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?