Thursday, February 25, 2010

Budgeting: Part 15: The Account Transfer Fallacy

"If you would be wealthy, think of saving as well as getting."

- Benjamin Franklin

(In this post and subsequent posts, I am walking though 12 different examples of household budgeting mistakes and how they can all be corrected with accrual accounting techniques. Accrual accounting recognizes income when it is earned and expenses when they are incurred. An alternate definition is that accrual accounting records events that change your net worth.)

The symptom:
Account transfers appear to be savings.

The example:
Last year you saved $500 every month by transferring the money from your checking account to your savings account or IRA. This year, however, that approach just doesn't seem to be working. There never seems to be enough money in the checking account to transfer. You are puzzled because both your income and your expenses appear to be about the same as last year.

So what happened? The first and most obvious possibility is that money is simply being transferred from one asset account to another. In other words, someone might be gradually drawing down their checking account (or other asset) and transferring it to their savings account. While this might be a reasonable investing decision, it is not saving money. For example, start with the following scenario:

$1,500 (checking account)
$5,000 (savings account)
$6,500 (total = net worth)

Then transfer $500 from checking account to savings account...

$1,000 (checking account)
$5,500 (savings account)
$6,500 (total = net worth)

Notice that the savings account grows, but not net worth. No money is being saved by the transfer. Thus, the first lesson to be learned from accrual accounting is that account transfers aren't savings. If there were any savings, they occurred earlier when income exceeded expenses. The transfer has nothing to do with it.

Another possibility is borrowing. Not paying down recent purchases on a credit card could be the source of the cash. For example, start with the following scenario:

+$1,500 (checking account)
+$5,000 (savings account)
-$1,200 (credit card)
+$5,300 (total = net worth)

Then draw down $500 more on a credit card and not pay it back. Transfer that money to savings account...

+$1,500 (checking account)
+$5,500 (savings account)
-$1,700 (credit card)
+$5,300 (total = net worth)

Again, no money is being saved. It's easy to see that the increase in the savings account came from borrowing. Unfortunately, real budgeting issues will not be as straightforward as the examples shown above. Households tend to have very irregular cash flows. It may not be so easy to spot asset transfers and borrowing masquerading as savings.

Certainly borrowing is not saving money. But also notice that the act of borrowing by itself is not an expense! Again, it's just moving money around. (However, any fees and interest you pay on the borrowed money are obviously an expense.) So if borrowing money doesn't decrease your net worth, what is the problem with borrowing?

The problem with borrowing is what you do with the money after you borrow it. If you spend the borrowed money on something that decreases your net worth (i.e. an expense), then the real problem is spending, which may be compounded by the fact that in extreme cases, the borrowing enables you to spend what you otherwise couldn't. Most chronic personal finance problems are either income problems (e.g. unemployment) or spending problems. "Borrowing problems" are usually just income problems or spending problems in disguise because borrowing can temporarily mask income problems and enable spending problems. Borrowing can also cause a cash flow crisis if you can't pay the money back according to schedule. Thus, borrowing increases risk.

Additionally, the interest and/or fees on the money are often much higher than what you might gain from the borrowed funds. In the above example, why borrow money from a credit card at 10% or 15% to fund a savings account at 2%? Financial markets are usually reasonably efficient. Generally speaking, the markets are not going to let you borrow money at a rate that is much lower than the return you could get from investing in financial instruments.

For non-financial assets, however, this may be a different story because you may be able to indirectly profit from certain scenarios. For example, the return on certain small home insulation projects can be huge. If you really had to borrow $20 to buy a few tubes of caulk, you might come out way ahead, not because you are making money on the caulk, but because if you apply the caulk to a badly sealed house, you could quickly save several times that amount of money in heating and A/C costs. The same could be true with borrowing money for a car to commute to work. While the car will go down in value, a good job could contribute substantially to your income, and overall it would be a better situation than staying unemployed for lack of transportation. Similarly, people are often surprised to learn that after interest, taxes, repairs, and other items, they often don't make money on their principal residence. However, in many cases it still makes sense to purchase because you have to live somewhere and in the long run it may be much cheaper than paying rent.

Now clearly a person cannot go on forever draining down their checking account or borrowing money to fund their savings account. Eventually they will "figure it out". However, there are several reasons why you don't want to wait until cash flows indicate there is a problem.
  1. The charade could go on for a very long time - months, even years.
  2. In the mean time, you're left with the misleading impression you are savings money.
  3. Since you assume your financial picture is rosier than it really is, you may exacerbate the situation by spending more than you otherwise would.
  4. Even after the point is reached where transfers are no longer possible, you may waste a lot of time trying to find a recent change to your financial situation. Yet the reality might be that nothing has changed! The savings were simply never there in the first place!

