Personal Accounting: Cash Method or Accrual Method?
Every Accounting 101 course will tell you the difference between cash-based accounting and accrual-based accounting. Simply put, cash-based accounting recognizes your net worth changes when you actually receive or pay out money, while accrual-based accounting thinks your net worth changes when any of your activity increases your expected income and/or adds to your financial liability, regardless of whether your money actually flows or not.
When it comes to personal accounting, most people use cash-based accounting. Certainly, it is easy to understand and easy to handle. If you buy a birthday gift for your significant other, you should deduct your purchase amount from your cash or credit card account immediately, because your net worth does decrease the second you make the purchase. Nothing wrong about it at all.
On the other hand, I will argue for at least some cases, applying accrual-based accounting makes more sense to track your personal finance better:
Example 1: Property Tax
If you don't have your own escrow account, you will have to manage your own property tax payment. For me, I need to pay property tax twice a year in April and in October; each installment is about $1,800.
If I use cash-based accounting, the moment I pay an installment, I will be suddenly $1,800 worse off. Is this a good reflection of the financial reality?
Apparently no. I am incurring a liability in each month of January, February and March even if I don't have to pay a dime. But if you have ever bought or sold a house, you might still remember the property tax will be pro rated during the settlement phase. In other words, if I sell your house in March, although I haven't paid property tax, I still need to rebate your buyer for three months' worth of property tax because he will pay the half-year installment in April. The opposite is true too: if I sell your house in May, I will receive credit from the buyer for his fair share of the property tax for the month of June too.
So, the reasonable accounting in my mind (and in my practice) is to deduct 1/12 of the annual due every month from your net worth. (It requires you to add an extra account to your Microsoft Money or Quicken file to make it work, but it can be done very easily.)
Example 2: Auto Insurance
Auto insurance premium is usually due upfront. If I send a check of $600 today for my auto insurance coverage in the next six months, is my net worth suddenly $600 lower?
The answer is another no. Think about this: if I cancel the policy next month, I will receive a pro rated premium refund at about $500 (minus some "processing fee," if any), because the insurance company is not entitled to the premium for coverage (for the five months thereafter) it hasn't provided. (I know this because I had ben through this path in pre-PFBlog ages.)
Therefore, for accounting purposes, it's better to recognize $100 every month in this case. (One byproduct: This will also smooth your month-to-month spending variance and help to analysis your spending trend better.)
Note, I'm not advocating a pure accrual-based accounting system for individuals -- it would be extremely sophisticated, if not impossible. (An accrual system superfan would have to keep track of the gas left in the gas tank and food in the friger because they represent your net worth too, or at least will reduce your future spending if everything else being equal. That's largely unnecessary and sometimes does not conform to the conservative accounting principle.)
What I am advocating is we need a bit more than cash accounting pure play to track our money. Besides the property tax and auto insurance examples discussed above, other tricky areas include car-related expenses and tax liabilities for investment gains.
What do you think?
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This approach makes a lot of sense. I'm looking forward to hearing how to set this up in microsoft money.
I think that cash-accounting is more suitable as should you have to liquidaye you will have a big problem getting refund for payments you made upfront
I've thought about this and have come to the conclusion that for my needs, cash-based accounting is fine and the extra work involved in using accrual-based accounting for my personal finance isn't worth the effort. My actual cash in hand is much more important to me than my actual value-to-the-day, if that makes any sense.
Great post. As a former finance manager, I strongly advocate that when it comes to business, both systems should be adopted. For financial reporting purposes, accrual is the way to go. For cash flow monitoring and management, cash based is crucial.
The latter is basically spreadsheets and schedules but it really helps.
For individuals, if you're not a wealthy person and have regular income and expenses, cash systems with a budget in place are the norm.
I tend to use both forms of accounting in Quicken.
For instance, when I bought a snowblower and stopped having my driveway plowed, I created an asset account for the snow blower. The day I bought the snow blower, my net worth didn't change. Each time I clear the driveway, I deduct part of the amount I would have paid the plow guy from the snowblower account as a sort of depreciation.
Also, for autos, I use an asset account for each car and depreciate from them at the end of each year. Again, this keeps net worth from bouncing around every time a major purchase is made.
The key to making this useful is to have Quicken/Money reports that can give you either your net worth or your liquidity. For the net worth report, include all accounts, for liquidity, include only accounts that are liquid.
I think it is ridiculous to use the accrual system to track your personal finances. Unless you are very wealthy, the differences won't add up to much. In addition, for a business it may be important to track daily "networth" but what does the average person care about daily (or even monthly for that matter) networth? The cost/benefit analysis just doesn't work out for me. But remember- never buy a drink when you eat at a restaurant. Have water instead. You'll be shocked at how cheap your bills start to look.
Everybody keeps talking about Microsoft's Money and Intuit's Quicken; one's financial activity can be tracked much better via Quickbooks. Double accounting is much easier to use than weaseling around with Money/Quicken. Quickbooks 2003 or 2004 can be acquired at little expense (I purchased Quickbooks Pro 2005 w/ a student discount for less than $100)
