Accounting helps businesses track and organize financial information so business leaders can make informed decisions. Similarly in personal finance we all implement some level of accounting to help manage our finances to track, budget, spend, save, invest and file taxes. In a past life I managed multi-million dollar businesses with complex financial statements and taught basic accounting to US Air Force Officers. While individual people are not required to follow business accounting principles for their personal finance, key accounting concepts have helped me keep my personal financial path on course and helped me with many of life’s other important decisions. Here are my top 10:
- Conservatism. When budgeting and forecasting (when exact numbers are not known), always estimate expenses on the higher side and estimate income on the low side. A conservative approach will build confidence in one’s financial plan. Having conservative estimates in our financial projections helped convince my wife and I that we could afford to quit our jobs and travel the world full-time.
- Accounting Period. The accounting period is the timeframe (week, month, quarter, year, etc.) used for financial analysis and reporting. In my personal finance and rental business, I use a monthly period to track my expenses and an annual period for tax purposes. By tracking our spending and savings each month, my wife and I have a built in opportunity to discuss our finances and progress towards our goals and make adjustments. I use an annual period for net worth tracking update and taxes (since that is the IRS’s cycle) and we see our progress over time (e.g., year-over-year). Establishing the accounting period(s) helps me better manage my finances and apply the revenue recognition and matching principles.
- Revenue Recognition. The revenue recognition principle requires that revenue should be reported when it is earned, rather than when the cash is received. So for example, a catering business who receives a deposit in December on a wedding for the following June, should not recognize that revenue until the accounting period of June occurs, which leads me to the…
- Matching Principle*. The matching principle states that an expense should be reported (“matched”) in the same accounting period as the revenue generated by the expense. This allows for a better understanding of profit and loss in the accounting period (month or year). For example, when I book airfare or a month-long AirBnB in one year for future use in another year, I keep a separate spreadsheet to track these major expenses so I can account for the expenses in the month I actually used them and I have a better understanding of how much my nomadic traveling life is costing me. Note, I only do this for “major” expenses which leads me to the principle of…
- Materiality. Something is considered material if omitting or misstating it would impact a reasonable user’s decision-making. The principle of materiality requires businesses to properly account for all material items. For example, the purchase of a single $30 alarm clock for a large hotel would not require depreciating (more on depreciation later) the asset even though it would last for many years. However, purchase of 500 $30 alarm clocks for the same hotel would likely be material as the $15,000 total expense could significantly impact the current month’s financial statements. In an FI example, closely tracking and managing small expenses (e.g. daily lattes) is material for someone in credit card debt, and/or little savings, and getting started in turning their financial situation around. For those at FI or well on their way, tracking every miniscule expense is likely immaterial for that person. While my expense tracking is automated with Mint, I don’t track small cash expenses like tips and small street food and drink purchases – it is not worth my time and immaterial to my FI success now that I am FI.
- Depreciation. Depreciation is a reduction in the value of an asset with the passage of time, due to use, wear and tear, or obsolescence. Keeping depreciation in mind helps me understand how much the stuff I own (cars, furniture, outdoor gear, etc) loses value over time (often immediately after I buy it). Depreciation also makes me think about the amount of money I need to set aside in my emergency fund to replace major items that break or wear out over time. I also use depreciation to think about the value of what I buy over time. For example, if I decided to buy a $50K RV to live in full-time, I would not treat it in my tracking as a single housing expense in one month, but I would calculate the monthly depreciation expense of the RV over its useful life and consider only that portion to be my monthly housing expense.
- Consistency. The consistency principle states that businesses must use the same accounting methods across accounting periods and financial statements or well-document any changes. Applied to your FI journey, maintaining consistency of how you track your finances will help you better identify areas for improvement as well as progress over time. For example, consistently tracking my alcohol expenditures separate from eating out and groceries, enabled me to see how much I was spending in this category and the significant cost reductions when my wife and I focused on having a drink at home on our deck instead of at a restaurant or bar.
