CFP Board Financial Planning Competency Handbook. Board CFP

Matching principle (expenses have to be matched with revenues).

      The key statements in business accounting are the income statement (also called the profit and loss statement), the statement of financial position (often called the balance sheet), and the statement of cash flows. In addition, firms sometimes present statements explaining changes in equity or net worth. In general, planners should be familiar with business statements because sometimes their clients own businesses. Also when planners recommend the purchase or sale of individual securities, they must analyze and interpret GAAP-prepared statements of the prospective investments they are considering. An individual company security analysis recommendation is based on intimate and detailed knowledge of these statements and their associated accounting footnotes. For a planner who is not dealing with these situations, only a very general understanding of business accounting is necessary.

      The key statements for individual or family accounting are different. Whereas the income statement is generally considered to be the most important statement for businesses, it does not exist in individual accounting. The statement of financial position and cash flow statements are the most important statements in family finance. Budgets are actually pro-forma or forecasted cash-flow statements that are used for the purpose of tracking actual expenses relative to the amount budgeted for them.

      The importance of financial statements to the financial planning process may be, to some, a bit debatable. It would be possible to complete even a comprehensive financial plan without ever creating or analyzing a financial statement. However, most finance professionals agree financial statement analysis is the normal starting point for the evaluation of a company’s or individual’s financial condition, and is thus an excellent source of evaluating a client’s strengths and vulnerabilities of their current condition. Although it is not a clear practice standard that financial statements always be generated and evaluated, it is clearly a useful practice.

      The learning objectives reflect the needs of all planners to generate and analyze their clients’ financial positions and for planners who engage in specific areas to fully understand business accounting techniques.

      LEARNING OBJECTIVES

      The student will be able to:

      a. Construct statements of financial position and cash-flow statements as applied to clients consistent with sound personal accounting standards.

      Certain common conventions are widely practiced within financial planning. First, assets listed on balance sheets are properly listed with the safest and most liquid types first and the riskiest and least marketable last. Although grouping of assets into categories varies, at least three groups are common: safe (sometime called liquid or cash assets) are usually listed together, as are all investment assets and all personal (or use) assets. There is no agreement on whether business ownership (partnerships or proprietorships) should be listed separately, with investments, or with use assets. Another important tool is the use of footnotes to the statements a planner creates. Footnotes may list contingent assets (e.g., an expected year-end bonus or inheritance) or contingent liabilities. In fact, footnotes should list or explain any item whose omission would cause a material misunderstanding of the client’s financial position.

      The AICPA Personal Financial Statements Guide provides specific instructions for the construction of financial statements for individuals. Probably the most important innovation is the computation of taxes due on the liquidation of assets as a reserve liability account that results in an after-tax and more meaningful valuation measure of an individual’s net worth. Although most planners do not show this figure, its use would improve the usefulness of the net worth figure.

      Cash flow statements show revenues first and expenses later, sometimes in the following manner:

      Alternatively, instead of “fixed” and “variable” expenses, planners sometimes list categories of expenses, such as home ownership costs, food and restaurants, automobile expenses, and so on.

      b. Evaluate client financial statements using ratios and growth rates and by comparing them to relevant norms.

      Analysis of corporate statements usually begins with the computation of standard ratios and growth rates and the comparison of those ratios and rates with industry norms, usually adjusted for the size of the firm.

      Common ratios used in corporate analysis include liquidity ratios, profitability ratios, debt ratios, activity ratios, and investment valuation ratios. There are dozens of commonly measured ratios used to analyze a business’s financial condition.

      DuPont analysis is a common analyst’s tool. It decomposes return on equity into several components such as profit margin and asset turnover.

DuPont System 46

      Once ratios are computed, they are compared with those of similar companies. That means companies of comparable size and in the same or a similar industry. A common source of comparison ratios is Risk Management Associates (RMA).47 It is important to note that, apart from profitability measures, there is no such thing as a “good” ratio. The purpose of computing ratios is to better understand the nature of the firm. For example, a high liquidity ratio may be desired by a lender, but if it is too high it may indicate a lack of investment prowess by the firm’s management.

      Whereas ratios make comparisons among accounts in a business’s or client’s financial statement, growth rates review changes over time. The two most important growth rates are growth in gross income over time compared with growth of net worth over time. The computation of ratios for individuals is a newer and less developed science than for businesses. Bankers have used debt ratios to determine whether it is a good idea to lend to a family. But just because a family is able to borrow does not mean it should borrow. There are several good sources of ratios for use in evaluating family statements; some even contain norms for purposes of comparison.48 They divide ratios into various types: liquidity, savings, asset allocation, inflation protection, tax burden, housing, and solvency.

      In the introductory section, we mentioned some key differences in accounting principles for individual financial statements and corporate statements. However, probably the biggest difference is the use of market valuation of investment assets and replacement cost for individuals’ personal assets. This would be problematic for businesses because it would enable managers to easily manipulate earnings. Further, most business assets are not valued by the market directly.

      Whereas the single most important number in corporate accounting is net income, probably the most important number in individual statements is net worth. However, net worth is commonly overstated for individuals who own appreciated assets or tax-deferred assets (individual retirement accounts [IRAs], for example). The solution to this problem, employed by the American Institute of CPAs (AICPA), is to reduce net worth by taxes that would be paid if all investments were shown after tax. The AICPA calls this amount the estimated income tax on unrealized appreciation, but we could simply call it a tax reserve.

      It is important to remember that the sole purpose of planner-prepared statements is a better understanding of a client’s financial position.

      IN CLASS

      **Appropriate for both on-campus and distance courses.

      PROFESSIONAL PRACTICE CAPABILITIES

      Entry-Level: An entry-level personal financial planner can prepare and evaluate financial statements for a family.

      Competent: A competent personal financial planner can compute growth in earnings and net worth to determine if the client is making good progress toward stated goals.

      Expert: An expert personal financial planner can evaluate a firm’s financial condition given its 10-K and 10-Q reports and determine for whom, if anyone, it would

46

Zvi Bodie, Alex Kane, and Alan J. Marcus, Investments, 9th ed. (New York: McGraw-Hill Irwin, 2011), 635.

47

www.rmahq.org.

48

Sue Greniger, Vickie Hampton, Karrol Kitt, and Joseph Achacoso, “Ratios and Benchmarks for Measuring the Financial Well-Being of Families and Individuals,” Financial Services Review 5, no. 1 (1996): 57–70.