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Saturday, March 27, 2010

Budgeting: Part 18: The Depreciation Fallacy

"Time destroys the groundless conceits of men;
it confirms decisions founded on reality."


- Cicero


(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:
Depreciation doesn't feel like a cost.

The example:
Two years ago, you felt like your household finances were completely out of control. That was the year both you and your spouse each bought a new $25,000 car, not to mention a new computer, a new entertainment center, and new carpet throughout the whole house! It was almost reckless, and you used up almost all your savings on those spending binges. But then things changed. Without all that crazy spending on big-ticket items, you managed to save almost $10,000 last year, and you're on track to do it again this year! You congratulate yourself on your self-control, and you feel good that you finally have your act together.



The good news is that the original spending spree wasn't as bad as you might think. The bad news is that a lot more money is being spent each year than you might realize. To be blunt, the above budget is not in great shape, and to understand why, we need to talk about depreciation.

I seem to have a hard time convincing some people that depreciation is a real cost. Some people think depreciation is just an arcane accounting device, while others only see it as a tax giveaway on their rental property or their business equipment. But the fact is that depreciation is very real and very significant.



What is depreciation?

In the most general sense, the word depreciation simply means a lowering in value. Beginning in the 20th century, however, the word often began to be used to mean something more specific: the reduction in value of an asset, usually due to normal wear. In accounting, the word is further narrowed to mean the allocation of an asset's cost across its useful life.

Exactly how a corporation calculates that allocation is based on many factors, including the item being depreciated, the accounting standard used, the particular financial statement being prepared, and even the discretion of management. But like the other accrual concepts we've discussed so far, you don't need to get bogged down in those details to use the basic concepts in your household budget.



Why is depreciation important?

If you ask an accountant why depreciation is important, you might get a technical answer that depreciation is necessary to fulfill the matching principle, the time-period principle, and accrual basis accounting in general. (The matching principle attempts to match related revenue and expenses in the same time period, while the time-period principle makes the assumption that you're using an accounting system where it's possible to divide things into whatever time periods you desire.)

But let me keep it simple and practical. Corporations are required to use depreciation because it provides much more useful information to investors and creditors. Similarly, if you account for depreciation in your household budget, it will provide you with much better information.

If you merely record all your cash outflows, you're missing a lot of valuable information about your finances. A $3,000 cash outflow for a week at a resort is fundamentally different than a $3,000 cash outflow to purchase a used car. Why? It's different because after you've stayed at the resort, the money is truly gone. The car, on the other hand, still has value. The car will last for a while, and in the mean time, you can sell it to someone else and get some of the money back.

Like the inventory example a couple of posts back, it's misleading to view the $3,000 payment in isolation as an immediate cost. When you purchase the car, you are exchanging money for the car. You actually then incur the cost of the car as you hold onto it and use it. Your real cost each year for the car is the depreciation - how much it declines in value. That's how much the car is costing you each year. (Of course there are other car costs, like gasoline, maintenance, and insurance, but the depreciation cost is the basic cost just to hold onto it as opposed to selling it.) It's also your change in net worth due to owning the car.



What if depreciation still doesn't feel like a real cost?

If you are still having trouble grasping that depreciation costs are real, try these three exercises.
  • Imagine buying the item in question at the beginning of the time period and then selling it at the end of the time period. For example, imagine buying a two year old Camry at the beginning of the year and then selling a three year old Camry at the end of the year. This is one way to understand how much the car is costing you just to own it over the year. (This roughly corresponds to an accelerated depreciation method such as the declining-balance method.)
  • Imagine a way to finance the item so that the cash costs are evenly spread out over the life of the item. For example, suppose you pay $15,000 in cash for a car and then run it into the ground over five years. Instead of paying $15,000; $0, $0, $0, $0 for five years, you could have paid $283/month for 5 years at 5% interest. And if you were able to get a 5% return on the money you didn't pay up front for cash, you could reduce the effective cost down to $250/month. (This roughly corresponds to straight-line depreciation.)
  • Imagine that you will need to buy the same item after it is used up and that you need to save up for it in the mean time. For example, suppose you currently have a brand new car and that after 5 years, you would like to sell it and get another new car. How much will you need to save per year so that you will have the money to pay for it? For example, suppose you have a $20,000 brand new car and suppose you figure it will be worth $10,000 in five years as a trade-in for your next vehicle. That means you will need to save $2,000/year for the next 5 years in order to have the $10,000 (plus the trade-in vehicle) to buy the new car in 5 years and maintain your same standard of living over time. (This also roughly corresponds to straight-line depreciation.)