- Opportunity Cost. Possibly the most powerful financial concept on this list, opportunity cost is simply the loss of potential gain from other alternatives when one alternative is chosen. So my choice to maintain higher cash balances has an opportunity cost in terms of lost interest. For example, spending $200 at a fancy restaurant has the opportunity cost of lost long-term interest and dividends from investing the $190 (the other $10 spent eating at home instead). But likewise, investing all of my money in long-term stocks has an opportunity cost of lost flexibility (or potential financial loss). This concept also applies to my finite time on this planet and what I decide to do or not do and who I want to be. The hard part about opportunity cost is that it is often hard for me to see and value what I didn’t buy or do. For major decisions, I am in the habit of first asking myself what else could I do with this time and money before committing the resources. The answers frequently change my mind.
- Cash Flow. Cash flow refers to the net balance of cash moving into and out of a business (or your personal finances) at a specific point in time. Cash flow enables a business (or a person) to settle debts, reinvest in its business, return money to shareholders, pay expenses, and provide a buffer against future financial challenges. For example, having cash on hand enables a business to take advantage of bulk-purchase discounts even though the item purchased may not bring in income for several months or years. For FI, I like to keep a good amount of cash available to handle my cash flow needs. For example, I use a large emergency fund to self-insure for auto comprehensive and collision, travel insurance, and extended warranty protections. To meet my cash flow needs, I keep a healthy balance in my checking and savings accounts to ensure I never have to worry about covering several credit card payments at once or making large advance purchase. Before starting my nomadic traveling, I was able to fund about 8 months of advance airline and AirBnB purchases so I could take advantage of discounts and lock-in preferred choices. If too much of my money was locked up in stocks or other long-term assets, I wouldn’t be able to cash flow my spending as easily.
- Sunk Cost Fallacy. While not an accounting principle, no list of financial or business concepts should exclude the sunk cost fallacy. Simply, the sunk cost fallacy is our tendency to continue with an endeavor we’ve invested money, effort, or time into—even if the current costs outweigh the benefits. For example, the weight of spending well over $1,000 on my electric guitar, amp, and hours of lessons was keeping me from moving on even though I knew I no longer prioritized learning to play and wanted to travel and learn a language instead. This concept often applies to non-refundable purchases. If I had to miss a non-refundable show at the last minute the cost of that ticket is a sunk cost. This sunk cost should not impact my decision whether I should buy another ticket to the same show. I have to remind myself that purchases I made in the past should not prevent me from doing something different even if I can’t get my money (or time) back.
Accounting gets a bad rap being complex and boring, but it is really an important part of our financial lives and provides valuable tools to better understand and manage our finances. Like fractions and percents, everyone should have a basic foundation in accounting principles.
If you would like to learn more about the basics of accounting, the best method is taking an introduction to managerial accounting class, but since that may not fit your time or budget, there are some simple accounting books that, based on their online reviews, may help such as Wayne Label’s Accounting for Non-Accountants or Mike Piper’s Accounting Made Simple. Less-formally, search the internet for each principle above (Investopedia.com is pretty good) to find more details and examples of each. You are also welcome to drop me a question in the comments.
*A note on the matching principle. I technically use a cash-accounting system for my small rental business (integrated with my personal finances as a sole proprietorship) instead of an accrual accounting system most businesses use. As a result, I am required to report expenses (e.g., rental furnace replacement) and income (e.g., advance payment for rent) at the time I receive it for tax purposes. I use this requirement to my advantage. I plan my rental house improvements to fall in the tax year that I am trying to minimize my income, so my rental business has a lower profit in that year. Likewise, when my renters prepay their rent 6 months in advance (yes, I have some great renters!) I am able to ask them to pay on either December 31st or January 1st to enable me to recognize the revenue in the tax year I prefer. This helps me smooth out my taxable income fluctuations over tax years or help me maximize my Traditional to Roth IRA conversions in the 12% tax bracket for a particular year. This fluctuation would not follow the strict definition of the matching principle, but it allows me to “match” the expenses and revenue to my tax advantage.