. Anytime a financial planner is estimating the value of assets, it is always better to be conservative and not overvalue the assets.

For personal financial planning purposes, there are two principal financial statements and two supplementary financial statements. What are they

Principal Financial Statements • The Balance Sheet (A Statement of Financial Position or A Statement of Assets, Liabilities and Net Worth) • The Income Statement (A Statement of Income and Expenses) Supplementary Financial Statements • The Statement of Net Worth • The Cash Flow Statement

What are short term liabilities and what are some examples?

Short-term liabilities represent those obligations that are "current" in nature that are due or expected to be paid within the next 12 months ( 12 months). Examples of liabilities that are included in short-term or current liabilities are: • Electric, gas, water, garbage, and sewage bills incurred, but not yet paid • Principal portion of any debt obligations due within the next 12 months (mortgage and auto loan) • Unpaid credit card bills • Outstanding medical expenses • Insurance premiums due • Unpaid taxes

What does sole ownership mean?

Sole ownership is the complete ownership of property by one individual who possesses all ownership rights associated with the property, including the right to use, sell, gift, alienate, convey, or bequeath the property. Typically, a car is owned and titled in the name of one person. When preparing a balance sheet for a husband and wife, (H) is used to designate the asset or liability belongs to the husband only and (W) is used if the asset or liability belongs to the wife only.

What does tenancy by the entirety mean?

Tenancy by the entirety is similar to property owned as JTWROS between a husband and wife because property ownership is automatically transferred to the surviving spouse upon death. The two tenants own an undivided interest in the whole asset. However, the ownership cannot be severed without the consent of the other spouse.

What does tenancy in common mean?

Tenancy in common is an interest in property held by two or more related or unrelated persons. Each owner is referred to as a tenant in common. Tenancy in common is the most common type of joint ownership between nonspouses. Each person holds an undivided, but not necessarily equal, interest in the entire property.

What is Joint Tenancy with Right of Survivorship (JTWROS)

Tenancy with Right of Survivorship (JTWROS) is typically how a husband and wife own joint property. Joint tenancy is an interest in property held by two or more related or unrelated persons called joint tenants. Each person holds an undivided, equal interest in the whole property. A right of survivorship is normally implied with this form of ownership, and at the death of the first joint tenant, the decedent's interest transfers to the other joint tenants outside of the probate process according to state titling law. Probate is the process whereby the probate court retitles assets and gives creditors an opportunity to be heard and stake a claim to any assets to satisfy outstanding debts. Because of this right of survivorship, joint tenancy is often called joint tenancy with right of survivorship.

The budgeting process consists of the following steps:

The budgeting process consists of the following steps: • Establish goals with the client, such as saving for retirement, education, or a lump-sum purchase (a second home, new car, or boat). • Determine the client's income for a time period, which could be monthly or annually. Income is based on a client's past earnings and expected income for the time period that is being budgeted. • Determine expenses, both fixed and variable, for the time period of the budget. • Determine whether the net discretionary cash flow is positive or negative. If net discretionary cash flow is negative, expenses must be reduced or income needs to increase. If net discretionary cash flow is positive, no immediate action is necessary. However, there may be opportunities to further increase discretionary cash flow, which could reduce the time to achieve one or more goals. • Present expenses as a percentage of income for the time period being presented. At this point, it is necessary to compare expenses as a percentage of income for previous budgets as well. Generally, the expenses as a percentage of income should be level or decreasing over time.

With respect to budgeting, insurance includes what?

The insurance category includes premiums for life, health, disability, home, auto, long term care, and personal liability. Premiums should be 5-9 percent of gross pay.

What does net worth mean?

The net worth of the client as reflected on the balance sheet represents the amount of total equity (assets - liabilities = net worth) a client has accumulated as of the date of the balance sheet. When evaluating a client's financial position, net worth is an important consideration because it represents an absolute dollar amount reflective of a client's financial position. A positive net worth may imply the client has done a good job of saving, investing, and managing debt. A negative net worth implies that the client is insolvent and potentially facing bankruptcy

What is the purpose of creating a financial budget?