How do I calculate depreciation in my household budget?

Like all of these accrual accounting concepts, the biggest benefit is the ability to think correctly about your finances. However, unlike some of the other concepts, depreciation costs are large enough (for most people) that it is worth actually calculating at least some of these costs. If you own cars (or boats), I would suggest marking them to market each year. If you use budgeting software, simply create an asset account for your vehicle and adjust the value each year. You can easily find out the value of your car in just a few minutes at sites like edmunds.com. If you live in a jurisdiction that has a car tax, this information may already be sent to you each year.

For most other common items, there is no meaningful resale market, so I would suggest simply dividing the original cost of the item by its life (i.e. straight-line depreciation). The only decision to make is to determine how long the item will last. In most cases, it won't be that difficult to guess what an average lifespan will be. Just be honest with yourself, be reasonably conservative, and keep it simple. For example, if you buy a water heater and it has a 9-year warranty, then just use 9 years as its life.

An important thing to understand is that repair costs are not the same as depreciation costs. Even if you don't need to make any repairs, most kinds of items will still depreciate. For example, suppose you only needed to spend $100 on vehicle repairs last year. In that case, your repair costs are small. However, your vehicle is still worth considerably less than last year simply because it is a year older. Also note that you can't (substantially) increase the value of the car just by performing more and more repairs. In fact, some legal definitions stipulate that depreciation is the decrease in value that cannot be offset by repairs! This distinction is very important and will come in handy with a couple of the budgeting examples in future posts.



What are the consequences of ignoring depreciation?

Depreciation recognizes that if you own something that is gradually going down in value, it is costing you something to hold onto it. Recognizing that shows you how much it costs you to maintain your current lifestyle. It also allows you to compare those costs with other years and with other alternatives. In contrast, ignoring depreciation gives you a totally distorted view of your finances. It makes you feel that ownership of a depreciating item is "free" and makes it very hard to compare different alternatives and different time periods.

There is also a psychological danger in using cash based accounting for big ticket items like vehicles. It is human nature for people to mentally frame their personal finances to isolate gains and integrate losses. (I have previously discussed this phenomenon in an earlier post about mental accounting.)

In the above example, the couple spent approximately $60,000 in one particular year for a variety of things they will use for many years. The temptation is to lump all the original purchases into the past and forget about them, perhaps viewing them as "one time events" or undisciplined spending of your "former self". Then we would like to take each subsequent year in isolation and gloat over the fact that we aren't spending anything on those items this year. That seems much nicer than saying that these things are costing us something each year. So without recognition of the depreciation, costs appear much less than they really are, which in turn gives the pleasant illusion of $10,000 per year in savings. However, the yearly savings are largely an illusion.

It would not be unusual for the yearly depreciation of a new vehicle to be 15% per year during the first two years. Hence, the depreciation costs on the two vehicles alone would be $7,500 the first year and $6,375 the second year, and the depreciation on the other items would likely eat up another couple of thousand dollars per year. The sobering reality is that real savings may be close to zero.

When corporations engage in this sort of behavior it is called big bath accounting. Hence, a corporation may take a $5 billion "one time" charge, followed by a $500 million yearly profit for 10 years. As you can imagine, the original charge is long forgotten as something that happened in the distant past and is completely behind the company. The subsequent yearly profits, however, are trumpeted as consistent and reflective of the company's true earnings power.



What's wrong with just using the cash costs?

I understand why people question whether costs have to be allocated in your personal budget. Why not just keep it simple? In the above example, why not just recognize that $60K was spent on these items in the first year and nothing else was spent on those items in the next 5 years? Doesn't that fully capture everything?

I would be completely willing to accept that argument if those items were the only household spending and if we agreed to frame all financial discussions as a 5 year time period. Then the cash based and accrual based systems would converge.

But in fact people don't frame their financial discussions that way at all. Instead, we talk all the time about our costs for this year and next year and whether we saved more money last year than this year. Without allocating costs into yearly buckets, all these yearly numbers and yearly comparisons become meaningless. Additionally, various items are typically purchased at different times and have different lifetimes. Depreciation provides a way of generalizing all that spending information so that different time periods can be correctly compared.

Monday, March 8, 2010

Budgeting: Part 17: The Payment Deferral Fallacy

"If you think nobody cares if you're alive,
try missing a couple of car payments."


- Earl Wilson


(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:
Costs don't seem like they are incurred until you pay them.

