Tuesday, March 27, 2012

The Personal Income Statement


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Personal financial literacy is the first step towards developing true financial security and realizing a dream of quitting a job or having a comfortable retirement. In my last post I covered the basics of the personal balance sheet and how an individual's assets and liabilities look at a point in time. I also showed a couple of examples including a graduating student and a homeowner with an underwater mortgage. In this post, we will work more with the flows that affect the personal balance sheet: revenue, expenses, gains, and losses.

From a business perspective, revenues are different from gains in that revenues arise from a business' primary operating activities while gains arise from events that are not considered primary activities. For example, Best Buy would recognize revenue on merchandise that is sold in its stores while they might recognize a gain when a building is sold (in this case, it is assumed that the purchase and sale of real estate isn't one of Best Buy's primary operating activities). The same analogy holds for expenses and losses. Companies recognize expenses when they engage in activities that reduce the organization's economic resources and the activities that are closely related to the organization's primary purpose. Losses are often tied to events that are not routine and infrequent in nature.

One of the causes of difficulty for the lower and middle classes is that it is a lot easier to generate expenses and losses than it is to generate revenues and gains. A good example of this is that an individual could choose to eat out every night in a given week and triple their food expense, while they will receive the exact same paycheck that week. Businesses have a lot more flexibility to drive revenues and gains and are not limited in the same ways as individuals (upwards or downwards). For most people, the goal should be to operate more like a business than an individual for all things related to finance. This is also why there is an extraordinary and growing wealth gap in the world. The richest individuals are able to operate their finances in the exact same way that businesses operate, where there is no limit on upward potential. Most individuals are limited by the raises that their employers are willing to pay them, and increasing that amount is virtually impossible in an employer driven labor market.

Let's look at the mechanics of an income statement. An income statement differs from a balance sheet in that it shows how revenues, expenses, gains, and losses occur over a period where a balance sheet shows assets and liabilities at a point in time. Revenues and gains typically add to assets (e.g. more cash in the bank) while expenses and losses decrease assets (e.g. depreciation) or increase liabilities (e.g. credit cards).

Let's look at an example personal income statement for a guy named John Doe assuming the following:
  • John makes $1,500 per week (before taxes)
  • John's taxes take about 30% of his income
  • John spends the following
    • $2,000/month on rent and utilities
    • $450/month on doggie day care (because his landlord does not allow pets)
    • $200/week on food
    • $200/month on gas
    • $120/month for cell phone
    • $120/month for Internet and Cable TV
    • $300/month on student loans (20% of this is interest)

Let's determine if John is making any money after expenses. We will prepare an income statement that shows a typical month.

        Monthly Statement of Income
                John Doe
      For the Period Ended 3/31/2012

Wage Revenue                        6,000
Taxes Deducted                1,800
Wages, Net                          4,200

Rent and Utility Expense      2,000
Food Expense                    800
Doggie day care                 450
Fuel Expense                    200
Cell Phone Expense              120
Cable/Internet Expense          120
Student Loan Interest Expense    60

Total Expenses                      3,750

Net Income (Loss)                     450  
 
But wait... I've read a financial statement... aren't taxes subtracted at the end?  For businesses... yes... but no for individuals. Why? Think about it, although you may have negotiated $78,000 at the end of your last job search, you really only see a maximum of about $58,500 actually go through your bank account (the rest is a somewhat fictitious amount that appears at the end of the year on your W-2). The government knows that nobody would pay taxes at the end of the year if they weren't taken out of the paycheck, so legislation has been passed to make withholding mandatory for most individuals and they impose immediate and severe penalties on businesses that fail to send payroll taxes in to the state and federal government. Taxes are typically calculated values, but in this case it makes more sense to either create an asset (called taxes withheld in the personal balance sheet) or make an adjustment at the end of the year that reduces the total year expense by the amount of the refund expected. I prefer the latter approach.

Imagine what you could do over the course of a year with an additional $19,500, even if it had to be paid at the end of the year. Gains could be generated from the purchase and sale of stocks or interest income could be generated from bonds... but these doors are closed for the majority of people. The money could even be used as a down payment on a car or home and then taken out as a secured loan at the end of the year.

Another interesting thing to note is that the student loan interest expense is only $60. This is due to the fact that only 20% of the $300 cash outlay is interest. The other $240 is a reduction in the principal of the loan (and this is applied against the corresponding student loan liability on John's personal balance sheet). We'll look at working with loan calculations in more depth in a future post.

Ultimately the personal income statement tells you how much money you have made or lost for a given period of time. Figure out your expenses and debt service and see how they compare to your income. The answer may surprise you... I didn't touch on gains and losses yet because these are less straightforward than simply determining revenue and expenses. As we continue our discussion on assets and liabilities, I will cover more detailed scenarios involving gains and losses on homes, cars, stocks, bonds, and a number of other assets. I will also explore the darker area of gains and losses on liabilities.

See Also
The Personal Balance Sheet
Retirement in the 21st Century

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