If you use budgeting software of any kind, here is an interesting thing to experiment with for a few minutes. Only in your budgeting software (not in real life), try transferring money from any account to another account - any transfer at all. Move $500 from your checking account to your brokerage account. Pay off $500 of your credit card balance. Make an extra $500 principal payment on your mortgage. Borrow $500 from your home equity line of credit. (Remember to delete all these hypothetical transfers when you are done experimenting.) What happens to your net worth after you make each transfer? Absolutely nothing! With the possible exception of any transfer fees, your net worth is exactly the same as before! Thus, an account transfer is neither savings nor an expense. It's simply moving money around.

It may seem obvious that savings results from income exceeding expenses and not merely from moving money around. On the other hand, if you ask someone how they know that they are saving money, they almost invariably respond that their savings account of choice has increased. In other words, money has been transferred to that account. A few people might indicate that their expenses are less than their income, but unless their "income" and "expenses" are accounted for properly, their "savings" may be only a mirage.

Saturday, February 13, 2010

Budgeting: Part 14: The Accrual Solution

"Everything is simpler than you think and at the
same time more complex than you imagine."

- Johann Wolfgang von Goethe

Given the title of this post, I'm sure there are about three people actually reading it. That is unfortunate given the number of household budgets that could greatly benefit from simple accrual techniques.

Unless you are an accountant, you probably have only a vague idea of what accrual accounting involves. You may know that corporations use it, and you may wonder what it could possibly have to do with your household budget. You may also have heard that accrual accounting is complicated and involves hundreds of rules.

The good news is that you don't need to understand the details about accrual accounting to use it in your personal finances. Accrual accounting is complex for corporations because they have hundreds of rules about how to apply it in different situations to make sure that audited financial reports are uniform. Fortunately, you don't need to worry about those rules in your personal budget.

The basic concepts of accrual accounting are very simple. In many cases, you don't even need to do much different with the way you handle your household budget. The important thing is that you understand the fundamental idea of accrual accounting and that you consciously frame your budgeting and spending decisions through that lens.

The main idea of accrual accounting is really very simple:

Accrual Accounting: Income is recognized when it is earned and expenses are recognized when they are incurred.

This can be contrasted with cash accounting:

Cash Accounting: Income is recognized when cash is received, and expenses are recognized when cash is paid.

Here is an example of cash accounting versus accrual accounting. It is a totally trivial example, yet it shows show quickly things can get confusing with cash accounting.
You go out to eat tonight at a restaurant. The meal costs $25 for everything. How do you account for it?

In accrual accounting, it's very obvious what to do. You incurred the expense today, so you account for it today.

With cash accounting, there could be several possibilities.
  • If you paid cash, you would account for it today.
  • If you paid with a credit card, you would account for it 30-60 days later when you use cash to pay off your credit card.
  • If you paid for it with a restaurant gift card you bought last year, then I suppose you accounted for it last year!
  • What happens if you paid by credit card, and then don't pay off your balance next month? When do you finally account for it?
  • What happens if you paid for it with a general gift card you bought last year? At the time you bought the card, you wouldn't have known that you would use it for dining. Do you go back and adjust your budget from last year? Is that meaningful? (Hint: no.)

An even simpler definition of accrual accounting that is still fundamentally sound is:

Accrual-basis accounting records financial events based on events that change your net worth.

Can that previous sentence really transform the way you approach your personal finances? Yes, I believe it can. It might seem strange that something as simple as one sentence could be the consistent solution to all 12 examples of different budgeting mistakes in my previous post. But as the introductory quote from Goethe indicated, sometimes there are simple unifying principles that can be applied to a wide array of unbelievably complex problems.

Unfortunately, most people intuitively frame their personal finance decisions around cash events. Now cash inflows and outflows are certainly very important. Cash needs to be in the right place at the right time to meet our obligations in life. However, reducing everything to cash flows generally doesn't give you a very good view of what is happening with your finances. In fact, for a lot of people, understanding how to apply accrual accounting might be the most significant thing they could learn to help improve their personal finances.

Accrual accounting can give you a unified view of your financial picture. As I gradually corrected many of my financial mistakes over the years, I noticed that a lot of the errors were caused by framing everything as cash flow. In other situations, I was actually making good decisions, but I could not explain why my choices made sense and sometimes I got really confused about how to evaluate things. Accrual techniques gave me the tools to understand why those decisions were correct.

I hope you will walk through these examples of budgeting mistakes and their correction by accrual methods in the next few posts.

(As a side note, I'd also like to mention that there are a lot of phony arguments on the web about "cash flow vs net worth". Many of these arguments attempt to show that only one of these measurements is critical, while the other measurement is not very important. These arguments are completely bogus, and I suppose they grow out of our collective fascination with trying to reduce everything to a single concept or number. The reality is that these two concepts measure two very different things and they are both equally important.)