The purpose in creating a financial budget is to evaluate the client's spending and savings behavior, and to establish a spending and savings plan to assist the client in achieving their financial goals.

What is the purpose of the cash flow statement?

The purpose of the cash flow statement is to explain how cash and cash equivalents were used or generated between the period of two balance sheets. The cash flow statement is a supplementary financial statement of non-recurring transactions not reported on the statement of income and expenses. Recall that the income statement only captures monthly or annually recurring income and expenses. The major sections of the cash flow statement includes how nonrecurring cash transactions were used or generated from investment activities and financing activities.

What is the purpose of the statement of net worth? What are some transactions that would appear on the statement of net worth?

The purpose of the statement of net worth is to explain changes in net worth between two balance sheets by reporting financial transactions that are not reported on the income statement or other financial statements. Example transactions that would appear on the statement of net worth are: • Giving or receiving property other than cash • Inheriting property other than cash • Employer contributions or matches to retirement savings accounts • Appreciation or depreciation of assets such as a primary residence, investments, auto, jewelry, etc.

What are the three important tips to being successful in preparing and using a budget?

There are three important tips to being successful in preparing and using a budget. • Be realistic: Be realistic with spending behavior. It is easy to overlook credit card expenses for shopping or dining out. Credit cards are an easy way to "blow the budget." • Miscellaneous: Budget a line item expense for miscellaneous expenses and unforeseen expenses. Miscellaneous expenses include gifts at the holidays, car repairs, house repairs, traffic tickets, kid's sporting events, etc. As clients get older, the miscellaneous expense item tends to grow. • Practice: Being successful with a budget takes practice. The more often a client prepares a budget and compares their actual spending to a budget, the better they will become at budgeting. The first few budgets are likely to be unrealistic and not very accurate. Over time, the client will become more comfortable with budgeting and more realistic with their spending, savings, and miscellaneous expenses.

With respect to budgeting savings includes what?

avings include contributions to retirement accounts, education savings accounts, or any other accounts the client deems for a savings goal. As a general rule, clients should save at least 10-13 percent of their gross pay for retirement savings. This amount includes any employer match or contribution. Older clients will have to save a larger percent of their income. If clients have an education goal, clients should include an additional 3-6 percent of savings in their budget.

What is one of the most difficult investment assets to value? What questions should be considered regarding this asset?

of the most difficult investment assets to value is ownership in a privately-held business. Unlike a publicly-traded company, there is no established market value for a privately-held company. The following questions should be considered regarding business valuations: • Who prepared the valuation? If the valuation was prepared by the owner, it may be significantly overstated or understated. Owners often overestimate the value of their own business. Alternatively, a professional valuation expert may have valued the business. However,it is important to understand the purpose of the valuation and to understand important assumptions of the valuation. Professional valuations are prepared for various reasons (potential sale of part of all of the business, gifting an interest of the business to family members, etc.). In practice, the purpose of the valuation can influence the final valuation of the business. Valuations conducted for purposes of transfer tax reporting (gifting) tend to be lower than valuations conducted for the purposes of selling a business. • How current is the valuation? The valuation may be accurate or it may be understated or overstated if the underlying assumptions no longer apply. • Is goodwill associated with the business or with the owner? Some businesses are critically dependent on the owner and founder of the business and can be negatively impacted upon the owner's departure. • Will the business be sold to fund retirement? It is important to understand how the owner is planning on selling a business and over what time period he expects the proceeds. This information will assist the planning in a conversation about any risks associated with the exit strategy. For small business owners, a large portion of their net worth is often invested in the business. Financial planners should be very cautious and conservative when valuing business ownership interests on the balance sheet, especially if the proceeds from the sale of the business will be used to fund retirement or other important goals. If the business is valued too high, the client's financial position will be too optimistic, perhaps resulting in a shortfall at retirement. If the business is valued too low, the client's financial resources may be improperly allocated, jeopardizing other financial goals

