Friday, December 10, 2010

Think Like an Accountant

I decided to take a moment and just share with you a good money management technique that I feel a lot of people (myself included) would do well to follow. Think like an accountant. Why? If you think about it, the world's richest people all have accountants working for them. If you're thinking "that's because they have more money than they can keep track of", you're wrong. You have to be able to manage a little before you can manage a lot.

Accounting is defined by the American Institute of Certified Public Accountants as "the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of financial character, and interpreting the results thereof". In other words, accounting is recording where money comes, and money goes, and then analyzing the results.

If you have ever used Quicken, Microsoft Money, or even Excel you may already be familiar with some accounting principles. If not, there are thousands of websites on the subject. However, I will save you a little time and give you some pointers on how to start using this concept immediately. (A quick disclaimer here: this will not teach you accounting but more accounting theory. Therefore I will purposely leave out otherwise crucial details).

1.) Calculate your net income/loss. This is simple. Take your income and subtract your expenses. Expenses, for the sake of clarity, are bills: period. Everything else is going to be factored in later. Overall, a company wants to get net income as high as possible because that is their spending money for necessary items they call assets. So far I am stating the obvious right? Moving on.

2.) Factor in your supplies and equipment. Supplies are anything you need to function however they run out so you have to consistently buy more. Food, toiletries, cleaning supplies, etc. Supplies are closely linked to expenses but are considered an asset because they benefit the company (you and your family). Equipment is anything that is purchased that has some sort of a lifespan and can be sold (think: can I sell this at a garage sale?). Clothes, furniture, cars, cell phones, computers, microwaves, dishes, toys, and most other tangibles, are considered equipment.

3.) Keep an inventory.  While on the subject of supplies and equipment, it is good to keep an inventory of these things. First, it will give you a great idea of what you have and what you don't have, how much you use, how fast you use it, and what you don't need (and could possibly sell). Secondly, you have a more accurate concept of your total assets. Accountants keep track of inventory in terms of money. So if you bought 3 bars of soap for $4.50 and one is used up, you now have $3.00 worth of soap (think of it like the dad in Everybody Hates Chris).

4.) Track your Depreciation/Appreciation. Part of an inventory is tracking the depreciation/appreciation of your assets like equipment and land. Depreciation is basically what you paid for something, minus what it is worth now. Appreciation is the same concept except the item in question is worth more. You mainly hear about depreciation with cars and appreciation with land. Thanks to the internet, you can track the current value of pretty much anything accept clothes. You have to come up with your own numbers for clothes.Knowing the actual value of all your stuff helps in determining net worth as well.

5.) Establish a Payroll. Yes, a payroll. This is your allowance and the allowances of everyone in the household for one purpose only. To blow it all. Do whatever you want with it: buy junk food, drink it up, smoke it up, gamble it away, all guilt free. I wouldn't even track this money.  Keep in mind after that money is gone you have to wait until next pay day. Also keep in mind that your gifts to others will come out of this money as well. For the record, payroll counts as an expense. Make sure it is a set budgeted amount (though that amount may change from month to month).

6.) Established Retained Earnings. Retained earnings is the business term for a savings account. In business, retained earnings serves a few purposes. It increases the net worth of a business. It also makes up for any net losses that you might incur during the year. Finally, if the retained earnings account grows large enough, you can buy more assets. Businesses usually worry about retained earnings after everything is said and done (which technically goes against every personal finance guru out there which states to save first and spend later). The key to retained earnings is discipline. Money left over does not mean extra spending money (that's what your BUDGETED payroll is for). Throw it right into savings and keep moving.

7.) Determine your net worth. This is the end all be all number financially. Most people don't know their net worth. Others are scared to find out. Anyone else is most likely rich, or about to be within a matter of years. The concept is simple. Assets - Liabilities = Net Worth. The actual execution is a little more involved depending on what you define as an asset (remember earlier I mentioned keeping an inventory). An asset is essentially anything you can sell or use for a benefit. So this includes Cash, investments, clothes, food, furniture, your 300 pairs of shoes, your library of DVD's, your baseball card collection, your video games, and anything else you have possession of that you can find the current value of. Look at it this way, if you sold everything you own and I mean everything and combined it with the cash you have now, that is the value of your assets. Liabilities is just a fancy word for debt. Loans, mortgages, and past due bills are pretty much the only liabilities you have.

A quick note on liabilities. Many people would have you to believe that if you have a car with a car payment, that car is a liability. Wrong! The car is an asset. The car loan is a liability. You have to treat them as two separate beasts. Same thing with your house and your mortgage or your furniture and furniture payment.

8.) Analyze. What is the purpose of all this work? What do you do with all this data that you have organized and compiled? You find ways to improve the numbers in front of you. If your net worth has a minus sign in front of it, find out ways to make it a plus sign. If you have no retained earnings or even enough money for payroll, find out where you can cut back, and where you can make more money.

It's a lot of hard work and it wont happen overnight, but if you keep at it, you will master this concept and ultimately be able to better manage your money. The key is organized thought and effort towards managing your money. Here are a few more tips:

  • A great way to manage your inventory is to keep all your receipts and build your lists from that. Take stock of inventory weekly or monthly. Daily would kill you.
  • is a great way to estimate the value of your belongings. 
  • Keep a log of everything that you spend (except your payroll funds, remember, that is guilt free).
  • Keep track of your accounts and their values (e.g.: Cash, Clothes, Cars, Furniture, Technology etc.)
  • If you're married or share finances with anyone (room mate, live in girl/boyfriend, etc.) then let them in on the info. Have meetings regarding the numbers and think up ways to improve them.
  • Just like past due bills are liabilities, pre-paid bills are assets. Keep your bills paid a few months in advance.
I will create a spreadsheet that will make all of this info a little easier to manage. Let me know if you have any questions.  

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