Chapter 1
Financial Statements: Personal Accounting
10
Revenue increases net worth and expenses decrease net worth. The more revenue earned, the
more should be added to net worth. Therefore the revenue T-account increases on the right
side and decreases on the left side.The more expenses incurred, the more should be subtracted
from net worth.Therefore the expense T-accounts increase on the left side and decrease on the
right side.
The balance of a T-account at the end of the
period is simply the difference between all the
increases and decreases. Figure 1.17 shows
an example of the cash account. Since cash is
an asset, the left side of the T-account is for
increases and the right side is for decreases.
Cash has an opening balance of $1,000, which
is shown at the top of the increase side of the
T-account. After all transactions have been
recorded, we total both sides of the T-account,
which is shown in red in the figure. The increase
side will include the opening balance in addition
to the transactions. The difference between the
increase and decrease sides is $4,400, which is
the closing balance of cash. The difference is placed on the side which had the larger subtotal,
which is the increase side in this example.
Accrual-Based Accounting
A typical reason for personal financial failure (and small business failure) is not understanding
accruals. People tend to think intuitively that an increase in cash represents an increase in wealth,
and vice versa.The notion of the accrual is recognizing how much you are worth at a point in time.
Accrual-based accounting
means that revenue (an increase to net worth) and expenses (a decrease
to net worth) are recorded in the period in which they occur, regardless of when cash payment is
received or paid.
So far we have assumed that every expense is paid when it is incurred. In reality, many expenses
are not paid until a later date. The examples in Figures 1.18 and 1.19 illustrate how expenses are
recorded as they occur.
Assume that you have $1,000 of cash and net worth of $1,000. If you pay for a $300 expense with
cash, your cash and your net worth will decrease by $300 (see Figure 1.18).
If instead you receive a phone bill for $300 to be paid next month, there would be no change in
cash in the current month. However, the phone debt (or unpaid accounts) would increase by $300
and net worth would decrease by $300 (see Figure 1.19). In other words, you would recognize
the
expense which decreases net worth.
______________
FIGURE 1.17
CASH
+
-
$1,000
1. 2,000
4. 4,000
5. 500
Subtotal
7,500
$4,400
Closing
Balance
2. 1,500
3. 1,000
6. 600
3,100
Opening
Balance
INCREASE
DECREASE