The planner should prepare forecasted balance sheets and a statement of income and expenses for several years into the future, such as next year, three years from now, and five years from now. The forecasted financial statements should reflect the following:

• Implementation of recommendations. If the planner recommends increasing 401(k) plan savings, the forecasted financial statements should indicate the amount of savings and balance of the 401(k) plan for the next year, the next three years, and the next five years. • Inflation adjustment for expenses. Certain expenses will generally increase over the next five years, such as insurance premiums, utilities, gasoline for autos, groceries, clothing, etc. The financial planner should prepare forecasted statements of income and expenses based on a historical inflation rate that is likely to continue for the next five years. Fixed interest rate debt payments are not impacted by inflation, so no inflation adjustments should be made to fixed rate loans. However, if the client has any variable interest rate loans that are likely to increase over the next five years, adjustments to the forecasted income statement should include increased debt payment for variable rate loans. • Inflation adjustment for income. If the client expects to receive salary increases each year, those salary adjustments should be reflected in the forecasted statement of income and expenses. • Other adjustments. Other adjustments to the forecasted financial statements may include: • Whether the client is retiring and experiencing major changes to their income in the next five years. The financial planner should prepare forecasted financial statements to reflect with-drawing retirement assets to generate income. The possibility of the client living on reduced income during retirement should be evaluated and forecasted in financial statements. Whether the client is expected to retire debt in the next five years. The financial planner should reflect the retiring of debt on the balance sheet to determine the impact on the bal-ance sheet, net worth, and discretionary cash flow on the statement of income and expenses. • Whether the client expects to begin paying for college education expenses, and how the tui-tion payments and living expenses for the child impact the financial statements. The planner should reflect the draw down on any college savings and the increased expenses on the income statement associated with a child living away from home while at college. • Whether the client expects to borrow money for a car, house, boat, college education, etc. The planner should incorporate the debt into the forecasted balance sheet and statement of income and expenses

When developing a budget the planner should help their clients create a cash flow plan that follows the presentation of a Statement of Income and Expenses. The budget will identify spending by major categories and line item income and expenses within those categories. The major categories are:

• Income • Savings • Debt Payments • Living Expenses • Insurance • Taxes

Recurring expenses represent those items that are paid regularly by the client during the time period being presented. Examples of recurring expenses include:

• Mortgage Principal and Interest • Utilities • Taxes • Insurance • Telephone • Water • Cable or Satellite • Internet • Cell Phone

What are examples of recurring income accounts earned by the client?

• Salary • Interest • Dividend • Pension • Retirement Account Withdrawal • Business Income • Alimony Received

As part of the balance sheet presentation, it is important to disclose how an asset or liability is titled (owned). The most common forms of ownership are:

• Sole Ownership • Tenancy in Common • Joint Tenancy with Right of Survivorship (JTWROS) • Tenancy by the Entirety • Community Property

The planner should obtain the following documents with which to prepare the statement of income and expenses:

• W-2s (reports income and deferred retirement savings) • Credit card statements (provides insight to expenses and spending, with year-end statements being especially informative) • Billing statements (such as utilities, telephone, satellite, internet, water) • Bank statements (especially those with bill payments) • Federal and state income statements

What are some typical investment assets?

• retirement accounts (401(k) plans, profit sharing plans, IRAs, annuities) • brokerage accounts • education funds • cash value in a life insurance policy • business ownership interests • the vested portion of any pension plan • rental property • other: investment partnership interests, oil and gas interests, collections (such as art), etc.

What are examples of cash transactions that are non-recurring?

• the sale of stock • an employer's contribution to a retirement plan • giving or receiving a gift of cash, or • an inheritance