The example:
Your goal is to pay off an extra $1,000 on your student loan at the end of each month. The payback requires a sustained effort each month, but you feel the sacrifice is worth it to get the debt monster off your back. Near the end of some months, it appears you won't be able to make your goal, but you are determined. During the last week of the month, you usually stop paying for anything with cash, and start using your credit cards for everything. That way you'll have the money on hand to pay extra on the student loan. You also delay some utility bill payments a few days into the next month. Even if you have to pay a small late fee, it's worth it to keep the paybacks on schedule.



You know the drill. Examine when expenses are actually incurred. Examine what happens to net worth.

First, realize that the extra $1,000 loan payback is neither income nor expense - it's merely an account transfer. Second, determine the effect of the transfer. The typical interest rate on a student loan is about 7%. Thus, applying the $1,000 to a student loan balance saves you about $70/year. So far so good. But the other side of the coin is the source of the money. If the money was just sitting around in a checking account earning nothing, then applying it to the student loan balance is probably reasonable. In the example, however, there was a shortfall of current cash that was made up by temporarily ignoring current bills and by increased credit card use. Both of these actions can be shown to be unwise.



When did you incur the utility expenses? You incurred them when you used the electricity or water or gas. Not paying the bills doesn't change the fact that you've already incurred the expenses. Not paying the bills doesn't make you more wealthy, and paying them doesn't make you less wealthy. The payment is just an account transfer. You became less wealthy (i.e. your net worth decreased) when you used the utility services. However, not paying the bill on time indirectly costs you money through late fees, interest, and lower credit ratings!



The strategy of paying for everything with a credit card also doesn't really help the situation. At best, it postpones the cash outflow of your spending by a few weeks. Assuming nothing changes, the next month you will also be short the extra money you want for the loan prepayment, plus now you'll have an additional credit card bill for the items you purchased on credit last month. For example, suppose you were short $200 last month and resorted to borrowing $200 on your credit card to come up with the money for the student loan prepayment. The next month you'll be short $200 again plus you'll have a $200 credit card bill due. At that point, you have two options:

Option #1
  • Pay the $200 credit card bill.
  • Realize you are now $400 dollars short for the prepayment.
  • Only pay $600 extra on the student loan.
  • Realize that $1000 last month plus $600 this month = $800 per month.
  • Learn that you can't game the system by paying down more than your real monthly savings.

Option #2
  • Don't pay the credit card bill.
  • Borrow another $200 dollars on your credit card.
  • Pay $1,000 extra on the student loan.
  • Don't realize that you are simply borrowing money on a credit card at 10% or 15% to payoff a loan at 7%.
  • You are gradually replacing student loan debt with credit card debt. This is horrible financial management.




In the above example, also note the inclusion of a controversial item often discussed in the blogosphere: the artificial cash-flow crisis. No one is forcing you to pay back the student loan early. A conscious choice is being made to create an artificial cash-flow crisis each month. Although these devices are popular with many bloggers, generally speaking, I'm not a fan of these contrivances. The usual argument is that an artificial cash-flow crisis will motivate you to do what you otherwise couldn't bring yourself to do. Personally, I think it's highly debatable whether people who don't otherwise have the motivation to follow through on unpleasant austerities will be able to do so by simply manufacturing a crisis. It doesn't sound logical, but people are not entirely rational and so there may well be instances where this can change motivation. Thus, I'm not really sure how well this works as a motivator.

But what I'm much more certain about is that when people encounter a cash-flow crisis, whether self-inflicted or otherwise, they tend to make a lot of bad financial decisions. The fact is that it's usually very easy to temporarily alleviate a cash-flow crisis. For most people in most circumstances, there are many, many ways to temporarily shift money around to fulfill your obligations in the short term. However, many of these ideas reduce your net worth and/or create a much bigger cash-flow crisis later.



Here's an example. One person says it's mathematically better not to get an income tax refund at year end because that money could have been invested during the year. Another person comes along and says that although the math is correct, as a practical matter, they will spend all that extra cash flow each month. They claim that if they have it in their pocket, they will spend it. Hence, rather than having $500 of extra cash flow each month, they claim it's better to get a $6,000 refund, which will supposedly then be recognized as a significant amount of money and not frivolously spent. I suppose this might work for some people. Maybe some people would blow the extra $500 per month but they wouldn't blow a big lump sum. I don't know.

