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Chapter 4

FIN 502 Chapter Notes - Chapter 4: Personal Finance, Current Liability, Income Statement


Department
Finance
Course Code
FIN 502
Professor
Laleh Samarbakhsh
Chapter
4

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Chapter 4 – Measuring and Controlling Personal Finances
Accounting and Personal Finance
- Planning and controlling your personal finances is nothing more than keeping track of how well
you are doing, and families and businesses both need to do that
- 1st: you prepare personal F/S to manage the family finances
oNo one outside the family will use them, except to help you with your planning
oLenders will make their decisions based on some specific amounts, such as total debts and
value of the house, but they won’t use the entire statements
oNo such thing as GAAP for personal F/S
- 2nd: the articulation that is necessary for a business B/S and I/S isn’t critical in personal finance
oArticulation – the I/S items all link directly to the b/S and the new worth amount (or R/E
on a business B/S) is exactly the sum of all the previous incomes minus dividends paid
- 3rd: treated on a cash basis not accrual income
Family Financial Statements
- Treated on a cash basis vs. accrual
- Should be done in way that is most useful for you (or client)
How Much is the Family Worth
- Family B/S or Statement of Net Worth – snapshot of family’s financial standing at a point in time
oSummarizes the major assets and liabilities, with the balancing figure being the net worth
oNet worth = Assets – Liabilities
It’s simply the excess of your assets over your debts
oBalance sheet is essential for 2 reasons:
1) Provides benchmark to measure progress in meeting the family’s goals
2) Listing and valuation of assets – shows how much you have to spend or manage
oThe list of assets for each category is subjective and must reflect your own or your client’s
own personal values and choices
Defining the Family
-Family is any group of people (including a single person) that share their wealth, revenues and
expenses – typically occupy a common residence
oBy sharing we mean that they pool them, and make communal decisions about their use and
management
Assets
-Financial assets – provide income or return - are part of what you will consume in retirement
oMost impt. for planning purposes b/c they are the resources that determine progress toward
financial goals
-Personal use assets – the ones you use in everyday life (house, car, clothing, appliances, etc.)
oThey don’t yield income, they provide consumption
-Luxury assets – for personal use, but they are very marginal to family’s needs (jewellery,
collections)
Liabilities
-Current liabilities – due within one month - include the current months portion of any long-term
liabilities like mortgage
-Long-term liabilities – due later than one month, often payable monthly for many years
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Valuation of Assets and Liabilities
- Valuation of assets and liabilities depends on what you want the info for.
-Market value – what someone else would pay for the asset in a fair, arm’s length, unhurried
transaction
oPrice for which you have a buyer available and willing to buy at that price
-Historic cost – the original price
-Depreciated cost – the historic cost minus an allowance for wear and obsolescence
oIt’s the closest to market value (estimated)
-Replacement cost – the price to replace the asset in new condition
oIs close to market value for assets for which there is a ready market, like financial assets,
homes and cars
oPersonal use assets like clothing have little market value relative to their replacement cost
oUsually a higher value
-Transaction costs – typically ignored, but can be significant (house)
oLawyers, fees, agent costs
- Depreciated value for everything else – ie. A computer – don’t capitalize
- Insured items – valued at replacement costs
Financial Assets Valuation
-Financial assets – always value them at market – we hold financial assets for the purpose of their
income or cash value and so they are a means to consumption
-Historic costs – irrelevant for planning (except for calculating taxes)
-Transaction costs – ignore or deduct 2% if you want to be precise
- Can’t ignore accumulated income taxes – major tax issues are capital gains and sheltered retirement
savings – the asset values must be recorded net of tax payable in these cases
Personal Use Assets
- Value house and cars at market value – if you are planning to sell them and use part or all of the
proceeds for something other than buying another house or car (ex. retirement fund, purchase of a
business), value them at market less all costs associated with the sale
- Value all other personal use assets at replacement cost – value any assets you are planning to sell
and not replace, at market less all costs associated with the sale
Luxury Assets
- Value them the same as personal use assets other than the house and car
- Difference between replacement cost and market is much larger for luxury assets
Human Capital
-Human capital is the earning power that a person possesses
oProvides a form of security
oDon’t put human capital on B/S even though it is valuable
- Ex. a doctor has more human capital than a carpenter b/c she has spent many years to learn difficult
skills that society rewards well
-3 important decisions related to human capital:
1) Acquire it – higher material wealth is closely linked to higher levels of education
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