But what concerns me is whether the person is making a lot of really poor decisions by not having that extra $500 per month. When people don't have much cash sitting around and they want things, they resort to ideas that might be worse than simply spending cash. In other words, it might be better to let the person have the $500 each month and blow it, rather than have them move their money around in order to spend the $500 from other sources. The $6,000 refund won't be such a great idea overall if the person ends up spending $500 extra each month anyway by borrowing it on credit cards or raiding retirement accounts or not paying bills or the many other ways that people can temporarily circumvent the absence of cash in the pocket. After all, someone who already claims to have no discipline about handling $500 each month would seem to be able to find a way to blow $500 each month even without the cash sitting in the checking account.

Thursday, March 4, 2010

Budgeting: Part 16: The Inventory Drawdown Fallacy

"I have enough money to last me the rest of my life,
unless I buy something."


- Jackie Mason


(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:
Household inventory drawdowns seem like frugality.

The example:
This past year you instituted a no-shopping weekend every other week. You didn't buy any groceries or household products on those weekends. Instead, you simply ate and used only what you had on hand in your house. It sure seemed like you were spending a lot less money, but as you total things up at the end of the year, you are surprised to find that you've spent about the same as the prior year.



It's interesting how many people think they are "saving money" if they don't buy groceries this weekend. But think about it. If you consume $10 worth of food each day, it doesn't really matter how often you shop for it. You can shop once a day, or once a week, or once a month. The result is the same. You are still consuming $10 worth of food each day. Paying $140 for groceries every other week is the same as paying $70 for groceries every week!

Let me briefly explain what I mean by a "household inventory drawdown". Like a business, your household maintains an inventory of items on hand that you are always purchasing and consuming. Your household inventory consists of a variety of different things, including food, soap, paper, medicine, cosmetics, batteries, etc. Unlike a business, however, you directly consume your inventory rather than reselling it or assembling it into something else. Both business and household inventory levels can fluctuate significantly for many reasons. An increase in inventory levels is an inventory buildup and a reduction is an inventory drawdown.



So why do household inventory drawdowns seem like frugality? It feels like you are saving money because there is no immediate trip to the store and no immediate cash outflow. And if you had previously intended to shop that weekend, it sure seems like you are delaying gratification because you're delaying that shopping. However, assuming your food consumption stays the same, you are only delaying the purchase for a few days. More importantly, the longer you delay the purchase, the more you will need to buy to restock your inventory. Hence, you aren't really reducing spending or savings money. Since you're not reducing consumption, you're merely shifting the timing of the cash outflow by a few days.

While the above analysis should be intuitive, focusing on cash flows alone can sometimes cause confusion. So if you need some mathematical underpinning to accept the above line of reasoning, then consider the following accrual concepts.

When you purchase groceries, you are exchanging money for food. The act of purchasing the food doesn't really change your net worth. If you bought $100 of food, you now have $100 less money but $100 more food in your kitchen. Your net worth decreases only when you consume the food (or waste it by throwing it out).

You actually incur a food expense when you eat the food. The cash flow to purchase the food could have come earlier (on an inventory buildup) or could come later (if you purchase the food on credit). Although these sorts of purchases can cause very uneven cash flows, the accrual of your food expenses is relatively constant.



Having said all that, the consumption of your groceries is surely not something you should track. It would require an enormous amount of effort to calculate the value of the food you ate each day or week. While it would indeed show that your real food expenses are probably quite steady most of the time, it wouldn't be worth all that effort. Instead, you can simply be cognizant of the basic accrual concepts without tracking them in your budget.

The two important points to understand are:
  • Household inventory buildups are not usually an expense because they are merely an exchange of money for goods.
  • Household inventory drawdowns are usually an expense because they are the consumption of the goods.



Why is it helpful to view your finances this way?
  • An accrual view helps you understand why your grocery bills vary considerably. More often than not, increases and decreases in grocery bills have little to so with saving or not saving money. Usually the fluctuations simply reflect how much inventory you are buying. Thus, increases aren't usually cause for worry and decreases aren't usually cause for celebration.
  • An understanding of cash-flow variations helps you avoid gimmicks like temporarily not buying groceries and toilet paper. This doesn't save you money, and it creates delusional thinking.
  • Avoiding gimmicks allows you to concentrate on things that really do save you money. Instead of adjusting your grocery shopping schedule, learn to buy and consume cheaper food. Instead of worrying about how often you buy paper towels, concentrate on how often you actually consume them.



I have worked through the easiest of the 12 examples first. Some of the later examples are more complex and the issues are more subtle, but if you thoroughly understand the simple examples, you will be able to dissect and correct the harder ones without difficulty.